To encourage home buying during the Great Depression, the government created the Federal Housing Administration to provide insurance to banks on FHA-approved loans. If the borrower defaults, the bank is repaid in full and the home is taken over by HUD, the Department of Housing and Urban Development for sale.
FHA-insured loans are known as conforming loans, with loan limits of $417,000 or tens of thousands higher for high cost of living areas. They have their own requirements including income verification, credit scores, and work history.
If a borrower meets the loan standards, but doesn't have enough money to put down, the borrower is required to pay mortgage insurance premiums, or MIP.
Borrowers are required to pay 1.75 percent of the loan amount up front. This amount is usually rolled into the loan balance.
Borrowers will pay MIP until the loan is refinanced or otherwise satisfied, according to the loan to market value.
As of January 4, 2014, annual FHA MIP rates are as follows:
15-year loan terms with loan-to-value over 90% : 0.70 percent annual MIP
15-year loan terms with loan-to-value under 90% : 0.45 percent annual MIP
30-year loan terms with loan-to-value over 95% : 1.35 percent annual MIP
30-year loan terms with loan-to-value under 95% : 1.30 percent annual MIP
For FHA "Jumbo loans" exceeding $625,500, but less than $729,750, borrowers can expect to pay an additional 0.25 percentage point.
FHA loans are desirable because borrowers can finance within 3.5% of the purchase price of the home, and are subject to ceilings on the interest rates that can be charged by banks. In fact, MIP cannot exceed 1.55 percent.
A solution for non-conforming borrowers
But not every borrower meets FHA guidelines, particularly those who want to finance a larger, more expensive home, or unique homes that are more difficult to appraise. To serve these borrowers, lenders increasingly turned to non-government-insured loans.
Conventional loans are bank loans that are intended for purchase by the secondary market dominated by Fannie Mae and Freddie Mac. Conventional loan limits are larger and there is no interest rate cap, but their higher risk requires a bigger down payment from borrowers, usually 20% of the purchase amount. The loans are purchased by the secondary market and packaged into securities, allowing the banks to borrow fresh money for lending by the Federal Reserve.
Many otherwise qualified borrowers who are short on down payments can meet loan requirements by paying PMI, or private mortgage insurance. Like MIP, PMI allows borrowers to purchase a home with less money down, with PMI insuring the difference.
PMI is paid to the lender at closing by a private mortgage insurance company. The borrower pays back the PMI, along with principal and interest payments.
For example, a borrower could put 10% down, and obtain a conventional 80% mortgage with PMI paying the remaining 10%.
If you are planning to buy a home with less than a 20 percent down-payment, expect to pay MIP or PMI. To eliminate PMI, borrowers must pay their mortgages on time over time. PMI is automatically removed when the amount owed is no more than 78 percent of the original loan.
But to get mortgage insurance removed sooner, borrowers must provide a written request for cancellation of PMI as well as a copy of a professional appraisal that shows homeowner equity is at least 22 to 25 percent.