This is part of an ongoing series in which we answer common questions about FHA home loans. Today’s question is: why do FHA loans require mortgage insurance premiums to be paid by the borrower?
Here’s the short answer: The Federal Housing Administration requires borrowers to pay mortgage insurance premiums when using an FHA loan because that is how they maintain their capital reserves. They use these funds to cover insurance claims made by mortgage lenders, when a borrower defaults on an FHA-insured home loan.
In other words, the insurance premiums paid by borrowers / homeowners pays for the entire program. Without these premiums, there would be no FHA loan program. And without it, borrowers would not be able to enjoy the low down payment and flexible criteria available through this program.
That’s the short answer. Here’s an in-depth look at FHA insurance requirements.
Why FHA Requires Borrowers to Pay Mortgage Insurance
The Federal Housing Administration mortgage insurance program gives borrowers a path to home financing with a relatively low down payment option. Borrowers who use this program to buy a house can make a down payment as low as 3.5% of the purchase price or the appraised value, whichever is less.
The FHA does not lend money directly to borrowers. Instead, they insure mortgage loans that are generated through the primary market by regular lenders.
This government-provided insurance protects mortgage lenders from financial losses related to borrower default (failure to repay). This added layer of protection also allows lenders to offer low down payments and flexible qualification criteria.
That’s the primary reason why FHA loans require mortgage insurance to be paid by the borrower. The Federal Housing Administration uses the revenue generated from these borrower-paid premiums to sustain its capital reserves.
Congress actually requires the FHA to maintain capital reserves at a certain level (2%), in order to cover insurance claims made by mortgage lenders. So this is a self-sustaining program. Many people think that FHA loans are insured from taxpayer dollars. But that’s not the case. In fact, the program generates its own funds by requiring mortgage insurance premiums from borrowers.
Simply put, FHA makes money by charging insurance premiums, and uses that money to cover claims made by mortgage lenders in cases where borrowers default on their loans.
How Much Does It Cost?
There are two different kinds of mortgage insurance premiums for FHA borrowers. There is an upfront premium that usually equals 1.75% of the base loan amount. There is also an annual premium that comes to 0.85% for most borrowers (though it can be higher than that in some cases).
You might have to pay the annual premium for as long as you keep the loan.
These premiums can usually be rolled into the loan and paid on a monthly basis, despite the fact that one of them is called an “upfront” premium. So it’s not necessarily something that has to be paid up front at the closing.
This is one of the drawbacks of using the FHA mortgage program. These insurance premiums can increase the size of your monthly payments, as well as the total amount paid overtime.
But there is another side to this coin as well. As we’ve discussed, the reason why FHA loans require mortgage insurance is because the program cannot run without. It is a self-sustaining program that uses funds generated from borrowers to cover claims made by lenders. In doing so, the Federal Housing Administration mortgage insurance program gives borrowers a low-down-payment financing option with flexible qualification criteria.
To recap: FHA requires mortgage insurance premiums from borrowers in order to sustain the federally-mandated capital reserves they use to cover insurance claims made by lenders. While these premiums do increase your borrowing costs, they offer advantages as well. This program would not function without funds generated from mortgage insurance premiums. And without this program, many borrowers would have to make larger down payments and/or wait longer to buy a house. So you can think of it as a necessary “evil.”