FHA mortgage insurance

Question:We want to buy a first house, and everybody is recommending that we finance with an FHA-insured mortgage. What is FHA insurance, and why do we need it?

Answer:The FHA insurance program has been around since the 1930s. It was developed to restart the housing market at the height of the Great Depression, a time when homes were typically financed with five-year term loans. If such loans could not be refinanced – say, when home values fell, and lenders were making few loans – the owners could be foreclosed.

At first, the FHA offered 15-year, self-amortizing loans. These loans had several big advantages when compared with term financing.

First, the new FHA loans were selfamortizing. There was no big balloon payment due at the end of the loan term and nothing to refinance.

Second, if home prices went down it didn't matter to owners as long as they made their monthly payments.

Third, private-sector lenders began offering longer-term loans to compete with the FHA program. In effect, the mere existence of the FHA program changed the mortgage marketplace.

Today, 30-year financing is the standard. Balloon notes and prepayment penalties are rare as a result of the 2010 Dodd-Frank Act, legislation enacted to make the mortgage marketplace less risky. Foreclosures are also rare: according to CoreLogic "the overall U.S. mortgage delinquency rate declined to a new low in March, buoyed by an exceptionally strong job market."

Friends are likely encouraging the use of the FHA program because it has helped so many first-time buyers. That's because it allows individuals to purchase with just 3.5% down and credit scores as low as 580. For those with scores between 500 and 579, the program requires 10% down. But be aware, few FHA loans are made to those with credit scores at 579 and below and rates are likely to be steep.

How is it possible for the FHA to back financing with so little down?

The FHA is not a lender. It's an insurer and what it insures is that if a borrower finances with FHA backing and doesn't make their payments, the FHA will step in and cover the lender's losses. With that protection, lenders will finance homes with little down rather than the 20% upfront they prefer.

The FHA – like any insurance program – has to have reserves in case there are lender claims. It gets the money from borrowers by charging premiums. In most cases, there's a 1.75% upfront mortgage insurance premium (the upfront MIP), and a .55% monthly charge (the annual MIP). The annual premium was lowered from .85% in March, reducing monthly costs and making the FHA program more attractive.

If you're looking for a mortgage program with little down, also consider such options as VA mortgages (0% down for those with qualified service), the USDA program (0% down) and 97% LTV options (3% down) from Fannie Mae and Freddie Mac. Local mortgage lenders can give you specifics.

Question for the Expert? Email your real estate questions for Mr. Miller to peter@ctwfeatures.com