Created under the U.S. Housing Act of 1934, the Federal Housing Administration (FHA) is charged with promoting home ownership and has helped tens of millions of Americans reach that goal. FHA insures loans made to lower and moderate income borrowers as well as those made to first-time home buyers for the purchase of that initial property. FHA is part of the U.S. Department of Housing and Urban Development (HUD) and is overseen by HUD’s secretary.
FHA Loan Programs
FHA charges mortgage insurance premiums on every loan it covers in order to provide lenders with a level of security against defaulting borrowers. HUD has enforcement responsibility for the Fair Housing Act which also created Ginnie Mae.
Mortgage Insurance Premiums (MIP)
Depending on the specific transaction, MIPs are paid through upfront charges and on an annual basis, broken up into monthly installments built into the mortgage payment.
For all 30-year FHA mortgages and some 15-year FHA mortgages, the upfront MIPs are collected at the time of closing and also require the annual payment. Under FHA rules, MIPs are required for a period of at least five years on all loans. Once the minimum five-year period is reached, the loan-to-value ratio (LTV) reaches 78%, and the borrower has a history of making payments on time, the annual MIP is automatically canceled. The 78% threshold is based on the original appraised value or the original sale price, whichever is lower. Note that cancellation of the premium is not automatic if the borrower has a history of late payments.
Since 2008, the mortgage lending industry has dealt with repeated updates and changes regarding upfront and annual mortgage insurance premiums. Most recently, as a result of the passage of Public Law 111-229, the Secretary of Housing and Urban Development has additional flexibility with the amount charged for FHA mortgage insurance premiums.
HUD has decided to raise the annual premium and correspondingly lower the upfront premium, with the exception of Home Equity Conversion Mortgages (HECMs).
Annual MIPs will be charged based on the initial LTV ratio and length of mortgage.
The National Housing Act, as amended by the Housing and Economic Recovery Act of 2008, authorizes upfront premiums of up to 3.00%, except in the case of first-time home buyers completing HUD-approved counseling (cannot exceed 2.75%). Since the new upfront premium rate of 1.00% remains below the statutory cap, these limits do not apply.
FHA Home Mortgages – 203(b)
203(b) mortgages are mainly designed to help first-time home buyers as well as other lower to moderate income families obtain financing. These loans are attractive because they are fixed-rate loans that require a 3.5% cash investment (usually a down payment) in the transaction. This is based on either the sale price or the assessed value, whichever is lower.
Another aspect that is attractive and beneficial to borrowers is having terms that allow the financing of some closing costs. Limits are placed on 203(b) mortgages in order to serve the targeted borrowers who are at lower to moderate income levels. These borrowers, however, as of October 4, 2010, must meet the requirements for LTV and a minimum credit score.
FHA Adjustable-Rate Mortgages – 251
FHA-insured adjustable-rate mortgages (ARMs) are known as Section 251 loans. Section 251 mortgages are based on the 203(b) loans, requiring the same cash investment and maximum loan amount. As with other ARM loans, the interest rate adjusts over time. Interest rate changes are determined by using the Treasury Constant Maturities Index.
There are a wide range of FHA-insured adjustable-rate mortgages. Borrowers may choose from one-, three-, five-, seven-, and ten-year ARMs, as well as ARM products that utilize the one-year LIBOR index in addition to the Treasury Constant Maturities Index. All of the ARM products feature annual and life of loan caps. These products were introduced in addition to the standard fixed-rate loans in order to better serve a wider range of borrowers in the lower to middle income brackets, as well as first-time homebuyers.
Condominium Mortgages – 234(c)
In addition to fixed- and adjustable-rate mortgages, FHA also insures loans meant specifically for the purchase of condominium units. These mortgages fall under Section 234(c). These mortgages became available in response to the growing popularity of condominiums in all areas of the United States as well as the potential need for low to moderate income borrowers to purchase rented units if the building was to be converted to condominium units.
Section 234(c) loans are available for condominium projects that have at least four units and include detached, semi-detached, row houses, walk-up, and elevator equipped “high-rise” structures. FHA also requires that a minimum of 51% of the units in the project be owner-occupied.
Energy Efficient Mortgages
Energy efficient mortgages are available to allow borrowers to finance the costs of energy efficient improvements on existing or new construction properties containing one to four units. Standard requirements apply to energy efficient mortgages, and the borrower does not need to make an additional down payment for financing the costs of energy efficient improvements.
The amount that can be financed for these improvements, however, is limited to the lesser of:
- 5% of the property’s value;
- 115% of the median price for a single family home in the area; or
- 150% of the conforming loan limit for Freddie Mac
2-1 Buy downs
For borrowers with fixed-rate loans, FHA offers temporary interest rate buy-downs. The buy-downs may only lower the interest rate up to 2% below the note rate. When qualifying a borrower, the lenders must use the note rate and are prohibited from qualifying at the reduced rate. This temporary reduction in the interest rate allows borrowers to hold onto more of their income during a period of possible adjustment (e.g. a new job). The borrowers may pay the funds for a buy down themselves, or through premium pricing from the lender.
An example of a typical temporary interest buy down is as follows:
|Loan Amount||Term||Note Rate||P & I Payment|
|$100,000||30 years||7.00 %||$665.31|
|2-1 Buy Down||Note Rate||P & I Payment|
|1st Year||5.00 %||$536.83|
|2nd Year||6.00 %||$599.56|
Calculate the difference from note rate to 1st and 2nd year principal and interest (P & I) payments:
($665.31 – $536.83 = $128.48) × 12 months = $1,541.76
($665.31 – $599.56 = $65.75) × 12 months = $789.00
Total of both years difference = $2,330.76
The total amount of funds is deposited into an escrow account held by the lender. Each month for the first two years, the borrower makes the reduced monthly payment, and the lender applies the portion of the buy down funds to make a full P & I payment. The borrower would then make full P & I payments beginning in year three of the loan.
Good Neighbor Next Door – 203(g)
One FHA program that is aimed at community reinvestment is aimed at, and limited to, specific individuals within the community. 203(g) mortgages are often referred to as the Officer and Teacher Next Door program because pre-kindergarten through 12th grade teachers, law enforcement officers, firefighters, and emergency medical technicians are all eligible for the program.
Homes are offered at a 50% discount if the borrower is employed in one of the professions listed above, commits to living in the home for at least three years, and he/she is employed in the community where the residence is located. Though HUD requires the borrower sign a second note on the property for the discounted rate, there is no interest or payments required on the second mortgage as long as the borrower fulfills the three-year residency requirement.
Special Programs – 203(k)
Many borrowers who purchased existing homes, especially those that were older properties, with the purpose of rehabilitation, found that they had to obtain secondary financing in order to fund the rehabilitation that was in addition to the financing needed to make the initial purchase of the property. This secondary financing was often extremely costly in terms, interest rates and fees. FHA, seeing the need for borrowers to be able to finance the costs of rehabilitation with the funds to purchase the property, launched the 203(k), or special program, loans.
203(k) loans are available for individual borrowers as well as nonprofit organizations. Individuals who obtain these loans have the option of choosing from either fixed- or adjustable-rates. Nonprofit organizations, however, are limited to fixed-rate loans, only. Investors are no longer permitted to obtain financing under the 203(k) program.
A reverse mortgage is available for homeowners 62 years of age and older and allows these borrowers to use the equity in their homes in the form of a loan. FHA mortgages fall under the Home Equity Conversion Mortgage (HECM) program and were among the first reverse mortgages to be offered. A reverse mortgage is often an attractive product for a senior citizen on a limited or fixed income because it allows him/her to use the equity acquired over time to pay living and other expenses without having to sell the home.
In addition to being 62 years of age or older, there are other requirements a borrower must meet in order to be eligible for a HECM loan. The property must be owned by the borrower as his/her primary residence and must remain so, or the mortgage will become due and require full repayment. Eligible properties are those that are one to four units and can be attached, detached, townhomes, some types of modular/manufactured homes, and FHA-approved condominiums.
HECM loans do not contain any income, asset, or appraised value limitations. HECMs are, however, rising-debt loans. With rising-debt loans, the interest is added to the principal each month. Borrowers are still required to maintain payments for servicing and origination fees, mortgage insurance premiums, and all property taxes. Borrowers do have the option of financing mortgage insurance premiums in order to ensure they will never owe more than the value of the home (in total debt).
FHA Purchase Loan Scenario
Matt and Erin have been renting a house for the past five years. Their landlord has made numerous attempts to assist them in qualifying for a loan to purchase the house, but Matt and Erin weren’t able to quite get to the point of qualifying. After years of shrugging off the idea of using a co-signer, they agree to accept the help of Erin’s father to finally position themselves to qualify for a loan. They are able to come up with the necessary down payment through a combination of their own funds and some gift money from Matt’s father.
Because of Matt’s credit profile, and the strength of Erin’s father’s credit as a co-signer, a decision has been made to leave Matt off of the loan entirely. Initially, he is concerned about this but agrees to move forward with the plan because they originally intended to refinance within a few years, as Matt’s and Erin’s credit continued to strengthen, and remove Erin’s father from the loan altogether. This was still the idea, and Matt not being on the initial loan didn’t affect that.
Acceptable forms of down payment for an FHA loan
In some cases, borrowers choose an FHA loan because of its flexibility with down payment options. FHA borrowers don’t always have the required 3.5% down payment, so HUD allows for the money to come from sources such as gift funds, a one-time bonus from an employer, the borrowers’ funds, or the sale of personal property to mention a few.
FHA requires the use of mortgage insurance premium with its loans. Purpose and the collection of the MIP.
Mortgage insurance premiums insure the lender against the possibility of the borrower defaulting on the loan. More specifically, it insures the lender against losses during a foreclosure. MIP is collected in a lump sum upfront, known as Up-Front Mortgage Insurance Premium (UFMIP), and an additional amount annually, for at least the first five years of the loan. This portion is collected with the monthly mortgage payments in 1/12 of the annual amount.
Two types of FHA mortgage programs and appropriate scenarios that they might be used for.
The two primary FHA programs are the 203(b) and the 251. The 203(b) is the fixed-rate program and might be used for anyone purchasing a home for the first time. An unfamiliar or nervous borrower would likely find the fixed-rate feature attractive, knowing that they will be able to afford their payment, and it will not change.
The 251 is an adjustable-rate mortgage and might be perfect for first-time homebuyers who know they will not be in the home for more than a few years. FHA ARMs are offered in one-, three-, five-, seven-, and ten-year fixed terms up front, so borrowers could mitigate their initial risk substantially by choosing an ARM length that fits their plans.
Maximum Lending Limits
FHA, as required by the National Housing Act, sets loan limits for loans that fall under Sections 203b, 203h, and 203k. Though limits are often thought of as an amount that cannot be exceeded, a ceiling, FHA also sets minimums, or floors, for the required loan programs.
The mortgage limit for any area may not exceed 115% of the median housing price as determined by HUD. The exception is that the limit cannot exceed the FHA ceiling, or be lower than the FHA floor (defined below).
The floor is defined as an area where 115% of the median house price is less than 65% of the Freddie Mac limit:
Any area where the loan limit may exceed the floor is known as a high-cost area. Because the Economic Stimulus Act of 2008 (ESA) used a higher multiple in establishing the national FHA loan limit “ceiling” as a percentage of the conforming loan limit than does HERA (175% versus 150%), the ESA national ceiling is binding as a maximum value for 2010 loan limits:
In order to ensure eligibility for FHA loans, underwriters must review the potential borrower’s complete loan file and consider all layers of risk. FHA guidelines dictate that borrowers meet a debt-to-income ratio of 31%. Also, a total fixed payment ratio, according to FHA standards, should not exceed 43%, meaning the total monthly debt obligations should not exceed 43% of the borrower’s monthly income. These ratios are the basis for making approval decisions and are what FHA considers acceptable.
If borrowers do not meet the required ratios of 31% and 43%, the underwriter may consider other factors that would make up for the slightly higher ratio(s). Such factors focus on the borrower’s history with use of credit, the ability to make payments specific to housing that were greater than the potential PITI, and if the borrower is willing to make a down payment in excess of 10%.
Factors, like education, that could lead to higher compensation in the future can also be considered in the equation. Other factors in the borrower’s history or current financial situation may be considered where deemed appropriate. The decision to consider or disregard certain compensating factors is left to the discretion of the underwriter, who must also weigh layers of risk when determining eligibility.
When calculating ratios, all debt that requires monthly payment must be taken into account. This includes, but is not limited to, credit card payments, alimony, student loans, child support, auto loan or lease payments, and contingent liabilities.