Insuring Federal Housing Administration Mortgages

All FHA loans require two types of mortgage insurance

Reviewed by Thomas BrockReviewed by Thomas Brock

The Federal Housing Administration (FHA) insures mortgage loans to protect FHA-approved lenders against default or nonpayment by borrowers. As a result, FHA-insured loans offer benefits to borrowers, including a lower down payment—as low as 3.5%—versus the typical 20% required for conventional mortgage loans.

However, borrowers with an FHA loan must purchase mortgage insurance, which protects the lender in case of nonpayment. Although there’s a cost to mortgage insurance, it can be a better option than waiting several years until a borrower can save a large enough down payment to avoid it.

Discover how Federal Housing Administration (FHA) mortgage insurance works, how much it costs, and when you can stop paying for it.

Key Takeaways

• FHA mortgage insurance protects lenders from losses that result from default.
• Borrowers with an FHA loan must purchase FHA mortgage insurance.
• FHA-insured loans require borrowers to pay an up-front mortgage insurance premium of 1.75% of the total loan amount.
• FHA-insured loans also require an annual insurance premium as a percentage of the loan amount, and is based on the loan’s size and down payment.
• The length of time you must pay for FHA mortgage insurance depends on your down payment.

FHA Mortgage Insurance: An Overview

The Federal Housing Administration (FHA) is overseen by the U.S. Department of Housing and Urban Development (HUD). Although the FHA insures the loan, you must go through an FHA-approved lender. 

If a bank lends money to someone with a lower-than-average credit score or a less-than-perfect borrowing track record, they want assurances they will get repaid. Mitigating the risk of loss is the underlying principle behind mortgage insurance.

Although it protects mortgage lenders from loss, FHA mortgage insurance can also help borrowers qualify for a mortgage loan that might be out of reach using a conventional loan with its larger down payment.

FHA Qualifications

FHA loans are attractive to many consumers, especially first-time homebuyers, due to the lower down payment requirement of 3.5% and lower income and credit score thresholds. Your credit score is a type of credit rating that represents your creditworthiness and is based on your credit history contained in your credit report.

With an FHA loan, a borrower with a credit score as low as 580 may qualify for a mortgage, and those with a credit score between 500 and 579 can qualify with a 10% down payment.

FHA Mortgage Insurance

All FHA loans require borrowers to take out mortgage insurance and require that the property is in an insurable condition without needing costly repairs. FHA mortgage insurance protects the lender because borrowers—particularly new ones—pose a higher risk of default when they have minimal equity in their homes.

The Cost of FHA Mortgage Insurance Premiums

The FHA requires two types of mortgage insurance on its loans: An upfront premium followed by an annual premium. Below contains the costs of FHA mortgage insurance premiums.

Upfront Mortgage Insurance (UFMI)

Borrowers must pay an up-front mortgage insurance premium (UFMI) of 1.75% of the loan balance. Below are examples of the UFMI cost based on various loan amounts:

• $100,000 loan: $1,750
• $250,000 loan: $4,375
• $350,000 loan: $6,125

The mortgage lender may allow you to finance the upfront mortgage insurance amount, which would get rolled into the loan balance. However, you would pay interest on that amount, and your monthly payment would increase slightly since the total value of the loan would be higher.

FHA Annual Mortgage Insurance Premiums

In addition to the upfront MIP, borrowers must also pay an annual mortgage insurance premium (MIP) based on the total value of the loan. The cost of the annual MIP can range from 0.15% to 0.75% based on the loan amount and the size of the down payment.

The table below breaks down the costs for loans that are $726,200 or less.

The table below breaks down the costs for loans that are greater than $726,200.

With a down payment of 10% or more, you must pay the annual MIP for 11 years, but if your down payment is less than 10%, you pay the annual MIP for the loan’s lifetime. The only way you can get rid of the annual MIP is by refinancing the loan to a conventional mortgage, such as a fixed-rate 15-year or 30-year loan.

Example of FHA Mortgage Insurance

To demonstrate, here’s how much you’d pay in FHA mortgage insurance with a $300,000 loan:

• Mortgage Amount: $350,000
• Down Payment: $12,250 (3.5% of $350,000)
• Loan Amount: $337,750
• UFMI: $5,911 (1.75% * $337,750)
• Annual MIP: $2,533.13 each year (0.75% * $337,750) or $211.09 per month

The example assumes you pay the upfront premium at the loan’s closing and don’t roll it into the loan amount. If you roll the UFMI into your loan, you’ll increase your loan balance, costing you more in interest and a higher annual mortgage insurance premium payment.

Warning

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report with the Consumer Financial Protection Bureau or HUD.

Avoiding or Getting Rid of FHA Mortgage Insurance

Because FHA mortgage insurance adds a significant expense to the cost of homeownership, it’s preferable to reduce or avoid it. The most straightforward way to avoid mortgage insurance is to put down 20% at the loan’s closing. You can do this by waiting to buy until you’ve saved more or purchasing a less-expensive property.

However, coming up with a 20% down payment can be challenging for many borrowers. You can also refinance the FHA-insured loan into a conventional fixed-rate mortgage, if mortgage interest rates have fallen enough for it to worth the closing costs.

One way to remove mortgage insurance through refinancing is to wait for your home’s value to appreciate. For this to work, your home’s value will need to appreciate enough to give you 22% equity in the house. You can also wait until you’ve paid enough in monthly payments so that your loan balance decreases enough that you have 22% equity in the home.

If you can’t refinance, consider paying down your principal balance. This will help you get rid of mortgage insurance more quickly and help you pay off your house faster, reducing the amount of interest you’ll pay over the long run.

If you take this route, you will need to contact your lender to get your mortgage insurance canceled. Some lenders may offer special loan programs that don’t require monthly mortgage insurance premium payments despite a small down payment, making it vital to shop around.

Important

Your lender is supposed to automatically drop mortgage insurance when you hit the appropriate loan-to-value ratio of 22%.

FHA vs. Private Mortgage Insurance (PMI)

An alternative to FHA mortgage insurance is private mortgage insurance (PMI). You may be required to buy PMI as a condition if you have a conventional mortgage. PMI is provided by a private insurance company and arranged by the lender. Like FHA mortgage insurance, PMI protects the lender, not the borrower.

You must purchase PMI if your down payment is less than 20% of the total loan. Many lenders also require PMI when you refinance your mortgage with a conventional loan and the equity is less than 20% of the property value. However, there’s a big difference between FHA mortgage insurance and PMI: Not all lenders require an upfront mortgage insurance payment.

PMI can cost anywhere between 0.2% to 2.0% of the total loan value annually, so a mortgage of $200,000 will cost you as much as $4,000 more each year at the maximum rate of 2.0%. Of course, your rate depends on your credit score—the better your credit, the lower the rate. If your credit score is lower, you will need a larger down payment before you’re offered any type of insurance.

FHA mortgage insurance requires a minimum credit score of 580 to be eligible for a 3.5% down payment. However, most private lenders require a credit score of at least 620, which still allows you to buy a home sooner. If you have to have mortgage insurance, the FHA kind can be the lesser of two evils.

If you’re a veteran, service member, or an eligible surviving spouse, you may qualify for a VA mortgage loan, which is partially guaranteed by the U.S. Department of Veterans Affairs. As a result, you can often get a home loan without a down payment or private mortgage insurance (PMI).

Know that there has been considerable discussion about the impact of redlining and other forms of discrimination in the private mortgage insurance industry. Although many private mortgage insurers do not discriminate, be aware that it can happen and report it promptly.

What Is Up-Front Mortgage Insurance (UFMI)?

UFMI is a one-time payment of 1.75% of the FHA loan amount usually made at the start of a mortgage. The amount can be rolled into the mortgage amount instead of being paid upfront, which will result in you paying more money over time for your mortgage.

What Are Annual Mortgage Insurance Premiums (MIPs)?

MIPs are paid once a year based on the total value of the FHA loan and its term, which is in addition to paying UFMI.

What Is Private Mortgage Insurance (PMI)?

PMI is required for mortgages where the down payment is less than 20% of the purchase price. It can cost between 0.2% and 2.0% of the loan amount and is generally more expensive than the mortgage insurance paid on FHA loans.

When Does Paying Mortgage Insurance End?

When your home equity reaches 22%, a lender is required to stop charging mortgage insurance automatically. When it hits 20%, you can request that it be dropped.

The Bottom Line

When considering an FHA loan with a small down payment, consider whether the UFMI and the monthly MIPs are worth paying to buy a house sooner. However, waiting to buy a home has risks since housing prices or mortgage interest rates might increase by the time you’ve saved enough for a sizeable down payment. Please consult a mortgage professional or a financial expert if you’re unsure if an FHA loan is right for you.

Read the original article on Investopedia.