BLOG VIEW: The Federal Housing Administration's (FHA) recent move to reduce its mortgage insurance premiums has been celebrated by many people in the mortgage industry as a positive step toward improving homeownership opportunities. However, there are many reasons to be concerned with this reduction, including borrower inexperience and broader issues such as FHA solvency, the health of the housing market and taxpayer burden.
Borrower Inexperience
As borrowers approach lenders about reduced FHA premiums, it's important for lenders to use their expertise to discuss the loan options that are best for each borrower. Although borrowers who intend to stay in their new home for only a few years might benefit from the decrease, those who intend to stay for many years could be paying significantly more over the life of their FHA-insured loan as opposed to a loan with private mortgage insurance. Â
The private mortgage insurance industry and the FHA handle insurance premium cancellation for high loan-to-value (LTV) borrowers differently. The FHA does not allow borrowers who put less than 10% down on a house to eventually cancel their insurance. Instead, premiums must continue to be paid over the life of the loan.
With private mortgage insurance (PMI), borrowers are required to pay premiums only until they build sufficient equity in their home, which is typically when they reach 80% LTV. This difference in approach can translate into thousands of dollars in savings.
Most loan officers will point out that there are two ways private mortgage insurance can be cancelled: The mortgage servicer automatically cancels the mortgage insurance once the loan balance is scheduled to reach 78% of original value as mandated by the Homeowners Protection Act of 1998 – or the borrower makes enough payments to achieve approximately 20% equity in their home, at which point they can proactively request cancellation.
With the latter option, the request can either be based on 1) original amortization schedule, 2) home price appreciation, or 3) making a prepayment.
In markets with a stronger economy, borrowers may see the value of their home quickly appreciating. When their home is worth more, borrowers can reach 20% equity sooner than their originally scheduled loan amortization. In this situation, borrowers can get an appraisal to document the home price appreciation and then, upon confirming an LTV of 80% or lower, petition to cancel their PMI. If cancellation is permitted based on the investor's cancellation guidelines, this would reduce the borrower's monthly payment, a feature that is unavailable on FHA-backed loans where the insurance cannot be cancelled under these conditions.
Let's assess an example: A couple purchases a home for $200,000 with $10,000 down; their $190,000 loan is protected by private mortgage insurance with a monthly premium of $86 for a total monthly payment of $1,062. Assuming an annual home price appreciation of 3%, the home value would rise by $23,783 in less than four years, and the borrowers' equity would increase accordingly, resulting in a 79.5% LTV.
Although the scheduled amortization indicated that the borrower would reach 78% LTV in 112 months, the 79.5% LTV achieved in 44 months due to home price appreciation allows them to petition to cancel their mortgage insurance, therefore decreasing their monthly payment to $976.87. Should the borrower opt for an FHA loan, the insurance would remain on the loan for the entire 30 year term, amassing to $31,590 in premiums – almost ten times the total $3,784 paid in mortgage insurance premiums over the 44 months.
So, while the FHA borrower might have benefited in the short term, their long term cash flow will be much more restricted than for a borrower who uses PMI.Â
Even in markets where home values aren't appreciating, borrowers who get an inheritance, another type of lump-sum, or simply decide to pay down some of the loan ahead of schedule can still request to drop their PMI based on their actual loan balance.
Let's say we have a $190,000, 30-year loan in good standing. In month 24, the loan receives a prepayment lump sum of $10,000 to help pay down the principal balance. This lump-sum payment accelerates the PMI cancellation timeframe up from month 112 (9.3 years) to month 66 (or 5.5 years) thereby decreasing the monthly payment by $86 for a roughly four-year net savings of $3,956 against auto-cancelled PMI, and $25,914 over an FHA-insured loan. This puts extra money back into a borrower's monthly savings plan for life's next big event.
It's important to note, however, that if your borrower reaches the cancellation threshold before their amortization date by using one of these methods, they must take action to inform their mortgage servicer or else risk continuing to pay premiums between the date the threshold is reached and the originally-planned cancellation date.Â
The Broader Issues
While borrowers should become knowledgeable about the savings differences between FHA and PMI, industry executives are monitoring the financial state of the FHA. Not only have the FHA's indemnification actions surged in the past year, leading to more than $2.5 billion in legal settlements, preliminary analysis suggests that this premium decrease could reduce FHA revenue by approximately $3.75 billion per book year, before considering any resulting volume increase. In accounting for said volume increase, the FHA would need to increase volume by an estimated 40% to offset lost revenue from the decreased premiums. This lost revenue would further delay the FHA's efforts to build its capital reserves back up from .41% to the required 2% minimum.
The FHA's financial health impacts the risk taxpayers face should FHA loans default to an extent requiring government intervention. For loans with private mortgage insurance with the PMI industry in the first loss position, nearly $44 billion in claims has been paid to the GSEs since 2007, directly reducing taxpayer exposure.
The FHA premium reduction has generated a great deal of discussion and is certainly well intended. But with every major policy change comes pros and cons – and the issues triggered by the FHA premium reduction are no exception. Whether it's FHA or PMI, educating buyers on the financial realities between the two will distinguish a lender in the field. This is vital not only for borrowers' financial futures, but also for the health of the mortgage industry, the FHA, and taxpayers alike.
Steve Richman is national spokesperson and customer trainer for Genworth Mortgage Insurance.
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