Federal Housing Authority, or FHA, mortgages come in many different varieties. Most FHA mortgages are used for home purchase, but FHA also offers home equity lines of credit, or HELOC, loans. The calculation of FHA mortgage rates is somewhat different than the calculation of rates for conventional loans, and it is useful to understand the differences between these types of loans.
Comparing FHA Loans to Conventional Loans
In a conventional loan agreement, a private company loans money to a borrower, and the company assumes a risk that the borrower will default on the loan and the company will lose money.
As with conventional loans, an FHA mortgage is a loan made by private mortgage company. The difference is that FHA charges a small fee to the borrower, and it uses this fee to guarantee the loan. This means that that the if the loan is not repaid, the loss will be assumed by the FHA insurance program instead of the lender.
Advantages of FHA Loans
The benefit of FHA loans is that they reduce the risk of lending to first-time home buyers or borrowers with low credit scores. FHA also allows lenders to make loans on risky types of property, such as manufactured houses or multi-family homes. In addition, FHA offers special low-cost loans for veterans of the armed forces, as well as teachers, police officers and senior citizens.
FHA loans often require a lower down-payment than conventional loans require. They may also offer more competitive rates, especially for borrowers with low credit scores. Another bonus is the absence of pre-payment penalties on FHA loans. This can be helpful to borrowers who plan to sell their home or refinance in the near term.
Disadvantages of FHA Loans
Although there are many good reasons to apply for an FHA loans, there are a few drawbacks compared to conventional loans.
Lending Limits: FHA loans were created for borrowers with low or moderate income. The amount of money available from an FHA loan is limited, and borrowers who plan to buy a higher-value home may need conventional financing unless they can make a large initial down payment. FHA does increase its lending limit in areas such as Alaska or Hawaii, where the cost of living is particularly high. The limit may also be higher for borrowers who are purchasing a multi-family home. Your FHA lender can help you determine what the lending limit is for your loan product.
Limited Options: In the past few decades, conventional mortgage lenders have offered a wide array of options to borrowers, such as balloon payments and interest-only loans. These options are not available on FHA loans.
Understanding FHA Mortgage Rates
When choosing a mortgage product, a lower interest rate is usually preferable. Lower mortgage rates mean that the cost of the loan is lower. For this reason, a borrower who can qualify for a lower interest rate may qualify to borrow more money, because less of the borrower’s income will be spent on interest.
On the other hand, some interest rates may be low at the time of closing but increase later. For this reason, it is not enough to pay attention to the initial interest rate. Borrowers also need to understand how the rate is calculated and how it may change after the closing.
FHA mortgage rates are calculated using an index, a margin and a mortgage insurance premium. The rates may be fixed, or they may adjust on a monthly or annual basis. Adjustable rates are capped to keep them from rising too high.
FHA Rate Indexes
Interest rates for mortgage loans are calculated using an index, which is a fluctuating indicator based on the returns from a group of financial investment instruments. The indexes for FHA loans are based on the yields on United States Treasury securities. Rates for a shorter-term loan will be calculated using yields from shorter-term Treasury bills. Rates for a longer-term loan will follow the yield on longer-term Treasury bills.
FHA Rate Margins
The index is only one part of the FHA mortgage rate. The rate also includes a margin, which is an amount added to the index to increase the rate. For example, if the index is 1% and the margin is 2%, the rate will be 3%. There are a few different factors which affect the margin:
- The margin varies depending on the type of loan.
- The margin may vary depending on which lender you choose. For this reason, it is wise to obtain quotes from more than one lender.
- The margin may vary depending on whether you have good credit.
FHA Mortgage Insurance Premium
Many FHA loans also require a mortgage insurance premium, or MIP. This MIP is paid into an insurance fund which reduces the amount of risk that the lender takes when it makes the loan. Some conventional loans have private mortgage insurance, or PMI, premiums instead. The benefit of the insurance premium is that it allows the lender to make loans to borrowers who might otherwise be too risky to lend to. The drawback to the insurance premium is that it may make the loan more expensive to the borrower in the long run.
The MIP on FHA loans comes in two parts:
- An upfront fee which is either paid at closing or added to the loan balance, and
- An annual fee that is calculated as a percentage of the loan balance, just like an interest rate. The annual fee does not apply on all FHA products, and on some products, it is only charged for the first few years.
If you refinance your FHA loan, you may receive a discount on the MIP for the amount paid on your original loan.
Fixed Vs. Adjustable Rates
FHA mortgage products are offered with fixed or adjustable interest rates, or a combination of the two.
Fixed Rates
A fixed interest rate is determined at the time of closing. The benefit of a fixed rate is that the monthly interest payment remains the same, and the total cost of the loan is determined at the time of closing. The drawback to a fixed interest rate is that the margin is higher than the margin on an adjustable mortgage. This usually means that the initial interest rate is higher, so the borrower may qualify to borrow fewer funds at the time of closing.
Adjustable Rates
The margin on an adjustable interest rate will be determined at closing, but the rate will continue to fluctuate after the closing in response to changes in the index. The initial interest rate on an adjustable-rate mortgage is often lower than the rate on a fixed-rate mortgage, which may benefit the borrower by making more funds available at the time of closing. Unfortunately, the borrower assumes more risk with an adjustable rate, because the rate could skyrocket after the closing. This would increase the borrower’s monthly payment and also increase the total cost of the loan.
Caps on Adjustable Rates
FHA adjustable-rate mortgages are capped, which means that the rate cannot rise above a specified amount. This limits the borrower’s risk. The cap may limit how high the rate can rise overall, and it may also limit how high it can rise each year.
Initial Interest Rates
Some FHA loans offer a hybrid between fixed and adjustable rates. The loan may have a fixed rate for an introductory period of a few months or a few years. After the introductory period, the rate may switch to an adjustable interest rate.
Choosing the Right FHA Loan for You
There are many varieties of FHA loans, and it can seem difficult to choose the right option. Here are a few tips to help you navigate the confusing world of mortgage products.
Look for Hidden Costs
When comparing mortgage products, resist the temptation to choose a loan based on solely on the interest rate. FHA loans may include many other costs, such as fees for credit reports and appraisals. The lender may also receive fees for originating the loan, processing the application and handling the paperwork after closing. These fees are not necessarily illegal or unethical to charge, but they are not included in the FHA mortgage rate, and they will affect how much the loan costs.
Fortunately, you will receive several disclosures showing the true total cost of the loan. At least one of these disclosures will show you an alternate calculation of the interest rate including all of the “extra” fees. In most loan applications, this will be referred to as an Annual Percentage Rate, or APR. Some loan applications will disclose a Total Annual Loan Cost Rate, or TALC, instead. As you shop for the right mortgage loan, take into account the APR or TALC in addition to the initial interest rate.
Find a Reputable Lender
There are several reasons to shop around for a good lender. As already mentioned, some lenders may offer lower prices than others. They may also offer different ranges of FHA products; for example, some lenders specialize in making reverse mortgages for senior citizens, while others may specialize in loans for first-time home buyers.
It is also important to find a lender with a good reputation. Although all FHA lenders must meet minimum standards for solvency and good conduct, not all FHA lenders are created equal. It may be worthwhile to pay a slightly higher fee to an established company with experienced loan officers. Experienced loan officers often have a better understanding of FHA products and lending guidelines, so they can explain your choices more clearly and help you identify any potential stumbling-blocks prior to the loan closing.
Ask Who Will Service the Loan
The loan servicer is the company that processes the loan paperwork after the closing. In many cases, the company that services the loan is not the same company that closed the loan. The quality of the servicer is particularly important for FHA home equity lines of credit and reverse mortgages, because you may be relying on your servicer to process any creditline withdrawals in a timely fashion. Be sure to ask your loan officer who will be in control of the loan after the closing. If you are applying for an FHA reverse mortgage or other unusual niche product, try to find a servicer who has a department of specialists who are dedicated to servicing this type of product.
Read Before You Sign
As with any kind of mortgage, the guidelines listed here are subject to changes and exceptions. For this reason, you should always be sure to read your mortgage documents closely before signing on the bottom line. You may even want to consult with an attorney before you close the loan. Although FHA has many guidelines designed to protect borrowers from fraud, there is no substitute for understanding your mortgage contract.