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Financing Residential Real Estate

Lesson 11:

FHA-Insured Loans

Introduction

In this lesson we will cover:

l FHA loan programs,

l rules for FHA loans (including those governing maximum loan amounts, the minimum cash investment, sales concessions, secondary financing, and assumption),

l FHA insurance premiums,

l underwriting FHA loans, and

l specialized FHA programs.

Overview of FHA Loans

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

Federal Housing Administration


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

Purpose of act was to:

lgenerate new jobs by increasing construction activity,

lstabilize mortgage market, and

lpromote financing, repair, improvement, and sale of real estate.



Today, the FHA is part of the 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.



FHA insurance program is called the Mutual Mortgage Insurance Plan.

�Funded by premiums paid by FHA borrowers.

FHA mortgage insurance


Prospective FHA borrowers apply to lender, not directly to FHA.




Lenders authorized to make FHA loans either:

lsubmit applications to FHA for approval, or

lunderwrite applications themselves.




Lenders authorized to make FHA loans either:

lsubmit applications to FHA for approval, or

lunderwrite applications themselves.

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



If FHA borrower defaults on loan:

lFHA reimburses lender for full amount of loss.

lBorrower required to repay FHA.



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

Role of FHA loans



�But eligibility isn’t restricted by income.

�Instead, FHA sets maximum loan amounts.

�Maximum generally only enough to buy moderately priced house.

Role of FHA loans



�But eligibility isn’t restricted by income.

�Instead, FHA sets maximum loan amounts.

�Maximum generally only enough to buy moderately priced house.

lFHA also has low downpayment requirements, lenient underwriting standards, etc., to help buyers.

Role of FHA loans


FHA loans fell out of favor during subprime boom.

lConventional underwriting standards were loosened and loans were easier to obtain.

lFHA maximum loan amounts were too low to use in some areas.

Role of FHA loans


Now, however, low-downpayment conventional loans are harder to get, and FHA maximum loan amounts have been increased.

FHA loans are once again becoming more popular.

Role of FHA loans


FHA has many different programs to fit different needs.

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

FHA loan programs

FHA Loan Programs

Section 203(b) is the standard FHA program.

�Most FHA loans are 203(b) loans.

�Other programs are based on 203(b).

Section 203(b) – standard program

FHA Loan Programs

Section 203(b) is the standard FHA program.

�Most FHA loans are 203(b) loans.

�Other programs are based on 203(b).

203(b) loan 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.

203(k) loans are discussed in more detail at the end of this lesson.

Section 203(k) – rehabilitation loans

FHA Loan Programs

234(c) program covers purchase or refinancing of unit in condominium approved by FHA.

Section 234(c) – condominium units

FHA Loan Programs


lDeveloper usually applies for FHA approval when project is built or converted.


FHA Loan Programs


lDeveloper usually applies for FHA approval when project is built or converted.

lSpot loan: Loan for condominium unit in project that isn’t FHA -approved.


FHA Loan Programs

Section 251 ARM program can be used to purchase or 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

1-year, 3-year, and 5-year ARMs

lAnnual interest rate adjustment limited to 1%

lTotal rate increase over life of loan limited to 5%


FHA Loan Programs

1-year, 3-year, and 5-year ARMs



7-year and 10-year ARMs




FHA Loan Programs

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

lFor most FHA ARMs:

�qualifying rate is initial interest rate

lFor 1-year ARM with LTV 95% or above:

�qualifying rate is initial interest rate + 1%


FHA Loan Programs

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

255 loans are discussed in more detail at the end of this lesson.

Section 255 – HECMs

Summary


ÄFHAÄHUDÄMutual Mortgage Insurance Plan

ÄDirect endorsement lendersÄ203(b) programÄ234(c) program

Ä251 program

Rules for FHA Loans

When FHA -insured financing is used, transaction must comply with FHA rules regarding:

lowner-occupancy,

lmaximum loan amount,

lminimum cash investment,

lsales concessions,

lsecondary financing,

lproperty flipping, and

lassumption.

Rules for FHA Loans

FHA borrower must intend to occupy home as principal residence.

Owner-occupancy

Rules for FHA Loans


lFHA loan may be used for secondary residence only in limited circumstances involving hardship.

Owner-occupancy

Rules for FHA Loans


lFHA loan may be used for secondary residence only in limited circumstances involving hardship.

lInvestor loans generally not permitted.

�Exception may be made for investor buying property that HUD owns due to foreclosure.

Owner-occupancy

Rules for FHA Loans

FHA sets maximum loan amounts that vary from area to area and are based on local median housing costs.

These limits are tied to the conforming loan limits set annually by the secondary market agencies.

Local maximum loan amounts

FHA Local Maximum Loan Amounts

Currently, the basic maximum for FHA loans is 65% of Freddie Mac’s conforming loan limit.

In 2009, conforming loan limit for one-unit property is $417,000.

lSo 2009 basic maximum FHA loan amount for a one-unit property is $217,050:

$417,000 × .65 = $271,050

Basic maximum – most areas


In high-cost areas, the maximum may be increased up to 125% of the area median home price.

lBut maximum loan amount in any area can’t exceed 175% of conforming loan limit.

�In 2009, this “ceiling” is $729,750.

� Higher ceiling applies in AK, HI, Guam, and Virgin Islands.

Maximums in high-cost areas


FHA generally sets maximum loan amounts on acounty-by-county basis.

lLimit may be adjusted periodically to reflect changes in the cost of housing.

lCheck with a local lender for the current FHA maximum loan amount in your area.

Adjusted to reflect housing costs

Rules for FHA Loans

Borrower must make minimum cash investment of at least 3.5% of appraised value or sales price, whichever is less.

�So maximum loan-to-value ratio for FHA loans is 96.5%.

Borrower-paid closing costs, discount points, and prepaid expenses don’t count toward minimum cash investment.

Minimum cash investment and LTV

Rules for FHA Loans

Interest rates are negotiable between lender and FHA borrower.

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

Prepayment penalties are 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

It’s a seller contribution if seller (or other interested party) pays for all or part of:

lbuyer’s closing costs or prepaid expenses

lany discount points

ltemporary or permanent buydown

lbuyer’s mortgage interest

lupfront premium for mortgage insurance

Seller contributions


Seller contributions are limited to 6% of sales price.

�Excess contributions are treated as inducements to purchase and deducted from sales price in loan amount calculations.

6% limit doesn’t apply to fees and closing costs that sellers typically pay according to local custom.

Seller contributions


It’s an inducement to purchase if seller (or other interested party):

lgives buyer a decorating or repair allowance

lpays for buyer’s moving expenses

lpays buyer’s agent a larger commission than is customary

lpays real estate agent’s commission on sale of buyer’s current home

lgives buyer personal property not customarily included in sale of home

Inducements to purchase


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.

lRemember that excess seller contributions (over 6% limit) are treated as inducements to purchase.

Inducements to purchase

Rules for FHA Loans

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

lfor minimum cash investment, or

las 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:

lthe seller,

lanother interested party, or

lan institutional lender.

Financing minimum cash investment


But secondary financing CAN be used for minimum cash investment and other costs, if it’s from:

lclose family member, or

lgovernment/nonprofit agency.

Total financing can’t exceed property’s value plus closing costs, prepaid expenses, and discount points.

Other restrictions apply as well.



FHA borrower who is 60 or older may pay minimum cash investment with secondary financing from:

¡ relative,

¡close friend with clearly defined interest in borrower,

¡employer, or

¡charitable organization.

Total financing can’t exceed property’s value plus prepaid expenses.



Secondary financing for part of maximum loan amount allowed if:

1) combined loans don’t exceed FHA maximum loan amount;

2) combined payment doesn’t exceed borrower’s ability to pay;

3) payments on second loan (if any) are monthly;4) no balloon payment before10-year mark; and5) no prepayment penalty on second loan.

Financing part of loan amount


Since buyer still has to come up with minimum cash investment, what’s the benefit of using secondary financing for part of loan amount?

lSeller 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.

lConsidered 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:

lSeller must be property owner of record.

lMore than 90 days must have passed since seller bought property (otherwise, FHA may require extra documentation validating appraised value).

Certain types of transactions are exempt from these rules.

Property flipping prevention rules

Rules for FHA Loans

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

lBuyer must intend to occupy home as principal residence.

lLender will review buyer’s creditworthiness.

Slightly different rules apply to older FHA loans.

Assumption of FHA loans

Summary

Rules for FHA Loans

ÄOwner-occupancyÄLocal maximum loan amountÄMinimum cash investment

ÄSeller contributionsÄInducements to purchaseÄSecondary financing

ÄProperty flippingÄAssumption

FHA Insurance Premiums

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

For most programs, borrowers pay:

�an upfront premium, plus

�annual premiums.


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

�Percentage of loan amount.

�Currently 1.75%.

In 2008, FHA briefly applied risk-based pricing to UFMIP, but plan was put on hold.

lRiskier borrowers with high LTVs were charged higher percentage of loan amount for UFMIP.

Upfront MIP

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 the UFMIP

Upfront MIP

lFHA buyer can borrow local maximum loan amount plus UFMIP.

lTotal amount financed can’t exceed property’s appraised value.

Financed UFMIP and loan amount

Upfront MIP

lLoan origination fee is based only on base loan amount, not including UFMIP.

lDiscount points are based on total amount financed, including UFMIP.

Financed UFMIP and loan fees

Upfront MIP

FHA borrower may be entitled to refund of part of UFMIP if loan is paid off early.

lRefunds eliminated for loans made on or after December 8, 2004.

UFMIP refund


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

lOne-twelfth of premium included in monthly loan payment.

Annual MIP


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

lOne-twelfth of premium included in monthly loan payment.

lBetween 0.25% and 0.55% of loan balance per year, depending on loan term and LTV.

Annual MIP

Annual MIP

If loan term is longer than 15 years and LTV is 95% or less, annual premium is 0.50% of loan balance.

lIf LTV is over 95%, the premium is 0.55%.

If loan term is 15 years or less and LTV is 90% or higher, annual premium is 0.25%.

lIf LTV is lower than 90%, no annual premium is charged.

Charge depends on loan term and LTV

Annual MIP

For loans made before 2001, borrower might have to pay annual MIP only during early years of loan term or throughout term.

�Period varied with length of term and LTV.

For loans closed on or after January 1, 2001, annual MIP is canceled automatically once certain conditions are met.

Cancellation

Annual MIP

Loan term exceeds 15 years

Annual premium is canceled:

�when LTV reaches 78%,

�if premiums have been paid for at least 5 years.

Cancellation

Annual MIP

Loan term of 15 years or less

Annual premium is canceled:

�when LTV reaches 78%,

�regardless of how long premium has been paid.

Cancellation

Annual MIP

FHA determines when borrower has reached 78% threshold based on loan’s amortization schedule.

�Borrower who prepays can request earlier cancellation.

lEven after cancellation of annual MIP, FHA mortgage insurance remains in effect for rest of term.

Cancellation

Summary


ÄUFMIP (OTMIP)ÄTotal amount financedÄAnnual MIP

ÄCancellation

FHA Underwriting

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

FHA Underwriting

FHA requires lenders to consider credit scores, if available.

No FHA loan if credit score is below 500 (unless LTV is under 90%).

lThis minimum is considerably lower than Fannie Mae or Freddie Mac minimums.

Credit reputation

FHA Underwriting

Nontraditional credit analysis:

lApplicant may qualify for FHA loan even if no credit report and no credit scores available.

lUnderwriter analyzes applicant's reliability over past year in paying rent, utilities, and 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%

lIf buying energy-efficient home, ratios may be 2% higher (45% and 33%).

Income ratios


Fixed payments (for debt to income ratio) include proposed monthly housing expense and all recurring charges.

lHousing expense: principal and interest, property taxes, hazard insurance, annual MIP, and any homeowners dues.

lRecurring charges: monthly payments on debts and obligations with 10 or more payments remaining.

Calculating income ratios


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


1. Paid housing expenses at least equal to proposed expenses for last 12-24 months.

2. Plans to make large downpayment (10%).

3. Demonstrated ability to accumulate savings and conservative attitude toward use of credit.

4. Able to devote greater portion of income to housing expenses than most people.

5. Has income not counted as effective income that affects ability to pay.



6. Proposed housing expense only small increase (10% or less) over current housing expense.

7. Will have substantial reserves after closing (at least 3 mortgage payments).

8. Job training or professional education indicate potential for increased earnings.


FHA Underwriting

At closing, borrower needs enough cash to cover:

¡minimum cash investment;

¡prepaid expenses;

¡any discount points;

¡upfront MIP (if not financed);

¡any 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.

lBut reserves may be a compensating factor if income ratios exceed limits.

No reserves required

Assets for Closing

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

lDonor must be employer, labor union, close relative, close friend, charitable organization, or government agency.

lGift letter is required.

Gift funds

Assets for Closing

FHA borrower may also borrow funds needed for closing.

Unsecured loan:

�Lender must be a close family member.

Secured loan:

�Collateral must be property other than the home being purchased.

�Lender can’t be seller, real estate agent, or other interested party.

Borrowed funds

Summary

FHA Underwriting

ÄCredit reputationÄMinimum credit score

ÄNontraditional credit analysisÄIncome analysisÄIncome ratios

ÄEffective incomeÄFixed paymentsÄRecurring charges

ÄAssets for closing

Rehab Loans and 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 a residence with up to four units.



¡Portion of loan proceeds used to purchase or refinance property.



¡Portion of loan proceeds used to purchase or refinance property.

¡Remaining funds deposited in Rehabilitation Escrow Account.


lHome must be at least one year old to be eligible for 203(k).

lHUD imposes structural and energy-efficiency standards on all rehab work.

lLuxury/temporary improvements are ineligible.

Restrictions


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

lException: 203(k) borrower doesn’t have to pay an upfront mortgage insurance premium.

No UFMIP


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

1. property’s current value, plus costs of rehabilitation;

2. existing debt to be refinanced, plus costs of rehabilitation; or

3. 110% of property’s value after rehabilitation.

Determining maximum loan amount

Section 255 – FHA HECMs

FHA calls its reverse mortgages home equity conversion mortgages (HECMs).

Used by elderly homeowner to convert equity into monthly income or line of credit.

lRepayment not required as long as home remains owner’s primary residence.

Home equity conversion mortgages


lHomeowner must be at least 62.

lProperty must be principal residence and owned free and clear (or with only small mortgage balance).

lLoan amount depends on local area maximum, appraised value, current interest rate, and borrower’s age.

lNo income requirements or credit qualifications.

Requirements


Lender recovers principal and interest when property is sold.

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

Sale of property


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

HECM can’t be used to buy:

lSecond home

lInvestment property

lCooperative units

lSome manufactured homes

HECMs for purchase


Borrower must occupy purchased property within 60 days of closing.

Any difference between HECM loan amount and purchase price must come from borrower’s own funds.

�Can’t use bridge loan or any other type of financing to make up the difference.

HECMs for purchase

Summary

FHA Rehab Loans & Reverse Mortgages

Ä203(k) programÄRehabilitation loanÄSection 255 program

ÄHome equity conversion mortgageÄHECM for purchase

Real Estate Finance Lesson 11 Cumulative Quiz

1. Which of the following is NOT a characteristic of FHA loans?

A. Maximum loan amount which varies from area to area B. Minimum cash investment of 3.5% C. Mortgage insurance is required D. No downpayment is required

2. The primary function of the Federal Housing Administration is to:

A. build homes B. insure loans C. originate loans D. purchase loans

3. An FHA loan would be appropriate for:

A. a commercial space B. a vacation home C. an investment property D. an owner-occupied primary residence

4. Which of the following is true regarding the maximum loan amount for an FHA loan?

A. The maximum loan amount changes in response to changing interest rates B. The maximum loan amount depends on the borrower's income C. The maximum loan amount varies according to area housing prices D. There is no maximum loan amount

5. In a high-cost area, the maximum FHA loan amount is:

A. 65% of the general conforming loan limit B. 65% of the median housing price in the area C. 125% of the general conforming loan limit D. 125% of the median housing price in the area

6. Which of the following will be counted toward a borrower's minimum cash investment?

A. Closing costs B. Discount points C. Prepaid expenses D. None of the above

© 2009 Rockwell Publishing 1

7. Which FHA loan program provides mortgage insurance for reverse equity mortgages?

A. Section 255 B. Section 203(k) C. Section 223(e) D. Section 234(c)

8. An FHA buyer would apply for a Section 203(k) loan to:

A. buy a property in an older, declining neighborhood B. purchase and rehabilitate a property C. use a graduated payment mortgage D. use an adjustable-rate mortgage

9. To obtain FHA insurance for an adjustable-rate loan, a borrower would use a:

A. Section 203(k) loan B. Section 234(c) loan C. Section 245 loan D. Section 251 loan

10. The upfront mortgage insurance premium for FHA loans is _____ of the loan balance.

A. 0.25% B. 0.50% C. 1.0% D. 1.75%

11. A borrower obtains a 30-year FHA loan with an LTV of 90% and a balance of $100,000. What will the annual mortgage insurance premium be for the loan's first year?

A. $250 B. $500 C. $1,000 D. $1,500

12. For 30-year loans, annual FHA mortgage insurance premiums are canceled:

A. when the LTV reaches 78%, regardless of how long the borrower has paid the premium B. when the LTV reaches 78%, as long as the borrower has paid the premium for at least five years C. when the LTV reaches 80%, as long as the borrower has paid the premium for at least five years D. Mortgages with a 30-year term are not charged an annual MIP


13. A buyer buys a house for $100,000, using an FHA loan. The seller offers to pay $4,000 in discount points on the buyer's behalf. What contributions would be considered to be inducements to purchase rather than seller contributions?

A. $0 B. $1,000 C. $2,000 D. $4,000

14. Which of the following would be considered an inducement to purchase, if a seller paid for part or all of it?

A. Closing costs B. Discount points C. Moving expenses D. Upfront MIP

15. Who may provide secondary financing to cover the minimum cash investment for an FHA borrower?

A. A borrower's parent B. A real estate agent C. An institutional lender D. The seller

16. Which of the following is a rule the FHA uses to prevent abusive property flipping?

A. The resale price must not be more than 10% over the original sales price B. The sale must be an arm's length transaction C. The sales price must not exceed the median home price for the area D. More than 90 days must have passed since the seller bought the property

17. An FHA borrower generally may not exceed a _____ fixed payment to income ratio and a _____ housing expense to income ratio.

A. 43%; 31% B. 43%; 28% C. 36%; 31% D. 36%; 28%

18. Which of the following would not be considered a compensating factor which would allow the borrower to exceed maximum income ratios?

A. Applicant lives in an area with low median housing prices B. Applicant's education indicates potential for greater earnings C. Large downpayment D. Proposed housing expense is only a small increase over current housing expense


19. An FHA borrower will not need to have cash available at closing for:

A. prepaid expenses B. reserves C. the minimum cash investment D. upfront MIP (if it's not being financed)

20. Which of the following is not a way for an FHA borrower to cover the minimum cash investment?

A. Use a loan secured by collateral other than the home B. Use gift funds from a charitable organization C. Use gift funds from his real estate agent D. Use secondary financing from a relative


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