With the growing popularity of Federal Housing Administration (FHA)-insured financing, this article timely presents the requirements of the single-family mortgage insurance program administered by the Department of Housing and Urban Development (HUD) and the FHA.
Enabling renters to become homeowners
A tenant in an apartment housing complex is solicited by a real estate broker to buy a home. The financial future and tax benefits of home ownership are reviewed with the tenant and compared to the corresponding benefits of rental payments currently paid for shelter by the tenant.
As a result, the tenant indicates he is willing to look into the purchase of a home, but has not accumulated enough cash reserves for the down payment needed to qualify for a purchase-assist loan from a conventional lender, with or withoutprivate mortgage insurance (PMI).
However, the broker assures the tenant that first-time homebuyers with little cash available for a down payment can buy a home by qualifying for a purchase-assist loan insured by the Federal Housing Administration (FHA).
By insuring loans made with less demanding cash down payment requirements than loans originated by conventional lenders, and with high loan-to-value (LTV) ratios of up to 96.5%, the FHA enables prospective buyers, primarily renters, to become homeowners.
For example, when a buyer applies for a conventional loan to finance the purchase of a home, a conventional lender will require a down payment ranging from 10% to 20% of the property’s purchase price. Additionally, the loan is often an adjustable rate mortgage (ARM) with rates and payment schedules based on formulas which allow the loan amount to increase from month to month, called negative amortization.
Conversely, a typical first-time homebuyer is required to make a minimum down payment of at least 3.5% of the purchase price to qualify for an FHA-insured fixed-rate loan. The interest rate on the loan is negotiated between the buyer and the lender. The FHA does not regulate interest rates, leaving the setting of the interest rate to bond market operations in the secondary mortgage market. [24 Code of Federal Regulations §203.20]
The FHA does not lend money to homebuyers. Rather, the FHA insures loans with up to 30-year amortization periods which are originated by approved direct endorsement lenders to qualified buyers to assist them in funding the purchase of a home they will occupy as their principal residence.
One-to-four unit mortgage default insurance
The most commonly used FHA insurance program is the Owner-occupied, One-to-Four Family Home Mortgage Insurance Program, Section 203(b).
The purpose of Section 203(b) is to enable renters to become homeowners by allowing for a smaller down payment than required for conventional loans from portfolio lenders. For the privilege of making a small down payment, the buyer must pay a mortgage insurance premium (MIP) to FHA of 1.75% of the loan amount on closing and an annual amount of .55% of the loan amount, effectively increasing the annual cost of borrowing as an addition to interest.
Buyers obtaining a Section 203(b) loan must occupy the property as their primary residence. Investors are prohibited from using Section 203(b) to purchase property since their intended use of the property would be as a rental, a contradiction of the owner-occupancy purpose of the Section 203(b) program.
Similarly, homeowners with Section 203(b) loans who later sell their home to investors will not receive FHA approval of the sale. The FHA approval is a nonessential consent, but one which does have its advantages for the homeowner selling their FHA financed home.
The public policy rationale behind the Section 203(b) program is based on the proposition that individuals who become homeowners have proven in their later years to be less of a financial burden on the government than the burden imposed by life-time renters. No consideration is given when inducing homeownership to the risks a buyer take on by the debt burden accompanying an FHA-insured home loan and reduced job mobility during economic downturns.
Under Section 203(b), a loan for the purchase of an additional residence will be insured by FHA in the case of hardship to the buyer, such as relocation due to a job. FHA insurance was created to give home sellers the mobility needed to sell and relocate to better jobs. In effect, the mobility of the nation’s work force who do own homes is not to be hampered for lack of highly leveraged financing. [HUD Mortgagee Handbook 4155.1 Rev-5 Chapter-4 §B.2.d]
FHA loan limits by area
The FHA insures lenders against loss for the full amount of loans made to buyers under the Owner-occupied, One-to-Four Family Home Mortgage Insurance Program. The maximum FHA-insured loan available to assist a buyer in the purchase of one-to-four unit residential property is determined by:
- the type of residential property; and
- the county in which the property is located.
A list of counties and their specific loan ceilings is available from FHA or an FHA direct endorsement lender, or online from the Department of Housing and Urban Development (HUD) at //www.hud.gov.
Loan-to-value (LTV) ceilings
The FHA sets limitations on the amount of a loan it will insure, based on a percentage of the appraised value of the property, called the loan-to-value (LTV) limitation or ratio.
The LTV limitations on an FHA-insurable loan are capped at 96.5%. Thus, the minimum downpayment is 3.5%. [HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.b]
Additionally, even after including buyer-paid closing costs in the LTV calculations, the insurable loan amount cannot exceed the ceiling of 96.5% of the property’s appraised value.
To determine the loan amount the FHA will insure, multiply the appropriate LTV ratio by the lesser of the property’s:
- sales price; or
- the appraised value of the property. [HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.a]
Closing costs may not be used to help meet the 3.5% minimum downpayment requirement. Also, closing costs are not deducted from the sales price before setting the maximum loan amount. [HUD Mortgagee Handbook 4155.1 Rev-5 Ch-2 §A.2.d]
Such costs include the lender’s origination fee, appraisal fees, credit report charges, home inspection fees, recording fees, survey fees, and the cost of title insurance.
The lender’s origination fee included in the closing costs is limited to 1% of the loan amount, excluding any competitive discount points and the 1.75% upfront MIP.
Veterans applying for an FHA-insured loan are subject to the same LTV limitations applicable to non-veterans.
Either the buyer or seller can pay the buyer’s closing costs, called non-recurring closing costs. The lender may also advance closing costs on behalf of the buyer.
Discount points or upfront MIPs are not part of the buyer’s closing costs since they are considered prepaid interest. However, when the seller pays the buyer’s loan discount points and MIPs, these amounts are then considered financing concessions.
Any closing costs or other financing concession paid by the lender or seller in excess of 6% of the property’s sales price is considered an inducement to purchase and results in a dollar-for-dollar deduction of the excess from the sales price before applying the appropriate LTV ratio. [HUD Handbook 4155.1 Rev-5 Chg-2 §A.3]
The LTV ratio initially sets the loan amount. However, the loan amount cannot exceed the cap of 96.5% of the appraised property value.
For example, a buyer pays $100,000 for a single family residence (SFR) with an appraised value of $100,000. The buyer must pay the minimum down payment of $3,500 in closing costs (3.5%) from his own funds. Thus, the buyer’s cost basis for calculating the loan amount is $100,000. The LTV ratio of 96.5% is then applied to the $100,000 cost basis the buyer will have in the property, resulting in a $96,500 maximum loan.
In a seller’s market with too many buyers rapidly driving up prices, the price a buyer might agree to pay occasionally exceeds the appraised value of the property. Thus, the gap is widened between the FHA-insurable loan limit and the purchase price. The buyer then has the right to close the transaction by increasing the down payment amount to cover the higher-than-appraised price he is still willing and able to buy the property, an FHA purchase agreement right called an amendatory clause. [See first tuesday Form 152 §7.7]
Buyers may add the cost of a solar or wind energy system directly to the loan amount before adding MIPs and after applying the LTV ratio limit. The amount a buyer is permitted to add to the loan amount is the lesser of the solar or wind energy system’s:
- replacement costs; or
- effect on the property’s market value. [HUD Handbook 4155.1 Rev-5 Ch-2 §A.5]
Also, the amount added for a solar or wind energy system may exceed the statutory mortgage limit for the area by an additional 20%. [HUD Handbook 4155.1 Rev-5 Ch-2 §A.5.g]
Before FHA will insure a loan, the lender must determine if at least one of the co-applicants is creditworthy. [24 CFR §203.512(b)]
For a buyer to be creditworthy for FHA mortgage insurance, the following debt-to-income ratios must be met:
- the buyer’s mortgage payment may not exceed 31% of the buyer’s gross effective income, called the mortgage payment ratio; and
- the buyer’s total fixed payments may not exceed 43% of the buyer’s gross effective income, called the fixed payment ratio. [HUD Handbook 4155.1 Rev-5 Ch-4 §F.2]
A buyer’s income consists of his salary and wages. Social security, alimony, child support, and government assistance are factored into the buyer’s income to determine his effective income. The buyer’s effective income before any reduction for the payment of taxes is called his gross effective income.
The maximum mortgage payment ratio of 31% of the gross effective income determines the buyer’s maximum ability to the amount of principal, interest, taxes and insurance he can pay on the mortgage.
Lenders use the maximum fixed payment ratio of 43% of the gross effective income to determine whether a buyer can afford to incur the long-term debt of an FHA-insured mortgage in additional to all other long-term payments he must make.
When computing the fixed-payment ratio, the lender adds the buyer’s total mortgage payment to all the buyer’s recurring obligations (debts extending ten months or more), such as all installment loans, alimony, and child support payments, to ascertain the buyer’s total monthly fixed payments. [HUD Handbook 4155.1 Rev-5 Ch-4 §C.4]
However, even if the buyer’s ratios exceed FHA requirements, the loan may be approved if the buyer:
- makes a large down payment;
- has a good credit history;
- has substantial cash reserves; and
- demonstrates potential for increased earnings due to job training or education, called compensating factors. [HUD Handbook 4155.1 Rev-5 Ch-4 §F.3]
Since predetermined ratios may not indicate a particular homebuyer’s likelihood for default, lenders may be flexible when applying the qualification ratios.
For example, if the buyer’s debt-to-income ratios are above the prescribed maximum, the FHA may still insure the loan based on these compensating factors.
Although FHA considers good credit history and a large down payment to be compensating factors, lenders will not fund a loan in practice based on these two factors alone unless the buyer meets the prescribed payment ratios.
Further, race, religion, sex, handicap, familial status, sexual orientation, and ethnicity are not compensating factors for evaluating a loan application.
Conversely, a lender cannot deny the loan application of an African-American buyer in an attempt to exclude African-Americans as buyers of homes located in a particular neighborhood. [Holmes v. Bank of America (1963) 216 CA2d 529]
However, lenders in California can establish loan programs which promote homeownership in ethnic minorities or low-income neighborhoods, provided the programs comply with the federal Fair Housing Act or similar state and federal laws. [Calif. Health and Safety Code §35810]
RESPA and TILA disclosures
The Real Estate Settlement Procedures Act (RESPA) requires any lender making an FHA-insured loan to deliver good faith estimates of settlement costs paid to providers of services on the sale of a one-to-four unit residential property and a HUD information booklet within three days after receiving the buyer’s application. [See first tuesday Form 204 (DRE 883)]
The HUD information booklet contains information about real estate transactions, settlement services, and consumer protection laws. [24 CFR §3500.6 (a)(3)]
Upon closing a sale, an escrow agent handling the loan must deliver to the buyer and seller a HUD-1 closing statement detailing all loan related charges incurred by the buyer and seller. [24 CFR §3500 et seq.; see first tuesday Form 402 (HUD-1)]
Further, the Truth-in-Lending Act (TILA), referred to as Regulation Z, requires lenders making loans for personal use (i.e., the purchase of a personal residence) to disclose details about the loan terms, such as the amount funded, direct loan costs, payment schedules, the loans annual percentage rate (APR), and the interest rate. [See first tuesday Form 221]
Loans insured by the FHA under section 203 (b) are subject to both disclosure requirements since they fund personal use loans (TILA) and are federally related loans (RESPA). Thus, RESPA and TILA disclosures on FHA-insured loans are delivered together by the lender within three business days after receiving the buyer’s loan application. [12 CFR §226.19]
If the lender adjusts the APR by more than 1/8 (one eighth) of 1% from the rate initially offered after receiving the buyer’s loan application, the lender must redisclose the new adjusted APR before the buyer signs the loan documents. [12 CFR §226.19(a)(2)]
Lenders are not required to give the three-day right of rescission to buyers obtaining an FHA-insured home loan under the owner-occupied, one-to-four family home mortgage insurance program, Section 203(b), since the right to rescind does not apply to purchase-assist financing of residential sales, only to personal-use equity loans secured by any type of property. [12 CFR §226.23(f)(1); see first tuesday Form 222]
Editor’s note — In practice, lenders of residential purchase-assist loans generally give the right of rescission, although they are not obligated to do so. If given the right to rescind by the lender, the buyer may rescind the loan transaction up to three days after signing the loan documents. [12 CFR §226.23]
Before closing, lenders must also hand buyers a prepayment disclosure statement informing buyers they can prepay any or all of the remaining balance of the loan without a prepayment penalty on any installment due date. [24 CFR §§203.22(b), 203.558(a)]
The prepayment of loans insured by the FHA should be made on a regular installment due date, since some lenders charge interest on the amount owed through the end of the month if the loan is prepaid during the month between due dates.
When an owner sells his property subject to an existing FHA-insured loan and the buyer takes over the loan, the seller will be released from personal liability for that loan, if:
- he requests a release from personal liability;
- the prospective buyer of the property is creditworthy;
- the prospective buyer assumes the loan; and
- the lender releases the seller from personal liability by use of an FHA-approved form. [HUD Form 92210; 24 CFR §203.510(a); HUD Handbook 4155.1 Rev-5 Ch-7]
If the conditions for release from personal liability are satisfied, but the seller does not request a release, he remains liable to the FHA for any default occurring within five years after the sale. [12 USC §1709(r); see Chapter 23]
However, if five years pass from the time the property is resold, the seller is released from personal liability if:
- the buyer assumes the loan with the lender;
- the loan is not in default by the end of the five-year period; and
- the seller requests the release of liability from the lender. [24 CFR §203.510(b)]
Lenders must inform borrowers of the procedure for obtaining the release from personal liability on resale when the loan is originated. [24 CFR §203.510(c)]
Buyer liability on a default
If a buyer defaults on an FHA-insured loan, the FHA covers the lender against loss on the entire remaining balance of the loan, unlike PMI and insurance from the Veterans Administration (VA) which only insures a portion of the total loan amount.
After the lender acquires the property through foreclosure and conveys the property to the FHA, the FHA pays the lender the amount of the remaining original principal on the loan at the time of foreclosure of a property insured by the FHA. If a bidder other than the lender acquires the property at the foreclosure sale, the FHA pays the lender the amount of the unpaid principal balance, minus any amounts the lender receives from the bidder. [24 CFR §203.401]
Before accepting a conveyance from the lender, the FHA requires the lender to confirm the property is in a marketable condition and has not suffered any waste. The FHA then sells the property to recoup the amount it paid to the lender.
Unlike conventional home loans where only a lender is involved, a homebuyer who takes out an FHA-insured loan with a lender is personally liable to the FHA under the mortgage insurance program for any loss the FHA suffers as a result of the homebuyer’s default. When the FHA suffers a loss, the FHA can obtain a money judgment against the homebuyer for the difference between the amount the FHA paid the lender and the price received from the sale of the property. California anti-deficiency mortgage laws do not apply to FHA-insured loans. [24 CFR §203.369]