FHA Mortgages

Federal Housing Administration (FHA)

The Federal Housing Administration has long been a player in the mortgage industry. The Federal Housing Administration is a federal agency within the Department of Housing and Urban Development. The loan program was created in 1934 to assist homebuyers in acquiring property with small down payments. It is important to note that under the most prevalent mortgage program, FHA does not lend money. Lenders are given protection against default by the borrower. This protection is in the form of mortgage insurance and FHA is considered an insurance program. An FHA borrower actually pays for this insurance and these insurance premiums are called Mortgage Insurance Premiums, or MIP. Simply stated, FHA mortgages are mortgages made by private lenders that are insured by the Federal Government through premiums paid for by the users. Having insurance provided by the Federal Government enables the program to offer lower down payments, and allows more liberal qualification standards than comparable private mortgages.

The lenders actually can approve the mortgages for FHA under the Direct Endorsement Program. Lenders deal with FHA through the FHA Connection automated system. Through this system they can get case number assignments (for new appraisals under the CHUMS system), borrower credit watch (under the CAIVRS system), and access to MIP refund information for refinances. FHA-approved condominiums and appraiser lists are also available from this system.

Who is eligible to obtain FHA mortgages?

Any borrower of legal age can participate in FHA Mortgage Program. Citizenship is not required, though physical evidence of a social security number and picture identification must be presented at loan application. The lender must determine residency status for non-U.S. citizens. There are no income restrictions, however maximum mortgage limits ensure the program will serve primarily lower and middle income homeowners. In addition, all parties to the transaction must be checked through the Denial of Participation List and the Federal Government’s List of Excluded Parties. The validity of the social security number will be verified as well. Two or more borrowers, or co-borrowers, can finance a house under FHA program. These coborrowers need not be related, but they must have a family-type relationship if one of the coborrowers does not occupy the house. In this case the co-borrower is defined as a non-owner occupant co-borrower.

FHA currently limits one FHA mortgage per borrower that can be outstanding at any one time. Prior to 1992, each borrower was limited to one high balance (defined as above 75% loan-to-value) FHA mortgage outstanding at one time. Currently, there are exceptions to the one FHA mortgage rule for hardship situations (for example, transfers in which the home currently owned and financed by FHA cannot be sold, a new home is mandated by an increase in family size, or the home being vacated will be occupied by a co-mortgagor). In the price range of FHA mortgages, borrowers retaining more than one FHA mortgage are not common—especially now that assumptions are restricted to owner occupants.

In May of 2003, FHA released its ban on financing when the property is being “flipped” as defined a by resale in the first 90 days after a home is purchased. Resales within 91-180 days may require additional documentation if the original value increases significantly. The sale must also be from the owner of record. Rules released in December of 2004 specifically exempt property acquired through inheritance or properties bought and sold through FHA or other governmental agencies.

Types of transactions financed under FHA

FHA finances the following types of transactions:

Owner-occupied purchase transactions (203b). The vast majority of FHA financing is for purchases of primary residences (must be occupied within 60 days of settlement). Investors cannot finance purchases through FHA and the financing of second homes is restricted to hardship situations. FHA is prohibited from insuring a mortgage on a second home that is a vacation or investment property.

Owner-occupied rate reduction4 refinance transactions (203b). Homeowners can refinance their current mortgage through FHA program. If the homeowner currently has an FHA mortgage on the property and the new FHA mortgage will result in a lower payment, the homeowner can participate in FHA Streamline, or FHA Rate Reduction, refinance program. This program requires no income re-qualification as long as there is a good mortgage payment history. Although FHA does not require an appraisal if the original mortgage amount is not exceeded through including the costs of the refinance in the new loan amount, a lender may require that an appraisal be provided. A borrower may not receive cash back under this program except for minor adjustments that may occur at closing; these adjustments may not exceed $250. Under the FHA Streamline Program, a homeowner who no longer lives in the property but has an FHA mortgage can obtain an FHA mortgage with a lower payment through a refinance as long as no closing costs are financed. Though one can refinance a conventional mortgage to an FHA with full processing, this option is not popular due to the need to pay FHA mortgage insurance.

Owner-occupied cash-out refinance transactions (203b). An existing homeowner can refinance his/her primary residence to take cash out, or pull equity out, up to 95% of the appraised value of the property if purchased more than one year prior or up to 95% of the sales price if the property was purchased less than one year prior. In other words, if a homeowner had a property worth $100,000 and a present mortgage of $50,000, the homeowner could obtain a new mortgage of $95,000. Cash-out refinance transactions are limited to homeowners who have had their present mortgage for at least six months. This is also referred to as six months seasoning. The growth of conventional cash-out alternatives, including second mortgages, has caused the popularity of this option to decrease.

Rehabilitation mortgages (203k). These mortgages are used for the acquisition of properties that need repairs or rehabilitation. The cost of rehabilitation can be included in the mortgage amount with no additional down payment required. The eligible improvements must amount to at least $5,000 under this program. Minor improvements amounting to less than $5,000 are not eligible. The lender loans enough money to acquire the property and places the excess necessary to complete the repairs in escrow5—the estimate of which is determined by plans submitted at the time of the loan application. The repair money is then released in increments, or draws, as the work is accomplished in stages. Fixed rate and adjustable rate mortgages are available under this program. Previously, investors could finance properties under this program with a larger down payment, but in October 1996, FHA declared a moratorium on the financing of investor properties using 203k. Late in 2002, FHA proposed limiting the total improvements to 20% of the maximum FHA loan amount, but this rule has not been implemented as of early in 2005.

Qualified veterans (203b Vet). FHA finances purchases for qualified veterans. This program does not differ from any other FHA program except that the minimum 3.0% cash contribution does not apply. Therefore, the seller can pay all closing costs up to the maximum of 6.0% allowed by FHA without an increased down payment required. The program is open to all veterans, but is not for active military personnel. A Certificate of Veterans Status from the Department of Veterans Affairs must be provided.

Assumptions. FHA mortgages closed before December 1, 1986 are fully assumable by owner occupants and investors for a $125 fee. FHA mortgages closed from December 1, 1986 to December 14, 1989 are fully assumable by owner occupants but investors must pay the loan down to 75% LTV. Mortgages closed after December 15, 1989 require buyer qualification for a fee of $500. Investors cannot assume these mortgages.

Types of properties eligible for FHA

Generally, FHA programs include all properties that contain up to four units. Condominium projects must be approved by FHA for properties within the developments to obtain FHA financing. In January 2003, FHA announced it would no longer require approval of planned unit developments (PUDs). For new homes, FHA must approve the plans and specifications of the home to be financed. If the plans and specifications of the new home are not approved by FHA, the home must be covered under an FHA approved warranty program of at least one year, or the borrower must provide a minimum down payment of 10 percent. FHA does not finance farms and the land upon which the property is located cannot exceed what is necessary for livability.

The issue of condominium project approval is the most complex property issue associated with FHA mortgages. In general, condominium projects must adhere to the following rules:

70% of the project must be sold (the developer cannot hold more than 30% of the project, whether the project is complete or not);

100% of the common areas must be complete, or there must be approved financial protection such as bonds or escrows;

51% of the units must be the primary residences of the occupants (no more than 49% investorowned units). FHA local regions have the authority to increase this requirement to 70%;

The legal documents must be in compliance with local, state, and federal laws, with a specific reference as to compliance with FHA regulations;

The annual budget and insurance coverage must be acceptable to FHA;

There will be a site inspection by FHA to determine the acceptability of the facilities of the project (for example: is the roof in good maintenance?);

If a new project, the sales must be governed by a Fair Housing Plan;

If a conversion from rental units has occurred, the units must have been converted for at least one year before FHA lending can take place (except for existing tenants);

An environmental assessment of the project must take place;

If the project is built in legal phases, compliance may take place phase-by-phase;

If the project is approved by the Department of Veterans Affairs (VA), an abbreviated approval process may be acceptable, but the 51% owner-occupancy and 70% presale requirements will still stand.

In August of 1996, FHA issued procedures for condominium units to be approved on a spot basis when it appeared that the association could not make changes in the legal documents. Projects are limited in the number of units that can be "spot" approved.

FHA appraisals are called conditional commitments and lenders can hire staff appraisers (appraisers employed by the mortgage company) to issue the conditional commitments. These appraisals are valid for six months and approvals issued are called firm commitments, which expire when the conditional commitments expire. A blanket appraisal can be accomplished for a new subdivision and this is called a master conditional commitment, or MCC. In this case, FHA approves the plans and specifications for each model in the subdivision and a final inspection is accomplished when each home is completed. FHA regions no longer approve builders within a particular jurisdiction.

If the lender is Direct Endorsement (which means the lender approves FHA mortgages without sending the mortgage to FHA for the decision), the designated appraiser sends the appraisal directly to the lender and the lender issues the conditional commitment. Appraisers approved by FHA are said to be part of the HUD Appraisal Roster. In late 1994, FHA approved rules allowing lenders to choose their appraiser from the roster without employing the staff appraiser.

In 1999, FHA implemented new appraisal rules designed to increase the accuracy and thoroughness of FHA appraisals. The Valuation Condition (VC) form filled out by the appraiser clearly indicates areas that must be inspected, including: potential hazards, mechanical systems, roofs, foundations, and more. In addition, any deficiencies must be noted in a Summary Report prepared for the purchaser.

Mortgage types offered under FHA

FHA Mortgage Program offers several types of mortgage instruments:

Fixed rate mortgages. FHA will insure fixed rate mortgages that carry anywhere from a 15 to 30 year term, although the 30-year fixed mortgage is by far the most prevalent FHA financing instrument. It is typical for FHA fixed rate mortgage pools to be securitized and sold through Ginnie Mae, which is also a Division of HUD. Until November 30, 1983, FHA published an interest rate ceiling that was set in tandem with VA's maximum interest rate. On that date, FHA deregulated the interest rate and the rate and discount points became negotiable between the borrower and the lender. For the first time, the borrower was eligible to pay discount points.

Fixed rate buydowns. FHA allows the temporary buydown of FHA fixed rate mortgages. As of July of 2004, qualification must be at the note rate of the mortgage. Increases are limited to no more than 1.0% each year. Ginnie Mae securitization requirements are different for these mortgages, therefore, the price of the FHA mortgage with a buydown may be greater than a comparable FHA fixed rate mortgage.

Adjustable rate mortgages (251). FHA annually insures a limited amount of one-year adjustable rate mortgages with caps of 1.0% each year and 5.0% over the life of the mortgage. The down payment and qualification guidelines mirror those of FHA fixed rate programs. As of March 1998, FHA borrowers applying for 1-year adjustable rate mortgages must qualify at the start rate plus 1.0% if the LTV is 95% or greater. The volume of adjustable rate mortgages that FHA can insure are allocated through guidelines set up through Congress. FHA began insuring hybrid adjustable mortgages with a minimum fixed period of three years in 2004 under a pilot program authorized by Congress. The program includes 3/1, 5/1, 7/1, and 10/1 adjustables -- with 5.0% life caps (3/1 and 5/1) and 6.0% life caps (7/1 and 10/1). The 3/1 and 5/1 were originally restricted to 1.0% annual caps, however there was poor reception in the secondary market for 5/1 adjustables with such a limited annual cap after five years, so Congress authorized a change to 2.0% annual caps for the 5/1. These adjustables do not allow temporary buydowns.

Reverse mortgage program (255). Home Equity Conversion Mortgages (HECM) provide equity-rich elderly homeowners with the opportunity to convert their equity into monthly income or a line of credit to help them meet living expenses while they remain in their homes (see Chapter 3). In September of 2003, FHA allowed the borrower to lock in rates at the beginning of the process rather than closing.

Energy Efficiency Improvements. Under the FHA EEM Pilot Program, a borrower can finance into the mortgage 100% of the cost of eligible energy-efficient improvements. To be eligible for inclusion into the mortgage, the energy-efficient improvements must be "cost effective," i.e., the total cost of the improvements (including maintenance costs) must be less than the total present value of the energy saved over the useful life of the improvements. The mortgage includes the cost of the energy-efficient improvements in addition to the usual mortgage amount.

Costs to obtain an FHA mortgage

This section covers costs of obtaining an FHA mortgage that are unique to the FHA program.

The downpayment requirement is described in this table: FHA Maximum Loan-to-Value

FHA mortgage insurance - FHA mortgage insurance, typically referred to as MIP, is the one closing cost that is unique to FHA mortgage programs. Every FHA mortgage must have mortgage insurance, regardless of the amount of the down payment. FHA collects mortgage insurance up-front and monthly, except for condominiums (Section 234C) and rehabilitation loans (Section 203K), which are only subject to monthly insurance costs. HUD proposed eliminating this exemption late in 2003. As of early in 2005 this change was not implemented.

a. Up-front premium. Beginning January 1, 2001 the amount of the up-front mortgage insurance was lowered to 1.5% of the mortgage amount for 30 year and 15 year mortgages. The amount of FHA up-front mortgage insurance premium was 3.0% (2.0% for 15 year mortgages) for Federal Fiscal Years 1993 and 1994.6 This premium dropped to 2.25% of the mortgage amount for FHA mortgages closed on or after April 17, 1994. The entire amount of this MIP can be financed into the loan amount. In other words:

If the FHA loan amount is $100,000 (base mortgage amount);

The mortgage insurance premium would be $1,500 ($100,000 x 1.5%);

The mortgage amount including MIP would be $101,500 ($100,000 + $1,500) (mortgage amount including MIP).

What really happens during an FHA mortgage transaction is that the borrower owes FHA a lump sum mortgage insurance premium. The lender making the FHA mortgage will actually lend the money for the premium to the borrower and send the money to FHA so that the mortgage will be insured. (FHA issues a mortgage insurance certificate, or MIC, to the lender that must be sent to Ginnie Mae as proof of insurance so the mortgage can be included with other mortgages in a pooled mortgage security sale.) If the mortgage is paid off before maturity, either through sale or through prepayment, FHA must refund the unused up-front MIP7. The amount of mortgage insurance to be refunded will decline each year (See the Refunds of One-Time FHA MIP Table). Effective with Mortgages endorsed for insurance after December 8, 2004, FHA will not refund unused up-front MIP except incases in which the loan is refinanced into another FHA mortgage.

b. Monthly mortgage insurance - There are two types of monthly mortgage insurance for FHA mortgages:

Condominiums and 203K. Since condominiums and 203K are not subject to upfront MIP, the monthly cost is stable at 0.5% over the life of the loan. HUD proposed changing this exemption in 2003.

All other properties. The amount of monthly MIP and the length of the premium depend upon the amount of the down payment, or the loan-to-value. FHA loan-tovalues are based on the mortgage amount divided by the acquisition cost. The acquisition cost is the sales price plus any allowable closing costs that are actually paid by the borrower. There is no current provision for removing the premium once the loan-to-value drops through prepayment except for loans closed after January 1, 2001. For 30-year mortgages closed after January 1, 2001, the premium is eliminated when the loan balance is 78% of the original purchase price, provided the premium has been paid for at least five years. Tables 2-3 and 2-4 summarize up-front and monthly MIP for FHA mortgages and give examples of how to calculate the monthly premiums.

FHA streamline refinances - As discussed previously, FHA streamline refinances are simplified refinances that allow the borrower to lower the rate on current FHA mortgages with minimum documentation. Any refund of the MIP due from refinance of the old mortgage would be applied to the new MIP due. Please refer to the FHA Mortgage Insurance Chart. For example:

Original Base Mortgage Amount: $100,000 ($102,000 with MIP);

New Base Mortgage Amount $102,000 (rolling in closing costs);

MIP Refund From Previous Mortgage: $1,000;

New MIP: $102,000 x 1.5% = ($1,530 - $1,000 refund) $530.

Additional Considerations. While there are no other unusual costs associated with procuring an FHA mortgage, there are a few other rules that are interesting to note:

Non-allowable FHA closing costs - The borrower may not pay certain lender fees, e.g., tax service, underwriting fees, etc. If these fees are charged, the seller must pay these costs. The lender normally discloses these fees to the purchaser at loan application, therefore the seller may very well be surprised by his/her liability for these charges. The lender cannot charge these fees on an FHA refinance.

Seller Contributions - The seller is not allowed to contribute more than 6.0% of the sales price toward the borrower's closing costs. Allowable seller contributions include: discount points, prepaids, closing costs, and funds toward a temporary buydown. Any contribution over the 6% limit decreases the sales price as a basis for figuring the maximum FHA mortgage amount (in effect, this increases the down payment to the purchaser).

Grant Programs - FHA allows the downpayment to come from a grant from a government or non-profit agency. The seller's "participation" that formerly enabled the non-profit agency to fund these grants, is now considered illegal though the money may not be distributed directly from the seller to the purchaser.

Lender paid closing costs - The borrower may opt for a higher interest rate that will enable the lender to give a credit towards the borrower's closing costs. This does not affect the required FHA down payment in any way, unless the discount points to the seller are increased to accommodate this credit. For example, the lender interest rate quote of 6.00% with one point,or the closing cost credit quote of 6.50% with one point credit, or if the mortgage is $100,000 with a credit of $1,000 towards closing costs.

FHA prepayments - During the payoff of an FHA mortgage, the lender has the right to collect interest to the end of the month in which the payoff occurs. This differs from conventional mortgages in which interest collection stops the day the lender receives the payoff amount. This is important to note because a homeowner selling or refinancing a home with an FHA mortgage should not leave enough time for the closing agent to get the payoff to the present lender. If the payoff is received by the lender one day late (the first of the next month), the lender will be entitled to charge an extra month's interest.

FHA qualification requirements

The qualification requirements for FHA mortgages are less stringent than comparable conventional mortgages. The following differences highlight the extent of this leniency:

Qualification ratios. While standard conventional qualification ratios are 28/36, FHA allows a housing ratio of 31% and a debt ratio of 43%. FHA published Mortgage Letters that stated its intention for these ratios to be guidelines only. In addition, FHA publishes specific compensating factors by which these ratios may be exceeded:

A conservative attitude towards the use of credit and demonstrated ability to accumulate reserves, resulting in a minimum of three months mortgage reserves after closing.

A minimum of 10% cash investment in the property.

A small (not more than 10%) increase in housing expense.

The borrower receives compensation not reflected in the effective income, but directly affecting the ability to pay the mortgage and other obligations.

A considerable amount of effective income comes from non-taxable sources.

Income of a temporary nature, while not considered effective, may be considered available to meet short-term non-recurring charges.

The term of the mortgage is less (by five years or more) than the maximum available.

Smaller families whose living needs permit them to live on less than larger families.

The ratios may be exceeded by 3% when the dwelling has been identified as energy efficient.

A down payment of 25% or more decreases the importance of ratio calculations.

It should be noted that most FHA mortgages are now underwritten through automated underwriting systems and these systems may approve ratios significantly higher than 31/43 when positive factors such as high credit scores exist.

Cash requirements are less. The cash requirements for an FHA transaction are less than those for a comparable conventional transaction:

FHA requires less than the typical 5.0% down payment required on conventional mortgages. Conventional mortgages requiring less than 5.0% down typically require higher credit scores, a higher interest rate, and/or maximum income limits. FHA does not require minimum credit scores, though low credit scores will significantly affect the results of automated underwriting systems. In May of 2004, FHA required the use of its TOTAL Mortgage Scorecard as a tool to evaluate the results of automated underwriting systems.

FHA does not require two months cash reserves. Three months reserves are required on 2-4 unit properties. These reserves cannot come from a gift.

All cash may come from a gift from an immediate family member, or someone with a family-type relationship. Many conventional mortgages require 5.0% of the cash to be from the purchaser's own funds. Gifts from a bridal registry or other legitimate occasion where substantial gifts are typically received are allowed, if deposited in a supervised account.

The funds for down payment and closing costs can be borrowed, but the loan must be secured and the borrower must qualify for the additional monthly payments. Funds for the downpayment can be borrowed unsecured from an immediate family member or be provided by a non-profit or government agency.

All mortgage insurance can be financed in the mortgage amount rather than paid in cash.

FHA co-borrower rules. FHA allows co-borrowers to help qualify for the mortgage and these co-borrowers do not have to live in the property (one unit properties only). The co-borrower must be an immediate family member or have a family-type relationship, and cannot contribute the vast majority of resources (cash and income) to the transaction. In other words, it must make sense that the occupant can make the payments and that the co-borrower is not an investor. The property must be one unit if the LTV is over 75% and a non-owner occupant co-borrower is being used.

Non-citizens. Borrowers do not have to have a green card to receive an FHA mortgage. They must have a valid social security number and must be in the country legally. The social security number will be validated by FHA.

Second mortgages. Governmental agencies may lend money for second mortgages to defray the purchase costs for qualified purchasers. Otherwise, FHA is more stringent than most mortgage programs with respect to the placing of the second mortgage behind an FHA mortgage during a purchase transaction. FHA does allow the placing of a second mortgage but:

The combination of the first and second mortgage cannot lower the required down payment or raise the maximum mortgage amount. Therefore, the second mortgage will save the purchaser no cash at settlement.

Regardless of the loan-to-value due to the existence of the second mortgage, the purchaser must still pay FHA mortgage insurance.

The combined mortgage amount of the first and second trust cannot exceed FHA maximum mortgage limits set in the local jurisdiction.

In other words, there is no advantage to placing a second mortgage behind an FHA first mortgage during a purchase transaction. There are no restrictions regarding placing a second mortgage behind an FHA mortgage when the FHA mortgage is being assumed by the purchaser of the property. This practice is quite common because it lessens the cash required for purchase assumption transactions.

Disadvantages. No loan program comes without disadvantages. FHA mortgages are less advantageous than conventional alternatives when a larger down payment is made (or there is significant equity in a refinance) because mortgage insurance is always required. FHA also requires many forms in addition to forms required by conventional alternatives. One form, the Homebuyer Summary, essentially asks the appraiser to certify that many aspects of the home are working and/or in good condition. With this level of review, more conditions are expected on the FHA appraisals.