The Truth About FHA Loans

The Truth About FHA Loans

FHA loans are the highest cost loan that you can legally obtain for a primary residence.

Stated in another way, if you pursue an FHA loan, you will pay more for it than if you pursued any other mortgage loan type.

Why do retail lenders like Quicken Loans immediately direct their borrowers to FHA loans by default?

Why are FHA loans exempt from the typical high-cost loan tests associated with predatory lending?

What makes the APR on FHA loans 2% greater than the rate? 

If these questions intrigue you, please read on for some helpful information that may be difficult to find in other articles on the internet!

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Who is this blog article for?

If you’re a veteran or buying in a rural area, then the rest of this blog entry may not be helpful, because a VA or USDA loan may be a better fit for your purchase.

If you’re buying your first home in New Jersey and don’t have 20% saved for down payment, then this article is perfect for you, because we’re going to take an in-depth look at the best two loan options for your primary residence purchase – Federal Housing Administration (FHA) Loans vs Conventional Loans.

Congress created FHA in 1934, after more than 2 million construction workers lost their jobs. Only 1 in 10 American households owned their home, and the minimum down payment to purchase a new property was 50%!! FHA loans have evolved over the last 90 years, from primarily serving veterans and their families after World War II, to now federally insuring 8 million residential single family mortgages with about 1.3 trillion in total unpaid principal (hud.gov).

FHA loans have always had less stringent credit and qualification requirements than conventional loans, such as: lower minimum FICO score, mortgage insurance premium (MIP) that is a flat rate (regardless of FICO score – more on this later), decreased waiting times after derogatory credit events (bankruptcy, foreclosure, short sale), higher maximum debts are permitted vs qualifying income (higher DTI), lower down payment options for multi-family homes (only 3.5% down payment vs. 15% down payment). Another key difference is that FHA loans require owner-occupancy (meaning, you intend on living at the property as your primary residence for at least 1 year, otherwise it’s considered mortgage fraud).

The challenge with offering loans with less stringent guidelines is that a larger percentage of the loans default, meaning they are not paid on time or at all. The Department of Housing and Urban Development (HUD) uses insurance to solve the problem of riskier loans and higher default rates.

FHA loans have a cost called ‘Mortgage Insurance Premium’ (MIP), which is paid twice for every FHA loan. The upfront MIP is 1.75% of the loan amount and is paid on the closing day. The Annual MIP is paid each month that the loan is repaid. Your Annual MIP rate depends on your down payment.

If you make the minimum required down payment (which is what most FHA buyers do), then you will have the highest MIP rate 0.55%, and you will have to pay MIP for your entire loan term (typically 30 years). If you have 5% or greater down payment, you will get a little bit lower annual MIP rate – 0.50%, but you will still have MIP for all 30 years. If you have 10% or greater down payment, your annual MIP will still be 0.50% but your MIP will terminate after 11 years.

The cost of MIP (upfront and annual) is one reason why an FHA loan’s APR is usually 2% higher than the interest rate. The other extremely important reason is that annual MIP does not terminate unless you have 10% or greater down payment. This means that you will pay MIP ($100 - $500 per month) for 20+ years longer than you would pay Private Mortgage Insurance (PMI) for a similar conventional loan.

Why does FHA charge MIP twice? 

Why would anyone take such a high-cost loan? 

How are these high-cost loans permitted in our modern day, with so many consumer protections against predatory lending?

If you’re thinking any of these questions, keep reading!

FHA frequently uses the term “Federally Insured.” This means that if the borrower doesn’t pay the loan back (they default on the loan), FHA will cure any losses incurred by the broker or lender that made the loan. The benefit for the lender is that if they comply with all of FHA’s guidelines, they can collect payments from a client with almost zero risk. If the client defaults, the lender gets reimbursed from the government for any losses! How can FHA afford to do this? The answer is that they’ve built a huge reservoir of funds - $89.512 billion at the most recent measurement - so that FHA can pay for these losses if needed. How much are the losses each year? About $17.8 billion, according to HUD’s actuarial analysis completed for Fiscal Year 2022.

So, FHA charges MIP twice because they are trying to maintain enough funds in their giant reservoir to cover the possible losses associated with more risky mortgage loans.

Another clever aspect to the structure of FHA loans is the way upfront MIP is collected (1.75% of the loan amount). According to Zillow, the average NJ home price as of April 2023 is $451,559. If this is true, then the average New Jersey FHA mortgage borrower will pay $7,902 in UFMIP to obtain an FHA loan. This seems like a difficult fee to hide from a first-time homebuyer in New Jersey (we like to think we’re smart here in NJ!). The way that so many New Jersey borrowers are duped is that this large UFMIP fee is financed into the new loan.

Financed means added to the loan that you are taking.

For example, consider this scenario:

If you’re pursuing an FHA loan on a $500,000 home with 3.5% down payment, you probably are calculating your loan amount like this:

$500,000 x 3.5% = $17,500 Down Payment

$500,000 - $17,500 = $482,500 Loan Amount

…Right?

… Wrong!! For an FHA loan, you would be borrowing $500,000 - $17,500 + $8443 = $490,943. This clever trick (financing the UFMIP) is unnoticed or discovered too late in the homebuying process and is ultimately just accepted by all FHA buyers. If you think about it – how else could FHA extract $8,443 from New Jersey first-time homebuyers who may barely be able to pay their down payment and closing costs?

Financing this gigantic fee is legal through a series of exemptions from various federal and New Jersey state rules, including the Qualified Mortgage Rule (UFMIP does not count towards points and fees), Higher Priced Mortgage Loan definition (FHA is given an exception because the APR will almost always be greater than APOR), and a higher threshold for Points and Fees for New Jersey Home Ownership Security Act.

So why do many large retail lenders (Quicken being the most infamous) guide their prospective buyers (especially first-time buyers) towards FHA loans? There are legitimate reasons, like lower FICO minimum, more purchasing power, and lower interest rates (especially for lower-credit score borrowers). However, there are also lesser-known reasons: FHA borrowers refinance much less often (which means that there’s less of a risk of losing the client to a competitor); FHA loans are generally more profitable; and most importantly, FHA borrowers are typically less focused on shopping their rate and more focused on successfully obtaining their loan.

As a NJ mortgage broker, we have offered FHA loans and many other home loan types to our New Jersey homebuyers for the past 10 years. Despite being the highest cost option, sometimes they are the best option to meet our borrower’s goals (such as receiving a lower monthly payment but with higher closing costs, or not being able to qualify for a conventional loan due to low credit scores).

In summary, the truth about FHA loans is:

An FHA loan is your best option when it’s your only option.