Friday, May 9, 2014

The Mortgage Insurance Debacle

Mortgage insurance (AKA "MI") is one of those necessary evils that most buyers have to endure in order to get into their new house. I find that many people are unaware of exactly what MI is and what it "covers".

First a basic profile of loan types. Conventional loans generally conform to a set of standards and guidelines imposed mostly by one of two major investors; Fannie Mae and Freddie Mac. These loans are packaged and traded as securities on the open market. They are based on a 20% down payment. Since many borrowers lack the ability to make a 20% down payment; mortgage insurance companies offer to insure the down payment (or lack thereof). FHA loans are insured by the Federal Government rather than a private mortgage insurance company. VA and USDA loans are guaranteed by the Federal Government. A federal guarantee is stronger than Federal Insurance from an investors point of view. There are non-conventional loans that represent a very small percentage of mortgages. These loans are often held in the lender's portfolio rather than sold to investors.

MI is designed to cover the bank's (or investor) exposure to risk due to a small down payment. Traditionally a 20% down payment is required to avoid having mortgage insurance. Often people assume that the MI covers the full balance of the loan in case of default. It does not however. It covers the gap between what was actually paid as a down payment and what "should" have been put down. For example, if a borrower is buying a $200,000 home and plans on paying a down payment of 5% with conventional financing they will pay $10,000 down. The actual 20% down payment would have been $40,000. The bank is therefore taking on additional risk to the tune of $30,000. They will require  PMI (private mortgage insurance) to cover the $30,000 gap in the down payment. These conventional loans are packaged and sold to investors who are expecting a 20% down payment. This is why the PMI is needed.

Buyers need to understand the basic difference between these various programs and the insurance associated with them to make the best decisions possible when considering their options for buying a home. Since I am not a professional loan officer, I will only use broad terms for discussing mortgage rates and services. I always recommend consulting a licensed mortgage professional for more detailed information. Mortgages are complex and programs vary substantially based on lender, borrower's credit profile, location, etc.

In general FHA is the most commonly used mortgage in our current lending environment. The attraction to FHA is widespread because it offers a low down payment of just 3.5% and very lenient credit and debt ratios when compared to conventional loans. This however translates into a more aggressive MI. FHA loans require a 1.75% up front MI fee. This fee is financed into the loan amount. Then there is a MIP or monthly insurance premium which is based on an annual premium of 1.35%. Using the same $200,000 dollar scenario as I did above it works out as such: $7,000 as a down payment leaving $193,000 as the loan amount. $3,377 is added to the loan amount to cover the 1.75% up front fee bringing the amount borrowed to $196,377. Now the monthly MI is calculated annually at 1.35% of the loan amount that works out to $3,043.84 a year or $253.65 a month. The MI on FHA loans is very expensive. The silver lining is that government loan rates (VA, FHA) are often the very lowest around and the aforementioned leniency can help borrows qualify where they might not otherwise.

Conventional loans use private mortgage insurance. These loans are underwritten by the lending institution but are subsequently underwritten again by the PMI company. Borrowers are run through two underwriting gauntlets which increases the chance of a loan failure. Conventional loans typically have slightly higher interest rates and are generally underwritten with tighter standards on credit profile and debt ratios. Conventional loans also have the advantage of temporary MI payments. Whereby FHA loans the MI is paid over the full life of the loan, PMI on a conventional loan can be removed once the loan to value drops under 80%. A borrower must refinance or payoff an FHA loan to get the MI removed. Refinancing in the future could be difficult if rates are substantially higher. PMI rates will vary widely based on both the down payment amount and the borrower's credit profile. A 5% down borrower will see a range of PMI monthly payments in the annualized 0.67% to 1.20% based largely on credit profile with those over 720 FICO seeing the lowest rates. I have a comparison below.

USDA loans are for rural areas and have modest income requirements. These loans offer 100% zero down payment loans to people who earn less than 115% of the local median income. There are a variety of restrictions, but this program can be a godsend for many borrowers. My experience is that USDA rates trend closer to conventional interest rates rather than the lower government rates on VA/FHA. The upside is in the MI. There is a 2% up front MI payment that is added to the loan amount and then a very low 0.40% annualized monthly payment. On that same $200,000 scenario the MI payment would be based off a higher loan amount since there is no down payment the borrowed sum would be $202,000. MI monthly would work out to only $67.33 per month!

VA loans are the best loan product going. They have the low government interest rates like FHA but have no monthly MI payments at all. VA requires what they call a "funding fee" up front but financed into the loan of 2.15%. Veterans with disabled status have this fee waived.

Now I would like to offer up a comparison of these various programs based on a borrower with average credit and solid debt ratios. As I mentioned above, buyers should always consult a local trusted mortgage professional to have their individual scenario evaluated. This example is purely designed for a comparative analysis only and borrowers may see different results based on their individual situation.

Let's assume Rhonda Renter is seeking to buy her first home. Rhonda is a Veteran of the US Armed forces with out a disability rating. She is pondering her options for a mortgage in a USDA qualified rural area and her income falls below the 115% of median threshold. Let's assume that Government rates are at 4.25% and USDA about an 1/8th higher and conventional 3/8th higher. She is willing to put as much as 20% down but wishes to hold on to her cash if possible. She has low debt to income so she qualifies for any of the standard programs. Below is a chart showing an estimate with three different credit scores. This is just a rough estimate. I would like to thank Mike Roy at Pinnacle Mortgage Bankers for calculating the PMI on the conventional loans for me.


In most cases, the best bet for a Veteran is the VA loan. For non-vets you can see a dramatic difference in the programs. Remember, FHA is often the most expensive loan for monthly payment, but FHA can also require less income for the same amount of borrowed money. This is especially true when the borrower has other debts. Many loan officers can work an FHA loan with clients that have over 50% debt to income ratios whereby the conventional product will rarely allow a borrower to exceed 45% debt to income. Often it is even tighter than that. FHA is also a bit more forgiving for lower credit scores and less rewarding for higher credit scores. Buyers should try to keep their overall debt as low as possible and should work on getting that FICO score up above 720. Non- veteran buyers can look to areas where USDA loans are approved but should be warned the the USDA process is a bit longer and sometimes runs out of funding. Buyers should be certain to check with a qualified loan officer before presuming that USDA is available.

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