Mortgage Watch: FHA Tweaks Loan Formula -- Upfront Costs Lowered from 2.25% to 1%; Mortgage Insurance Increased from .55% to .9% Annually

Effective today, the FHA is tweaking its fee structure that will result in higher monthly costs for most borrowers in the first five years.

To recap, the FHA is in the business of insuring loans -- and not originating loans.  FHA loans were originally intended to help buyers with low downpayment (as low as 3.5%) and/or a low credit score.   As recently as a few years ago, FHA loans accounted for only 3% of the mortgage market.  Now, some estimates put FHA loan market share as high as 50%.

The good news is that upfront FHA loan origination fees will be lowered from 2.25% of loan amount to 1% of loan amount.  Most buyers roll these fees into the loan principal, resulting in marginally lower mortgage payments for the life of the loan.

The bad news is that mortgage insurance for FHA loans is increasing from .55% to .9% of loan principal annually.

Let's take a look at how this will impact the financing of a $500,000 purchase with 3.5% downpayment, resulting in a $482,500 loan.

Old Scenario:

Total Loan = $482,500 + 2.25% loan fees = $482,500 + $10,856 = $493,086 loan principal @ 4.5% interest = $2,498/month

Monthly Mortgage Insurance = .55% of loan amount annually = $493,086 x .0055 = $2,712 annually or $226 monthly

$2,724 monthly payment

New Scenario:

Total Loan = $482,500 + 1% loan fees = $482,500 + $4,825 = $487,325 loan principal @ 4.5% interest = $2,469/month

Monthly Mortgage Insurance = .9% of loan amount annually = $487,325 x .009 = $4,386 annually or $365 monthly

$2,834 monthly payment

Bottom Line:

For the purchase of a $500,000 property with 3.5% downpayment, the new fee structure will result in a $110 increase per month in payment, but the amount borrowed is $5,761 less.  Mortgage insurance is typically required only for the first five years of the loan, or until equity is above 20%.  After 5 years, the monthly payment under the new structure is $29/month less.

FHA loans have helped many borrowers purchase properties who otherwise would not qualify for a conventional loan.  These loans have experienced a high rate of delinquency (as of June 2009, there was an 8% delinquency rate on FHA loans), and it's no surprise that the FHA is raising their mortgage insurance fees.  These FHA loans remain a great resource for the buying public.