When you buy a home and don’t have at least 20 percent saved for a down payment, mortgage lenders want to protect themselves from risk if you can’t repay the loan. That’s why they require borrowers to pay for mortgage insurance, which protects the lender from loss when a borrower can’t repay the loan.
With a conventional loan, private mortgage insurance, or PMI, of up to 1 percent of the loan amount is charged every year until you have at least 20 percent equity in your property. Loans insured by the Federal Housing Administration, or FHA, also require mortgage insurance, but it works differently than PMI.
FHA loans are attractive to some buyers because they come with lenient credit requirements, low closing costs and competitive interest rates. The added expense of FHA mortgage insurance, however, is a key drawback to this avenue of financing.
What is FHA mortgage insurance?
FHA mortgage insurance, like PMI, is an additional fee you pay to protect the lender’s financial interests in case you default on your loan. FHA borrowers are required to pay two FHA mortgage insurance premiums — upfront at closing, and annually for as long as you repay your FHA loan, in most cases.
How much FHA mortgage insurance costs
Here’s a look at the premium pricing for upfront and annual mortgage insurance premiums for FHA loans:
- An upfront mortgage insurance premium, which is equal to 1.75 percent of the loan amount
- Annual mortgage insurance premiums, which are equal to .45 percent to 1.05 percent of the loan amount each year of your loan term
Upfront mortgage insurance premiums can, and often are, financed into the loan amount, says Peter Boomer, a mortgage executive with PNC Bank. Annual premiums are included in the borrower’s monthly mortgage payment.
Monthly mortgage insurance premium amounts are also determined by the loan term — whether an FHA loan is 15 or 30 years — and the initial loan-to-value ratio on the home when the borrower takes out the loan.
How long you’ll pay FHA mortgage insurance
One of the biggest differences between PMI on a conventional loan and FHA mortgage insurance is the fact that FHA mortgage insurance premiums aren’t optional and cannot be canceled in most cases.
Traditional PMI can typically be removed from a mortgage once a homeowner can prove they have 20 percent equity in their property, but the same can’t be said for FHA mortgage insurance.
“The length of time that a borrower pays the monthly mortgage insurance premium varies depending upon the original loan terms,” Boomer says.
While the law has changed more than once on this issue, current guidance states that consumers who put down less than 10 percent with an FHA loan must pay for FHA mortgage insurance until their entire loan term is over. If you put down at least 10 percent, you can have mortgage insurance removed after 11 years of payments.
FHA mortgage insurance vs. PMI costs
The speed at which you can have mortgage insurance removed is obviously very different among FHA loans and conventional loans, but the costs are another key differentiator.
Let’s compare how FHA mortgage insurance and PMI costs measure up.
The amount you pay for PMI can vary depending on your credit score and down payment amount. For borrowers with excellent or very good credit, or FICO scores of 740 or higher, PMI payments can be lower. Annual mortgage insurance premiums for FHA loans vary based on the loan term and loan amount.
How to remove FHA mortgage insurance
Paying for FHA mortgage insurance for 11 years or longer may sound like a drag, but this expense doesn’t have to last forever.
Many borrowers use FHA loans as a stepping stone that can help them reach the dream of homeownership, says Gary Acosta, CEO of the National Association of Hispanic Real Estate Professionals (NAHREP). From there, they take steps to improve their credit scores and acquire more equity in their homes so they can refinance out of their FHA loan into a conventional loan with better terms.
“The FHA is a wonderful starter loan but, at some point, it can also be beneficial to refinance out of it for lower monthly payments, including no (mortgage insurance premiums) or PMI,” Acosta says.
It’s understandable to worry about the high costs of FHA mortgage insurance. Forking over an up-front premium is a tough pill to swallow but paying additional premiums for years or even decades can really eat into your budget.
Fortunately, FHA mortgage insurance premiums don’t have to be paid forever, depending on your down payment amount and the option to refinance out of the loan in the future. Investing in a home now could be a smart move, and an FHA loan could be what you need to make it happen.
“First-time homebuyers who find it difficult to save for a down payment with a high debt-to-income ratio, such as college graduates with student loan debt, would find an FHA loan helpful,” Acosta says.