The true costs of a default-insured mortgage

This article exposes the inclusion of default insurance premiums and impounds as part of the total monthly payment on an FHA-insured loan, and their effect on the amount the homebuyer is qualified to borrow. Similarly discussed are the costs of private mortgage insurance (PMI).

Considering the MIP

With the recent collapse of the real estate market after the Millennium Boom, conventional lenders severely reduced lending on California real estate. In an effort to fill the home loan void left by their departure and keep homeownership levels from plummeting, the Federal Housing Administration (FHA) stepped up to the plate to offer prospective homebuyers low-downpayment, low-credit score alternatives to conventional financing.

As a result, FHA-insured loans have had a revival of popularity in California, and are now used by nearly 40% of all homebuyers in the Golden State (a percentage that will soon drop substantially, but will not adversely affect and may likely assist in the ongoing stabilization of pricing in our real estate market).

This increased popularity of FHA-insured loans in California needs to be accompanied by loan payment transparency. Prospective homebuyers must not be misled, but instead advised of the true costs associated with these low-downpayment, FHA-insured loans: the built-in mortgage insurance premiums (MIP) and accompanying impounds.

Consider a prospective first-time homebuyer independently searching for properties online. He finds numerous qualifying properties that appear suitable — some single family residences (SFRs), some condominiums — around $235,000 in current value. He then takes a look at his mortgage pre-approval options. Among them are:

• a conventional loan requiring a 20% downpayment; or
• an FHA-insured loan requiring only a 3.5% downpayment.

Editor’s note — The FHA recently proposed increasing the downpayment requirement from 3.5% to 5% to reduce default rates. This proposal was defeated in the House of Representatives Financial Services Committee in late April of 2010.

The prospective homebuyer researches mortgage interest rates online and discovers the advertised interest rates for conventional mortgages and FHA-insured mortgages are very similar – around 5%. He does not want to put down a big downpayment, and based on these advertised rates, he decides to seek pre-approval for an FHA-insured loan.

Keeping in mind his desired property price of $235,000, a 3.5% downpayment would be $8,225. That leaves him with a principal loan balance of $226,775. Impounds for taxes and hazard insurance are estimated by lenders at around 1.5% of the total price of the property, approximately $283 monthly. He finds an amortization calculator and discovers his principal and interest payments at 5% interest will be roughly $1,217 monthly. The combined amounts of $1,500 are within the homebuyer’s budget.

The mortgage payment is more than principal and interest

Armed with this knowledge, the homebuyer hires a real estate agent to help him locate a suitable property. The homebuyer discusses his loan research with his agent. The agent informs the homebuyer that while lenders do advertise FHA loan rates which are close to those for conventional loans, the homebuyer who makes a downpayment of less than 20% is always charged an additional monthly rate for  default insurance, called mortgage insurance premium (MIP), to cover the FHA’s risk of a homeowner’s default. The current premium rates charged for MIP, the agent informs his homebuyer, include:

• 2.25% of the loan amount paid up-front at the time of closing, called the up-front MIP (UFMIP); and
• an additional annual MIP of 1.55% of the loan amount, paid monthly, in addition to the 5% interest on the loan. [HUD Mortgagee Letter 2010-02]

Editor’s note —  The lender who originates an FHA-insured loan following FHA underwriting guidelines takes on no risk of loss. The entire risk is placed on the FHA – our government — who steps in to take the lender’s loss position, having guaranteed the loan in the event of the homebuyer’s default. The MIP paid for by the homebuyer goes towards the FHA reserves used to pay for losses on loan defaults. The FHA coffers have recently and rapidly been depleted by the unprecedented popularity of low-downpayment, FHA-insured loans — and their ensuing high rate of defaults. [For more information on FHA-insured loans, current students can access first tuesday’s Real Estate Finance, Chapter 39: “The FHA-insured home loan,” from within your Student Hompage in the “Library” tab. Log in with your Department of Real Estate (DRE) license number under “Enrolled Student Services.”]

In response to these losses, the House of Representatives recently passed a bill which would decrease the UFMIP rate and increase the annual MIP rate from the current .55% to 1.55%. While the bill is still pending passage in the Senate, first tuesday includes the higher annual MIP in this scenario since the bill will almost certainly pass if the Senate is to protect the FHA’s solvency and avoid another Treasury bailout. [HUD Mortgagee Letter 2008-22 ; for more information on the effect of this pending increase in FHA-insured MIP rates, see the June 2010 first tuesday article, FHA Reform Act Passed in the House of Representatives.]

Thus, the homebuyer’s 3.5% downpayment after factoring in the up-front 2.25% MIP, plus approximately another 2% on the price for escrow and other loan origination costs, is actually a cost of acquisition of 7.75% of the price of the property using an FHA-insured, purchase-assist loan. [See below for a specific discussion of the UFMIP and information on arranging for the seller to pay the 2.25% MIP, 2% loan fees and more.]

The 5% annual interest rate quoted by the lender is effectively 6.55% (5% interest rate + the 1.55% MIP rate). This combined rate is paid on the loan balance until the property’s loan-to-value (LTV) ratio is equal to or less than 78%, and then only if the homebuyer has been paying the MIP for at least five years. [HUD Mortgagee Handbook 4155.2 Chapter 7.3.c]

By doing a quick calculation, the buyer’s agent determines the MIP would cost the borrower $292.72 each month, which becomes part of the total monthly payment collected by the lender. FHA-insured loan guidelines set a maximum total monthly payment equal to a housing debt-to-income (DTI) ratio of 31% of the homebuyer’s gross monthly income. This 31% maximum housing payment includes:

• principal and interest;
• impounds for property taxes and hazard insurance, collectively known as TIs;
• MIP;
• homeowners’ association (HOA) fees;
• ground rent;
• special property assessments; and
• payments for any acceptable secondary financing. [HUD Mortgagee Handbook 4155.1 Chapter 4.F.2.b.]

The cost of not having a 20% down payment

Thus, by putting down less than 20% on the purchase of the home, the homeowner dramatically reduces the amount he can borrow to pay for a property.  The increased MIP payment, impounds, etc. he must make every month are considered part of his housing payment, and the payment is limited to a maximum of 31% of his income. If the homebuyer decides to purchase a condominium or an SFR in a planned unit development (PUD), that further reduces his borrowing power as HOA fees are also included as part of his 31% maximum DTI ratio (HOA fees generally represent another 1% of the property’s price).

After considering the information provided to him by his agent, the homebuyer then visits a representative with a local lender and obtains a pre-approval letter for an FHA-insured loan. He now understands his reduced borrowing ability when choosing an FHA-insured loan as pointed out in the pre-approval letter by the lender’s representative.

Later, the buyer’s agent goes over the pre-approval letter with the homebuyer to double-check the lender for omission of mortgage insurance premiums, impounds for TIs, HOA dues, and any other applicable fees which must be considered to determine the approved loan amount. This not only helps ensure his buyer will not have the unpleasant surprise of applying for a loan and finding out he does not qualify for the amount quoted in the pre-approval letter, but also keeps the buyer’s agent from expending time and energy negotiating a deal that cannot close if the loan amount is erroneously calculated.

The up-front MIP lump sum charge

In January of 2010, the FHA increased the UFMIP charge from 1.75% to 2.25% of the loan amount in an effort to offset their insurance fund losses caused by the rising default rate on FHA-insured loans. [HUD Mortgagee Letter 2010-02]

Although previously exempt from the UFMIP, FHA condominium loans are now also subject to the existing UFMIP rate. [HUD Mortgagee Letter 2008-22]

The UFMIP may be:

• entirely financed by adding it to the mortgage. If added, the total mortgage amount may exceed existing LTV limits by the amount of the UFMIP [HUD Mortgagee Handbook 4155.1 Chapter 4.F.2.b.]; or
• paid in cash at closing.

The buyer’s agent, when preparing his buyer’s purchase agreement, needs to consider negotiating with the seller to arrange for the seller to pay this premium by shifting the payment of the buyer’s non-recurring closing costs to the seller. The FHA currently allows sellers to pay up to 6% of the buyer’s closing costs on an FHA-insured loan. [See first tuesday Form 152 §7]

Editor’s note — In January 2010, the FHA proposed reducing the allowable seller concessions from 6% of the loan amount to 3%. The proposed effective date was stated as “early summer,” however no official effective date has been set. The delay is perhaps due to the pending change in MIP arrangements currently being discussed in the Senate. Similar to those changes, the reduction of allowable seller concessions is most likely a foregone conclusion — part of a larger FHA scheme to force the buyer to put “more skin in the game” to lessen his likelihood of simply walking away or defaulting on it.

If the buyer’s agent does not structure negotiations to have the seller pay the UFMIP and other FHA up-front loan costs, the homebuyer will end up investing another 2.25% of the price plus loan points and closing costs of another 2% in the property and have only a 3.5% equity to show for it (part of these costs are subsidized through income taxes).

This is a shaky start for any homebuyer, especially should the asset value of the property not increase at least at the current rate of consumer inflation. This property value increase allows the initial 96.5% LTV ratio for the mortgage to more quickly get to below the 94% break-even point at which the homebuyer begins to build up net equity through the amortization of principal, should he need to sell. Only by an increase in property value can the homebuyer recover his invested capital upon a resale of the property.

The annual MIP payment

The rate advertised by lenders for FHA-insured mortgages is not the rate (factor) used to set the loan amount a prospective homebuyer is qualified to borrow based on 31% of his income. The factor used to set the actual loan amount available consists of the advertised interest rate and principal amortization over 30 years, plus the MIP rate and the impound reserve for taxes and property insurance.

In our example, the homebuyer’s maximum permissable monthly payment is not used to determine what amount he can borrow on a 30-year fixed-rate mortgage (FRM) at 5%. First, his maximum monthly permissible payment set at 31% of his income is reduced by the amount of monthly MIP (1.55% annually) and impounds he must “escrow” with the lender, an amount roughly equal to 2.75% to 3.0% of the loan amount.

Only after these TI and MIP reductions will the buyer know what portion of his monthly payment is applied to principal and interest (PI) payments. When the PI and TI (collectively, PITI) and MIP figures are known, he will be able to determine the FHA-insured mortgage amount he qualifies to borrow. Further, he may be required to include other recurring expenses — HOA dues, ground rents, etc. — in his monthly payment which will further diminish his loan amount and in turn his purchasing power.

The current schedule of annual MIP rates is:

As discussed in our editor’s notes, the annual MIP rates will most likely be increased to 1.55% sometime in mid-2010.

For loans with amortization periods longer than 15 years, the annual MIP payments automatically terminate after:

• the homebuyer has paid the annual MIP for at least five years; and
• the LTV ratio reaches 78%.

For loans with amortization periods of 15 years or less and LTV ratios of 90% or greater, the annual MIP is automatically terminated after the LTV ratio reaches 78% (using the lesser of the sales price or the appraised value of the property), regardless of how long the homebuyer has been paying the annual MIP. [HUD Mortgagee Handbook 4155.2 Chapter 7.3.c]

Thus, homebuyers considering 30-year FHA-insured financing (the most popular type of FHA-insured financing) can count on being locked into paying the annual MIP for at least five years. An amortization schedule for our opening scenario shows a period of more than 9 years passing after the loan’s origination before the LTV reaches the required 78% LTV.

Agents need to consider the MIP costs over a minimum of five years — a total additional cost of financing the purchase of roughly 8% of the price paid — when counseling a homebuyer on his choice of a mortgage.  Thus, a simple comparison of lender’s advertised rates is insufficient information to make an informed decision.  Lenders, it must be remembered, are adversaries. Homebuyers need to understand lenders prefer conditions which nurture ambiguities and appear to give them a competitive advantage over other lenders.

Calculate a homebuyer’s purchasing power, quickly

The quest undertaken by a buyer’s agent to set the loan amount a buyer is qualified to borrow requires a factor be established. When that factor is divided into the buyer’s total annual amount of permissible payments for PITI/MIP (31% of income), it produces the loan amount he can borrow.

To calculate a very close approximation of the loan amount a homebuyer can borrow — his true purchasing power —  on a 30-year FHA-insured FRM with 1.55% MIP at a 5% interest rate, first figure 31% (the maximum housing DTI allowable by the FHA) of the homebuyer’s annual income.  For example, a homebuyer with an annual gross income of $60,000 is allowed to make a maximum annual amount of loan payments totaling $18,600 – the 31% of income figure.

Second, create the factor which represents all the components which comprise the annual 31% of income figure. When created, the factor is divided into the total annual payments which yields the amount of the loan the homebuyer can borrow.

For example, the total annual amount of payments paid to the lender for a non-HOA SFR is $18,600, with portions of the payments allocated to the different PITI/MIP components which make up the payment. When the components of the payments are stated as an annual percentage of the permissible loan amount, the payments are comprised of:

• 5% for interest (current rate);
• 1.4% for amortized principal reduction;
• 1.5% for property taxes and hazard insurance; and
• 1.55% for MIP;  equals
  • 9.45, the factor representing the total annual PITI/MIP payment.

Editor’s note — The 1.4% principal reduction component of the payments is calculated as the ratio between principal and interest in the first payment on a 30-year FRM. Thus, this ratio is only good for interest rates between 4.75% and 5.25%, as used in this scenario. Stay tuned to the first tuesday journal online in the coming months for a more detailed description of this factor as a divisor and our Maximum Home Price calculator.

Third, calculate the maximum loan amount by dividing the factor of 9.45% (0.0945) into the maximum annual housing payment of $18,600.  The result:  a maximum loan amount of $196,825.

Fourth, add the homebuyer’s down payment amount to this maximum loan amount to arrive at the maximum purchase price the buyer is qualified to pay for a home.

Further, to estimate the funds needed by the buyer to close escrow, whether paid by the buyer or in part by the seller, a buyer’s cost statement will be used. [See first tuesday Form 311]

FHA MIP vs. private mortgage insurance (PMI)

While the FHA’s MIP functions as the sole source of revenue to fund losses on FHA-insured loans, when homebuyers choose a conventional loan and put down less than 20% of the price, a third-party private mortgage insurer (PMI) provides the insurance coverage lenders require to make the loan and protect against loss on the homebuyer’s default. As these PMIs take on the loan risk created by a low down payment and high LTV ratio they too want to assess the creditworthiness of the buyer. Thus, their qualification standards are the conclusive test of whether a buyer requiring PMI is qualified for a loan, since lenders will not take the risk of default themselves.

From the mortgage meltdown late in December 2007 to May 2010, PMIs had decamped from California, leaving any homebuyers looking to put less than 20% down with no other options but to go with an FHA-insured loan. At the time, the costs for FHA-insured MIP and PMI were comparable.

Editor’s note — The acronym “PMI” can refer to either the industry term “private mortgage insurance” or “The PMI Group,” one of the largest US private mortgage insurance providers. It is also used as “PMI” to denote “private mortgage insurer.”

In May 2010, the three major PMIs — PMI, Genworth and MGIC — made a tentative return to California by offering mortgage insurance in risk-based tiers across the state. Current premiums quoted by each insurer are competitive with FHA-insured MIP rates (until FHA’s requested increase takes place). [For more information on the return of the PMIs to California and the current rates, see the May 2010 first tuesday article, Private mortgage insurers come back to California as FHA raises eligibility requirements.]

Unlike FHA’s MIP, the guidelines for PMI qualification do not focus on a maximum total monthly mortgage payment to set the DTI ratio to determine a homebuyer’s eligibility for coverage (as MIP does). Rather, all three major private insurers use a different more inclusive DTI ratio comprising a homebuyer’s total monthly installments paid on all installment debt, including property impounds, as their DTI ratio (41% to 45%) for considering  eligibility. Thus, the amount of existing installment debt a homebuyer has will control the  loan amount he can borrow.

The total DTI ratio does, of course, include all the housing expenses which are covered in the FHA MIP’s 31% DTI ratios, as well as installment debts (car and furniture loans), other loan payments (education) or lines of credit (credit cards), child support, etc.

However, unlike the FHA, most PMIs limit the homebuyers they will cover to those with a relatively high credit score (upwards of 680).  Neither private insurers nor lenders have devised a better, more cost effective method to analyze their risk of a mortgage default than to use the questionable credit scoring technique for determining the likelihood of a homebuyer’s default. [For more information on the fallacy of the credit score, see the June 2010 first tuesday article, The FICO score delusion.]

Lenders and PMI insurers do not fully appreciate it is the amount of the down payment that primarily controls the risk of default. However, forcing all homebuyers to put down 20% of the purchase price of the property would eliminate mortgage default insurance premiums and decrease the market demand for loans, and is thus against the best interests of PMIs and mortgage lenders.

These double DTI standards used separately by the lender and the PMI to qualify a homebuyer for a loan often surprise buyers who have been pre-approved by the lender only to later have the loan denied when the loan application is reviewed under the PMI coverage standards. This element of surprise is the result of a double check on the homebuyer’s creditworthiness:  the first by the lender when pre-approving a borrower; the second when processing the loan application and applying the insurer’s standard for issuing coverage. It is the difference between the pre-approval and the loan application process with its underwriting analysis which produces the denial when the pre-approval indicates everything is fine.

The lender creates this conflict when it accepts the loan application and the analysis shifts to the risk standards set by the insurer. Thus, the lender is more apt to pre-approve a loan. Of course a buyer’s agent wants to direct his homebuyer to lenders who will be most apt to pre-approve a loan and figure out how to also approve a loan application.

A buyer’s agent has the professional responsibility to determine and verify the homebuyer’s ability to obtain financing (and consequently, mortgage insurance) so that the agent does not invest time, effort and money working with a buyer at a price range that the buyer cannot qualify to finance under both lender and private mortgage insurance standards.

To avoid a surprise, the homebuyer needs to know about the readily-available financing options available from any lender. A buyer’s agent must keep an eye on conventional loans and PMI rates as more financially viable than an FHA-insured loan (a larger loan) if his homebuyer has the credit score to qualify and the additional cash reserves for a larger down payment.

When the FHA succeeds in raising its annual MIP rate to somewhere nearer the 1.55% annual amount, it won’t be long before PMIs will move rates to meet that competition.  All this action on mortgage insurance will adversely affect the pricing of low-tier housing until buyers as a group take the time to accumulate savings for the fundamentally correct downpayment of 20% and not be deprived of the purchasing power delivered by qualifying for a conventional loan, with or without mortgage insurance.

Disclosing what the lender does not

As the buyer’s agent, the broker and sales agent engaged to represent a homebuyer are the only gatekeepers to his entry into a purchase of real estate who have a fiduciary duty to protect and care for him. The concerns of the buyer’s agent are two-fold:

• protect, care for and inform his client regarding the client’s interests; and
• preserve the agent’s right to collect a fee (paid by the seller, funded by the buyer) for properly negotiating and closing the buyer’s purchase.

The lender will always be postured in an adversarial role instinctively acting against the best interests of the agent’s homebuyer.  Thus, the rates posted and information released to the buyer by a lender must be supplemented and clarified – translated – by the buyer’s agent to provide transparency into loan activity in the mortgage market.  A buyer’s agent steps in to avoid misunderstandings, or correct his buyer’s failure (for any reason) to inqure about all the ancillary facets and consequences of the financing offered by a lender and available alternatives.

Selling agents who do rise to the professional level of counseling with their buyers about the mortgage financing intregal to the purchase they have structured and negotiated will succeed where others won’t.  Also, due to their inevitable experience and thus expertise, buyer’s agents combat the ignorance and asymmetry of information borrowers and fellow brokers and agents have been increasingly subjected to by lenders during the three decades leading up to the current Great Recession and financial crisis in the real estate market.

Knowledge is the shield against loss of time, efforts and a fee, when deployed by real estate agents.