FHA Home Loans: What’s the Advantage?
With subprime, bad credit mortgages forcing many borrowers into foreclosure, more and more are considering FHA products. But what do these entail?
For the most part, according to Jack M. Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania, FHA home loan borrowers:
- Have blemished credit acceptable to FHA, but not strong enough for prime pricing in the conventional market.
- Don’t need a mortgage larger than the FHA maximum, which varies by county. (In 2006, it ranged from $200,160 to $362,790 in the highest-cost counties.)
- Can put 3 percent of the purchase on a down payment in cash.
- Don’t want an interest-only mortgage or an option ARM.
Credit Requirements: At risk of oversimplifying, credit standards in the conventional market range from A+ to D-, and within that range, FHA would be about B- or C+.
FHA credit requirements overlap the higher levels of subprime requirements. A good illustration is the underwriting rules applicable to a prior foreclosure. With exceptions, FHA won’t accept a loan applicant who has had a foreclosure within the prior three years.
Subprime mortgage lenders may have a three-year rule for their best credit grade, but the period scales down by degrees and might be only one year for the lowest grade.
Similarly, the maximum ratio of total debt service to income acceptable to FHA home loan borrowers is 41 percent, which is generally high relative to prime standards, but well below what passes in the nonprime sector.
A borrower who meets FHA credit standards will usually do better with an FHA loan than with a subprime loan, despite having to pay a mortgage insurance premium. The rate will be lower, the borrower will have access to a large menu of mortgages, and there are no prepayment penalties.
Most mortgages in the subprime market are 2-year adjustables with large margins, which means a high probability of a rate increase after two years, and they have prepayment penalties, usually for three years.
Home Loan Limits: The loan limits on FHAs are a major deterrent. HUD has asked Congress to allow the same loan amounts on FHAs as on loans purchased by Freddie Mac and Fannie Mae. In 2006, this would have meant an increase to $417,000 uniform across the country.
Down Payment Requirements: In 2000, FHA’s 3 percent down payment compared with 5 percent on most conventional loan programs. In 2006, however, zero-down home loans were widely available in the conventional sector, while the FHA minimum of 3 percent remained unchanged. Since zero-down loans have long been available under the VA program, FHA is now the only sector that does not have them.
This disadvantage of FHA is partially offset by down-payment-assistance programs available to FHA borrowers. One form of such assistance is second mortgages at preferential rates, which is the preferred method of public agencies at the city, county or state levels. These agencies have their own eligibility rules independent of FHA.
A second form of assistance is cash contributions from nonprofit corporations. These have no repayment obligation, but the funds provided come from home sellers who take account of the contribution in setting their sales prices.
Neither type of assistance is a good substitute for a zero-down program, a bill for which was introduced in Congress in 2004. So far, however, it has not been passed.