An FHA loan is a mortgage loan that is backed by the Federal Housing Administration, a government sponsored entity. The FHA was created with goal in mind to increase home-ownership throughout the nation. It accomplishes this goal by lowering the down payment required to purchase a home and providing guarantees to potential lenders through its mortgage insurance program.
To qualify for an FHA loan, you will need the following:
A 3.5% down payment if your credit score is 580 or above
A DTI (debt-to-income ratio) of below 50%
Documentation of income and employment
Occupancy of the home as your primary residence
Other contextual related factors such as time between bankruptcy or US citizenship
An FHA loan is great for first time home buyers, people with little cash for a down payment or people who have below average to average Fico scores. Ordinarily it would be difficult for an individual who falls in this bucket to receiving financing for a home purchase but because the FHA is providing backing, it expands the amount of people who can receiving financing for a home. The FHA does this through the use of mortgage insurance.
There are two types of mortgage insurance premiums that the FHA charges, UFMIP (Up Front Mortgage Insurance Premium) and MIP (Annual Mortgage Insurance Premium). The UFMIP is an initial fee that the FHA charges to help insure the rate of the mortgage and allow friendlier credit conditions for FHA borrowers. The charge is equal to 1.75% of the total loan amount. For example, on a loan amount of $350,000 a 1.75% initial charge, $6,125, will be added into the costs of the loan. The MIP (Annual Mortgage Insurance Premium) is a reoccurring yearly charge that gets paid down monthly. The MIP is typically .8% of the total remaining principle balance. For example, on a loan amount of $350,000, a .8% yearly charge, $2,800, is paid monthly and is included in your escrow payment. The .8% charge is uniform across all credit scores and all LTV (Loan to Value) levels.
While FHA loans can provide some a great opportunity to purchase a home, it does not come without its drawbacks. To build wealth long-term, one needs to achieve the highest return on investment possible for the lowest risk possible. There are two parts to receiving a high return on your investment, the appreciation of your home, and the reduction of your outstanding principal balance. In the beginning of an FHA loan, the majority of your monthly payment is going to the lender in interest and the FHA in insurance premiums. What’s left over goes toward your principal balance. For example, say that your home is worth $375,000, you make an initial down payment of $20,000 and that your remaining principal balance is $355,000. At an interest rate of 5.00% and a MIP rate of .8%, your total monthly payment (excluding property taxes and homeowner’s insurance) would be $2,142 a month. Of that $2,142 monthly payment, the portion going toward your lender in interest is $1,479 and the portion going toward the FHA in insurance is $237. That means of your $2,142 monthly payment only $426 is going toward paying down your principal. If we were to do the math annually, your annual payment would be $25,708 of which $17,750 would be paid to the bank in interest, $2,840 would be paid to the FHA in mortgage insurance and the remainder $5,146 would be paid to you by reducing your principal balance.
If we assume, for the sake of ease, that your home doesn’t appreciate in value, that would mean in the first year you would have made a $5,146/$20,000 = 25% return on your initial investment. While this is an extraordinary return measured against any metric, compared to the $20,590 that you paid in interest and mortgage insurance over the course of the year, the $5,146 amount that was paid toward your principal is low relative to what the lender and FHA were paid. Getting a lower interest rate and reducing your MIP interest rate or removing it all together, will lower your overall monthly payment and increase the amount that you pay toward your principle, resulting in a higher return on your investment.
If you are interested in learning more or refinancing to get you in the best rate possible, call today for more information.
