Real estate finance 9

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Financing Residential Real Estate

Lesson 11:

FHA-Insured Loans

Introduction

This lesson will cover:

FHA loan programs
rules for FHA loans
FHA insurance premiums
FHA underwriting standards
specialized FHA programs

Overview of FHA Loans

Federal Housing Administration (FHA) created in 1934 as part of National Housing Act.

Purpose of act was to:

generate new jobs by increasing construction activity
stabilize mortgage market
promote financing, repair, improvement, and sale of real estate

Federal Housing Administration

Overview of FHA Loans

Today, FHA is part of Department of Housing and Urban Development (HUD).

Primary function is insuring mortgage loans.
Compensates lenders for losses from borrower default.
Does not build homes or make loans.

Federal Housing Administration

Overview of FHA Loans

FHA insurance program is called the Mutual Mortgage Insurance Plan.

Funded by premiums paid by FHA borrowers.

FHA mortgage insurance

Overview of FHA Loans

Direct endorsement lender: lender authorized to underwrite its own FHA loans.

FHA borrowers apply to lender, not FHA.
Lenders authorized to make FHA loans either:
submit applications to FHA for approval, or
underwrite applications themselves.

FHA mortgage insurance

Overview of FHA Loans

If FHA borrower defaults on loan:

FHA reimburses lender for full amount of loss.
Borrower required to repay FHA.

FHA mortgage insurance

Overview of FHA Loans

FHA-insured loan program intended to help
low- and moderate-income home buyers.

But eligibility isn’t restricted by income.
Instead, FHA sets maximum loan amounts.
Maximum generally only enough to buy moderately priced house.
Low downpayment requirements, lenient underwriting standards.

Role of FHA loans

Overview of FHA Loans

FHA loans fell out of favor during subprime boom.

Conventional underwriting standards were loosened and loans were easier to obtain.
FHA maximum loan amounts were too low to use in some areas.

Role of FHA loans

Overview of FHA Loans

FHA loans once again becoming more popular.

Low-downpayment conventional loans harder to get.
FHA maximum loan amounts increased.

Role of FHA loans

Overview of FHA Loans

Many different programs to fit different needs.

Programs referred to by section numbers taken from provisions of National Housing Act.

FHA loan programs

FHA Loan Programs

Section 203(b) is standard FHA program.

Most FHA loans are 203(b) loans.
Other programs are based on 203(b).
Can be used for purchase or refinancing of principal residences with up to four units.

Section 203(b) – standard program

FHA Loan Programs

203(k) program insures mortgages used to purchase/refinance and rehabilitate homes.

Section 203(k) – rehabilitation loans

FHA Loan Programs

234(c) program covers purchase/refinance of unit in condominium project approved by FHA.

Developer usually applies for FHA approval when project is built or converted. Requires:
at least 50% of units owner-occupied
adequate reserves and insurance coverage.

Section 234(c) – condominium units

FHA Loan Programs

Section 251 ARM program can be used to purchase/refinance owner-occupied residence with up to four units.

Must have 30-year loan term.
After initial fixed-rate period, adjustments occur on an annual basis.

Section 251 – ARMs

FHA Loan Programs

Qualifying rate: interest rate used to calculate monthly payment when qualifying buyer.

For most FHA ARMs: qualifying rate is initial interest rate.
For 1-year ARM with LTV 95% or above: qualifying rate is initial interest rate + 1%.

Section 251 – ARMs

FHA Loan Programs

Section 255 provides insurance for reverse mortgages, which FHA calls home equity conversion mortgages (HECMs).

Section 255 – HECMs

Summary
Overview of FHA Loans

FHA
HUD
Mutual Mortgage
Insurance Plan
Direct endorsement lenders
203(b) program
234(c) program
251 program

Rules for FHA Loans

FHA-insured financing must comply with FHA rules:

owner-occupancy
maximum loan amount
minimum cash investment
sales concessions
secondary financing
property flipping
assumption

Rules for FHA Loans

Borrower must intend to occupy home as principal residence.

Secondary residence only in limited circumstances involving employment-related reasons.
Investor loans generally not permitted.

Owner-occupancy

Rules for FHA Loans

Maximum loan amounts vary from area to area and are based on local median housing costs.

Tied to conforming loan limits set annually for Fannie Mae and Freddie Mac.

Local maximum loan amounts

FHA Local Maximum Loan Amounts

2018 basic maximum FHA loan amount for one-unit property is $294,515.

Basic maximum – most areas

In high-cost areas, maximum may be increased above area’s median home price, up to stated ceiling.

In 2018, “ceiling” is $679,650.
Higher ceiling applies in parts of AK, HI, Guam, and Virgin Islands.

Maximums in high-cost areas

FHA Local Maximum Loan Amounts

Maximum loan amounts set on county-by-county basis.

Limit may be adjusted periodically to reflect changes in cost of housing.
Check with local lender for current FHA maximum loan amount in your area.

Adjusted to reflect housing costs

FHA Local Maximum Loan Amounts

Rules for FHA Loans

Minimum cash investment: at least 3.5% of appraised value or sales price, whichever is less.

Maximum loan-to-value: 96.5%.

Minimum cash investment and LTV

Rules for FHA Loans

Interest rates negotiable between lender and FHA borrower.

Lenders can charge whatever closing costs are “customary and reasonable” in area.

Prepayment penalties prohibited.

Loan charges and closing costs

Rules for FHA Loans

FHA limits amount that seller or other interested party can contribute to buyer in transaction.

Purpose is to prevent parties from using contributions to defeat FHA’s LTV and minimum cash investment rules.

Sales concessions

FHA Sales Concession Rules

Seller contribution: when seller (or other interested party) pays for all or part of:

buyer’s closing costs or prepaid expenses
any discount points
temporary or permanent buydown
buyer’s mortgage interest
upfront premium for mortgage insurance

Seller contributions

FHA Sales Concession Rules

Seller contributions limited to 6% of sales price.

Excess contributions:
treated as inducements to purchase
deducted from sales price or value in loan amount calculations
6% limit doesn’t apply to fees and closing costs that sellers typically pay according to local custom.

Seller contributions

FHA Sales Concession Rules

Inducement to purchase: when seller (or other interested party):

gives buyer decorating or repair allowance
pays for buyer’s moving expenses
pays commission on sale of buyer’s home
gives buyer personal property not usually included in sale of home

Inducements to purchase

FHA Sales Concession Rules

Value of inducements to purchase is subtracted from property’s sales price before maximum LTV ratio is applied.

Reduces maximum loan amount
available to borrower.
Remember: excess seller contributions (over 6% limit) = inducements to purchase.

Inducements to purchase

Rules for FHA Loans

FHA rules regarding use of secondary financing depend on whether it’s being used:

for minimum cash investment, or
as supplement to make up part of maximum loan amount.

Secondary financing

FHA Secondary Financing Rules

Secondary financing can’t be used for minimum cash investment if it’s from:

seller
another interested party
institutional lender

Financing minimum cash investment

FHA Secondary Financing Rules

Secondary financing can be used for minimum cash investment and other costs if it’s from:

close family member
government/nonprofit agency

Total financing can’t exceed property’s value or sales price.

Financing minimum cash investment

FHA Secondary Financing Rules

Secondary financing for part of maximum loan amount:

combined loans can’t exceed local FHA loan limit or maximum loan-to-value ratio
combined payment can’t exceed borrower’s ability to pay
monthly payments on second loan
no balloon payment before10-year mark
no prepayment penalty on second loan

Financing part of loan amount

FHA Secondary Financing Rules

Benefit of using secondary financing for part of loan amount:

seller second could have lower rate than FHA loan:
reduces buyer’s monthly payment
might help buyer qualify for loan when market interest rates are high

Financing part of loan amount

Rules for FHA Loans

Property flipping: reselling property for substantial profit shortly after purchasing it.

Predatory if it involves collusion to resell home to unsophisticated buyer at inflated price.

Property flipping prevention rules

Rules for FHA Loans

FHA rules designed to prevent predatory flipping:

Seller must be property owner of record.
More than 90 days must have passed since seller bought property.
If seller bought property within previous 91-180 days and resale price has doubled, second appraisal is required.

Property flipping prevention rules

Rules for FHA Loans

FHA loans contain due-on-sale clauses and place limits on assumptions:

buyer must intend to occupy home as principal residence
lender review of buyer creditworthiness
if buyer is creditworthy, original borrower released from liability

Assumption of FHA loans

Summary
Rules for FHA Loans

Owner-occupancy
Local maximum loan amount
Minimum cash investment
Seller contributions
Inducements to purchase
Secondary financing
Property flipping
Assumption

FHA Insurance Premiums

Insurance premiums for FHA loans are called the MIP (mortgage insurance premiums).

For most programs, borrowers pay:

upfront premium, plus
annual premiums.

FHA Insurance Premiums

Upfront premium (UFMIP) is also called
one-time premium (OTMIP).

Percentage of loan amount.
Currently 1.75%.

Upfront MIP

UFMIP can be:

paid in cash at closing by either borrower or seller, or
financed over loan term.

If financed:

UFMIP + Base Loan = Total Amount Financed

Paying UFMIP

Upfront MIP

FHA buyer can borrow local maximum loan amount plus UFMIP.
Total amount financed can’t exceed property’s appraised value.

Financed UFMIP and loan amount

FHA Insurance Premiums

Most FHA borrowers are required to pay annual premiums in addition to UFMIP.

One-twelfth of premium included in monthly loan payment.
Between 0.45% and 1.05% of loan balance per year, depending on loan term, loan amount, and LTV.

Annual MIP

Annual MIP for loans made after June 3, 2013:

LTV > 90%, paid for entire life of the loan
LTV ≤ 90%, canceled after 11 years

Duration of premium payments

Annual MIP

Even after cancellation of annual MIP, mortgage insurance remains in effect for rest of loan term.

Duration of premium payments

Summary
FHA Insurance Premiums

UFMIP (OTMIP)
Total amount financed
Annual MIP

FHA Underwriting

FHA underwriting standards aren’t as strict as Fannie Mae/Freddie Mac standards.

FHA Underwriting

FHA requires lenders to consider credit scores.

No FHA loan if credit score is below 500
If credit score is between 500 and 579, maximum LTV is 90%

Credit reputation

FHA Underwriting

Nontraditional credit analysis:

Applicant may qualify for FHA loan even if no credit report and no credit scores available.
Underwriter analyzes applicant's reliability over past year in paying rent, utilities, other obligations.

Credit reputation

FHA Underwriting

FHA underwriter determines applicant’s monthly effective income.

Effective income: gross income from all sources expected to continue for first 3 years of loan term.

Income analysis

Income Analysis for FHA Loans

Income ratios are used as guidelines in determining adequacy of effective income:

maximum debt to income ratio – 43%
maximum housing expense ratio – 31%
if buying energy-efficient home, ratios may
be 2% higher (45% and 33%)

Income ratios

Income Analysis for FHA Loans

Fixed payments (for debt to income ratio) include:

Housing expense: principal and interest, property taxes, hazard insurance, annual MIP, and any homeowners dues.
Recurring charges: monthly payments on debts and obligations with 10 or more payments remaining.

Calculating income ratios

Income Analysis for FHA Loans

If income ratios exceed 43% and/or 31% limits, applicant won’t qualify for loan unless there are compensating factors that reduce risk of default.

Compensating factors

Income Analysis for FHA Loans

Proposed housing expense is similar to current housing expense.
Large reserves.
No discretionary debt (only installment debt is current housing expense).
Borrower has residual income that would be adequate for VA loan.
Has income, not counted as effective
income, that affects ability to pay.

Compensating factors

FHA Underwriting

At closing, borrower needs enough cash to cover:

minimum cash investment
prepaid expenses
any discount points
upfront MIP (if not financed)
closing costs, repair costs, or other expenses not financed

Assets for closing

Assets for Closing

Generally, borrower not required to have reserves for FHA loan.

May be compensating factor if income ratios exceed limits.
One-month reserves required for manually underwritten loan.

No reserves required

Assets for Closing

FHA borrower may use gift funds for part or even all of funds needed for closing.

Donor must be employer, labor union, family member, close friend, charitable organization, or government agency.
Gift letter is required.

Gift funds

Assets for Closing

FHA borrower may also borrow funds needed for closing.

Unsecured loan: lender must be close family member.
Secured loan:
collateral must be property other than home being purchased
lender can’t be seller, real estate agent, or other interested party

Borrowed funds

Summary
FHA Underwriting

Credit reputation
Minimum credit score
Income analysis
Income ratios
Effective income
Fixed payments
Recurring charges
Assets for closing

Rehab Loans/Reverse Mortgages

In recent years, both rehabilitation loans and reverse mortgages have become increasingly popular with FHA borrowers.

Section 203(k) – FHA Rehab Loans

203(k) program: insures mortgages used to purchase/refinance and rehabilitate residence with up to four units.

Portion of loan proceeds used to purchase or refinance property.
Remaining funds deposited in Rehabilitation Escrow Account.

Restrictions:

home must be at least one year old
HUD imposes structural and energy-efficiency standards on all rehab work
luxury/temporary improvements ineligible

Restrictions

Section 203(k) – FHA Rehab Loans

Most of same rules used for 203(b) program apply to 203(k).

Exception: for larger loans, an FHA-approved consultant must inspect periodically to monitor progress.

Consultant

Section 203(k) – FHA Rehab Loans

For loan amount rules, property’s value is least of:

property’s as-is current value, plus costs of rehabilitation; or
110% of property’s value after rehabilitation.

Determining maximum loan amount

Section 203(k) – FHA Rehab Loans

Section 255 – FHA HECMs

Home equity conversion mortgage (HECM): used by elderly homeowner to convert equity into monthly income or line of credit.

Repayment not required as long as home remains owner’s primary residence.
FHA name for reverse mortgage.

Home equity conversion mortgages

Section 255 – FHA HECMs

Homeowner must be at least 62.
Property must be principal residence and owned free and clear (or with only small mortgage balance).
Loan amount depends on FHA’s ceiling for high-cost areas, appraised value, current interest rate, and borrower’s age.
No income requirements or credit qualifications.

Requirements

Section 255 – FHA HECMs

Lender recovers principal and interest when property is sold.

Any excess sale proceeds to go seller (or heirs).

Sale of property

Section 255 – FHA HECMs

Proceeds from FHA HECM can be used to purchase 1- to 4-unit principal residence.

Advantage is that borrower won’t make monthly payments; loan will be repaid when home is sold.

HECMs for purchase

Summary
Rehab Loans/Reverse Mortgages

203(k) program
Rehabilitation loan
Section 255 program
Reverse/home equity conversion mortgage
HECM for purchase