FHA Mortgage Insurance

Mar 9, 2012 by

The Federal Housing Administration (FHA) offers insurance of mortgage loans made by FHA-approved lenders. The FHA doesn’t lend money, but by guaranteeing repayment of a mortgage should the borrower default, some people will qualify for a loan who otherwise would not, absent the FHA insurance. And loans insured by the FHA will generally have lower rates and require less down payment than a comparable loan without the insurance.

Who Qualifies?

Determining whether you qualify for an FHA loan is no simple exercise, and the rules vary by region because the general cost of housing varies by region. Also, the terms of a particular FHA-insured loan depend on the borrower’s circumstances. For example, for creditworthy borrowers, the FHA may allow a down payment as low as 3.5%. But not everyone qualifies for this minimum. If you’re shopping for a home, ask your mortgage lender whether you qualify and on what terms. He or she likely already has the information needed to tell whether you meet the FHA’s criteria.

Debt to Income Ratio

One factor that the FHA does apply uniformly to all loan applicants is a Debt to Income ratio. To qualify for FHA insurance, the borrower’s Debt to Income ratio must be below a certain threshold. The FHA looks at two separate ratios: 1) Mortgage Payment divided by Gross Monthly Income, and 2) Total Fixed Payment divided by Gross Monthly Income.

The Mortgage Payment used in the calculation includes escrowed homeowners insurance, property tax, mortgage insurance premium, etc. Gross income includes a spouse’s, if married. And Total Fixed Payment means all debt payments the borrower is obliged to make, including for student loans, car loans, credit cards, etc. An example:

Mortgage Payment = $750 (for a loan under consideration)

Gross Monthly Income = $2,850

→ Ratio #1 = $750 ÷ $2,850 = 26%

 

Student loan payment = $145

Credit card minimum payments = $325

Car loan payment = $275

Total Fixed Payment = $750 + $145 + $325 + $275 = $1,495

Ratio #2 = $1,495 ÷ $2,850 = 52%

 

Under FHA guidelines, the maximum allowed Mortgage Payment to Gross Income ratio (#1) is 29%. So this borrower, with a ratio of 26%, would qualify under that criterion. The maximum allowed Total Fixed Payment to Gross Income ratio is 41%. With a ratio of 52%, this borrower would not qualify for FHA insurance on this particular loan.

Since the Total Fixed Payment to Gross Income ratio must be less than 41%, the largest allowed Total Fixed Payment is

41% x $2,850 = $1,168 (remember $2,850 is the borrower’s gross income)

But this borrower’s debt payments, excluding a mortgage are

$145 + $325 + $275 = $745

So, the maximum allowed mortgage payment would be

$1,168 – $745 = $423

A $423 mortgage payment—which remember includes escrow, etc.—is going to work out to something like a $75,000 mortgage loan at today’s 30-year rates. If the borrower is looking for homes much above this price point, he or she won’t qualify for FHA insurance without making a down payment large enough to drive down the mortgage to $75,000. And one of the benefits of FHA insurance is a much lower down payment than a lender would require for an uninsured mortgage loan.

This Borrower’s Options

The ratio has two parts, so to qualify for FHA insurance, this borrower has to make progress on one or both parts. The borrower must

→ Increase gross income, and/or

→ Cut debt to reduce monthly debt payments

Say the borrower would like to get a FHA-insured $100,000 mortgage. If the fully loaded mortgage payment is $600, then other debt payments must total less than $568.

Maximum Total Fixed Payment (from above) = $1,168 less $600 mortgage = $568 other debt payments

So the borrower could qualify by cutting non-mortgage debt payments from the current $745 to $568.

Alternatively, the borrower could increase gross income by $430 to $3,280. Then, with the current debt payments and a $600 mortgage payment, the Total Fixed Payment to Gross Income ratio would be

($600 + $745) ÷ $3,280 = 41%

Or many combinations of cutting debt and boosting income would also do the trick.

How Large a Mortgage Would Qualify?

Using the FHA ratio guidelines, we can back into the maximum mortgage payment this borrower could have and still qualify for FHA insurance.

FHA Insurance Isn’t Free

The FHA charges both an upfront premium and an annual premium for its mortgage insurance. (Keep in mind that anyone who makes less than a 20% down payment generally is going to be required by the lender to buy private mortgage insurance for a non-FHA loan.) The FHA’s premiums seem to change regularly, but presently the upfront premium, due at closing, is 1.5% of the loan amount and the annual premium is 0.5% of the loan amount. However, the upfront premium ($1,500 on a $100,000 mortgage) can be rolled into the loan and financed along with the mortgage.

Here’s a video featuring Mr. Frank Chen of REIClub.com on the pros & cons of FHA loans.

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