Thursday, January 22, 2015

What Effect Will Lower FHA Mortgage Insurance Premiums Have on First-Time Homebuyers?

by Dan McCue
Research Manager
As mentioned in Tuesday’s State of the Union address, the Federal Housing Administration (FHA) announced that it will lower costs of government mortgages by reducing the annual Mortgage Insurance Premium (MIP) rate on most of its new single family home loans by 50 basis points, beginning on January 26. This left many wondering what exactly this means for borrowers and, in particular, what effect it might have on first-time homebuyers who make up a high portion of FHA borrowers and who largely remain on the sidelines.   

The MIP is a fee that FHA charges borrowers to maintain a reserve of funds necessary to insure lenders against losses on its loans. Since the MIP cost is assessed annually as a percent of outstanding principal and then divided across 12 monthly payments, the effect of the drop in MIP rate is in many ways similar to a change in the interest rate of a loan. But the MIP payment is added on top of monthly principal and interest payments, so it does not factor into amortization schedules in quite the same way as interest rates. Additionally, unlike interest payments that change month to month as a borrower pays down the loan balance, the MIP amount is also recalculated just once a year and remains fixed for that time. FHA also charges an up-front mortgage insurance premium (UFMIP) that is a one-time fee incurred at the origination of the loan, which remains unchanged by the recent announcement and currently stands at 1.75 percent of the original loan balance for most FHA loans.

This recent move to lower the MIP comes after several rounds of increases made to cover losses to FHA loans following the housing bust. Even after tightening lending standards and four rounds of MIP increases starting in 2010 (see Table 1), FHA was still forced to draw $1.7 billion from the Treasury in 2013 to remain solvent.  However, FHA’s FY2014 annual report, released in November, shows the FHA Mutual Mortgage Insurance Fund grew by $6.1 billion last year to a positive $4.8 billion in value. Although the capital ratio remains at just 0.41 percent, still well below the legally-mandated capital ratio of 2 percent, the tide has apparently turned and, as pointed out in a recent Urban Institute analysis, financial projections must suggest there is room for FHA to reduce MIP on new loans while still growing its reserves. Indeed, as we see in table 1, the new, lower MIP rates are still well above levels prior to October 2010.

Table 1: History of FHA mortgage insurance premium changes

Date of Change
<=95.0% LTV
> 95.0% LTV
FHA Announcement
Prior to October 4, 2010
50 bps
55 bps
October 4, 2010
85 bps
90 bps
Mortgagee Letter 10-28
April 18, 2011
110 bps
115 BPS
Mortgagee Letter 11-10
April 9, 2012
120 bps
125 bps
Mortgagee Letter 2012-4
April 1, 2013
130 bps
135 bps
Mortgagee Letter 2013-4
January 26, 2015
80 bps
85 bps
Mortgagee Letter 2015-01

Note: Rates shown are for 30-year mortgage that is no greater than $625,500.

So what is the impact of this change? The 50 basis point reduction in the FHA MIP rate amounts to a difference of $500 per year, or about $42 a month for every $100,000 of mortgage balance. Based on the current median home sales price, the administration announced that the average borrower will see a reduction in costs of about $900 per year. Likely this will have some impact at the margins. For first-time homebuyers, to whom fully 75 percent of FHA loans in FY2014 were originated, the modest increase in affordability could result in a short-term bump in sales activity that may or may not be measurable. 

To see how this change may affect first-time homebuyers, we look at the impact on home purchasing power for the typical renter. According to data from the Census bureau, the median renter household had an income of about $34,000 at last measure in 2013. Assuming this renter obtains an FHA mortgage with 3.5 percent down, a 4 percent interest rate and maintaining a 31 percent front end debt to income ratio – which is the published limit for FHA manually underwritten loans - the change in MIP increases the amount of house they could potentially afford from about $152,000 to $163,000, or about 7 percent. This price is still well below the most recent published NAR median home sales price of $205,300, but nonetheless amounts to an increase of $11,000 in home purchasing power for this borrower – also equivalent to a 6.7 percent drop in home price – that may open up a few more buying opportunities depending on the number of homes available on the market in this price range. The administration announcement estimated this at approximately 250,000 additional buyers over three years. 

What is not addressed by the analysis of the new MIP rates is the extent to which they will help those with less than stellar credit. FHA lenders use credit overlays to narrow the field of potential borrowers to those with the highest credit ratings. These and other credit barriers – evidenced by the still-historically elevated median credit score of the typical FHA borrower - are likely much more limiting to first-time homebuyers than affordability of mortgage insurance payments.  At the same time, rising home prices and/or interest rates may prove to have much more of an impact on affordability over the coming months. At the end of the day, however, the result is that this is a modest step that most likely won’t jeopardize the financial standing of FHA but will increase mortgage affordability for thousands of FHA borrowers and potentially even increase home buying opportunities at the margins at a time when credit remains tight, home sales are sluggish, and first-time home buying is struggling - which seems like a step in the right direction.      


  1. As you have written, this is a modest step in the effort to expand the home buying base. The reduction of the annual premium from 135bps to 85bps was an appropriate start which will hopefully bring the annual premium back to 50bps where it was from 1934 until 2010. The immediate benefit to home buyers starts with the impact this reduction has had on home selling realtors, who now believe FHA insured financing is back in play. Realtors had written off FHA as a viable financing option almost two years ago. They are now giving FHA another look and suggesting their buyers do the same. For low and moderate income (LMI) families buying their first home, there is now an alternative to the FNMA/FHLMC dramatically increased guarantee fee combined with the loan level price adjustments that hit hard on LMI families with mid-range credit scores and minimal down payments. But there's more to FHA than just the cost of insurance. For these LMI borrowers who represent more risk for lenders, FHA has the best Loss Mitigation plan available should the borrowers run into tough economic times. This quality program benefits the lenders as well. If housing is going to contribute to our economic recovery it needs FHA to play a role. This will hopefully be the start.

  2. Although the new market for housing in the Bay Area has been hurt in some ways, there is room for optimism as markets shift to add value and offer deals to help Americans buy homes. FHA is a program that offers many great benefits and affordable interest rates and, quite frankly, our news media probably has not gone on record about how this financing program is helping people in great numbers today.

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