What it means
The FHA was created in 1934 to make home loans safer for lenders and more affordable for buyers during the Great Depression. Today a borrower applies to an approved lender, and if the loan meets FHA standards the agency insures it against default.
If the borrower stops paying and the home is sold for less than the debt, the insurance reimburses the lender for the loss. Because the lender is protected, it can offer lower down payments, often as little as 3.5% of the price for borrowers who meet the credit requirements.
That makes FHA loans popular with first-time buyers and with people who have limited savings. The agency sets limits on the size of loan it will insure, and those limits vary by area and are reviewed over time.
Borrowers pay for the insurance through a mortgage insurance premium. There is usually an upfront premium, which can be added to the loan, and an annual premium that is collected monthly with the payment.
The rates and the length of time the annual premium is charged depend on the loan size, the down payment and the term, and they change from time to time. For businesses, FHA lending matters in several ways.
Mortgage lenders and servicers earn fees from FHA loans, builders rely on buyers who qualify for them, and investors buy securities backed by FHA loans. Finance teams in those industries track the premium rates and the lending limits because a change can alter demand overnight.
One nuance is that FHA insurance protects the lender, not the borrower. A borrower who falls behind still faces late fees and possible foreclosure, although FHA programmes include options to help with temporary hardship.
Another is that FHA loans are generally for owner-occupied homes rather than investment properties. For anyone advising buyers, the key habit is to look at the full monthly cost rather than the headline down payment.
The premium, property taxes and homeowner insurance together can add a meaningful amount to the payment. Running the numbers early avoids a nasty surprise at the closing table.
In practice
Real-world examples.
Example
A teacher in a mid-sized city has $9,000 saved and a modest credit history. An FHA-insured loan lets her buy a $210,000 home with a down payment of about 3.5%. A conventional lender would have asked for a larger deposit, and she would have needed several more years of saving.
Example
A small home builder finds that most of its buyers rely on FHA financing. The finance director models what would happen to sales if the insurance premium rose by 0.25 percentage points. She finds that monthly payments for a typical buyer would rise by only a small amount, but that some marginal buyers would drop out.
Example
A mortgage bank originates $50,000,000 of FHA loans in a quarter. It pools the loans into securities guaranteed by a government body and sells them to investors. The bank earns origination fees and keeps the servicing rights. Its finance team tracks the servicing income separately because it continues for as long as the loans are outstanding.
Formula
Calculation
Upfront premium = base loan amount x upfront premium rate
Base loan amount = purchase price - down payment
Suppose a buyer purchases a $200,000 home with a 3.5% down payment and the upfront premium rate is an illustrative 1.75%. Down payment = 200,000 x 0.035 = $7,000, so the base loan = 200,000 - 7,000 = $193,000. Upfront premium = 193,000 x 0.0175 = $3,377.50. If the premium is added to the loan, the amount financed becomes 193,000 + 3,377.50 = $196,377.50.Case study
Seen in the real world.
Maplewood Homes is an illustrative, fictional builder of starter homes priced around $240,000. Its sales manager notices that buyers keep failing to get approved with conventional lenders because of low savings.
The finance director studies the numbers. With a 3.5% down payment, a buyer needs $8,400, compared with $48,000 for a 20% deposit. She trains the sales team to introduce buyers to lenders who offer FHA loans, and builds the upfront premium into the buyer's closing cost estimate.
Sales rise from 30 to 42 homes a quarter in this illustrative case, which adds 12 x 240,000 = $2,880,000 of revenue per quarter. The lesson is that understanding a government insurance programme can open up a whole segment of buyers.
Watch out
Common mistakes.
- Believing the FHA lends the money directly, when it insures loans made by private lenders.
- Ignoring the mortgage insurance premium when comparing monthly costs, which makes FHA loans look cheaper than they are.
- Assuming FHA insurance protects the borrower from foreclosure, when it protects the lender against loss.
Questions
People also ask.
Who can get an FHA loan?
Borrowers who meet the credit, income and property standards of an approved lender, usually for a home they will live in.
Is there a limit on FHA loan size?
Yes, the agency sets limits that vary by area and are reviewed periodically.
Does the FHA set interest rates?
No, lenders set the rates, although the insurance often helps them offer competitive terms.
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