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Q&A: Private Mortgage Insurance

Why finance a house through FHA

Question: I always thought that once borrowers have 20 percent or 22 percent equity in their houses, they can stop paying private mortgage insurance (PMI). However, I just heard that FHA will not allow borrowers to drop PMI no matter how much equity they accumulate. In order to stop it, they must refinance with a different lender. Is this true? And if so, why would anyone want to finance a house through FHA?

Ric: Yes, what you heard is true of FHA loans originated on and after June 3, 2013. FHA now requires PMI for the life of each loan regardless of equity.

That makes FHA’s mortgage insurance requirements far more expensive than those associated with conventional Fannie Mae and Freddie Mac loans. With FHA you pay a nonrefundable upfront fee of 1.75 percent at closing, plus an annual PMI fee of 0.85 percent for the life of the loan. By comparison, a conventional loan with 5 percent down has no upfront PMI, the annual PMI premium is only around 0.55 percent and PMI can be canceled when there is 22 percent equity in the house.

To clarify further, the 22 percent equity level to stop conventional PMI is based on the sales price on a purchase mortgage or on the appraised value on a refinance mortgage. It is not based on the house’s future value. Thus, if a borrower sees growth in value since the time of the purchase or refinance, simply getting a new appraisal that shows 22 percent equity does not guarantee PMI cancellation. That is entirely up to the mortgage company servicing the loan. It has no obligation to cancel the PMI.

Since FHA is so uncompetitive, why would someone use it for a mortgage?

One reason: FHA will allow the entire down payment (as little as 3.5 percent with FHA) to come from a gift from a relative or friend. Fannie Mae/Freddie Mac conventional loans require at least 5 percent of the down payment (which may be the entire down payment in many cases) to come from the borrower’s own funds.

Another reason is that FHA will accept lower credit scores without raising rates and fees than conventional lenders will.

Thus, someone with a relatively low credit score and little or no savings, but who is receiving a monetary gift, can buy using an FHA loan.

I would argue that people in such a position should rent until they improve their credit record, save enough for at least a 5 percent down payment and establish a rainy day fund as well. But unfortunately some real estate agents and mortgage loan officers who merely want to make a commission encourage people to obtain FHA mortgages — instead of coaching and educating them to get their finances in better shape before they take the home-buying plunge.

It’s a reminder that you should always take advice about financial issues from an independent, objective, fee-based advisor — not a commission-based salesperson who has a conflict of interest.

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