Yesterday I described How to game the system with FHA loans for maximum advantage. Today, I want to look at the cost of that financing. It’s up to you to determine whether you believe the benefits are worth the costs.
Many have quipped that FHA has become the replacement for subprime. They have very low standards for qualification (a 580 FICO score), a very low down payment requirement (currently 3.5%), and as a result, they have become the loan-of-necessity for anyone who doesn’t have the credit requirements or the down payment necessary to obtain other financing. In other words, they have stepped into the void left by the collapse of subprime lending.
The FHA insurance premium is a direct measure of repayment risk divorced from interest rates. Ordinarily, this risk is rolled up into the interest rate, which is why subprime loans used to carry a higher rate. However, FHA loans have the same interest rate as prime customers. Since the FHA insurance premium is an added borrower cost, with a little math, we can calculate the effective interest rate on an FHA loan and show just how much borrowers are paying for it. But first, a little background.
How Interest Rates are determined
In the Great Housing Bubble, I provided a conceptual framework for understanding how interest rates are determined in a somewhat-free market.
Mortgage interest rates are determined by investor demands for risk adjusted return on their investment. The return investors demand is determined by three primary factors: the riskless rate of return, the inflation premium and the risk premium. The riskless rate of return is the return an investor could obtain in an investment like a short-term Treasury Bill. Treasury Bills range in duration from a few days to as long as 26 weeks. Due to their short duration, Treasury Bills contain little if any allowance for inflation. A close approximation to this rate is the Federal Funds Rate controlled by the Federal Reserve. It is one of the reasons the activities of the Federal Reserve are watched so closely by investors. The closest risk-free approximation to mortgage loans is the 10-year Treasury Note. Treasury Notes earn a fixed rate of interest every six months until maturity issued in terms of 2, 5, and 10 years. The 10-year Treasury Note is a close approximation to mortgage loans because most fixed-rate mortgages are paid off before the 30 year maturity with 7 years being a typical payoff timeframe.
The difference in yield between a 10-year Treasury Note and a 30-day Treasury Bill is a measure of investor expectation of inflation, and the difference between the yield on a 10-year Treasury Note and the prevailing market mortgage interest rate is a measure of the risk premium. … The risk premium is the added interest investors demand to compensate them for the possibility the investment may not perform as planned. Investors know exactly how much they will get if they invest in Treasury Notes, but they do not know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This uncertainty of return causes them to ask for a rate higher than that of Treasury Notes. This additional compensation is the risk premium. Mortgage interest rates are a combination of the riskless rate of return, the risk premium and the inflation premium.
The federal reserve controls the base rate, and they have some measure of control over inflation expectations. Our current record-low interest rate environment is an attempt by the federal reserve to lower the cost of borrowing as much as possible to raise house prices and prevent their member banks from losing billions of dollars on their bad loans from the housing bubble era. However, the federal reserve cannot ignore the risk premium. They have no control over that.
The FHA attempted to ignore the real cost of mortgage risk for years as house prices collapsed, and as a result, they are facing a government bailout. As the losses continue to mount, reality has begun to set in at the FHA, and they are continually raising the cost of their insurance to cover the losses from their bad loans. This increased insurance cost adds to a borrowers cost of financing, and it serves as a proxy for raising interest rates on borrowers using FHA financing.
The subprime business model works by charging higher interest on subprime loans to offset the losses from the higher default rates associated with lending to people who default in large numbers. The FHA has been running on the subprime business model for several years, and as their insurance premiums increase, they provide a direct measure of mortgage risk in the market.
Keep in mind as you read these examples that they assume the minimum 1.25% FHA insurance fee. If you wan to borrow up to $729,750, the fee rises to 1.6%, and the numbers below scale up accordingly.
Current Risk Premiums are 50%!
To calculate the current risk premium, we need to examine the cost of the FHA insurance and convert that to an effective interest rate. Then by measuring the percentage increase, we can determine the current risk premium. The best way to do that is by an example.
Let’s review the borrowing costs on a $432,215 home purchase. I chose that number because it leaves a $417,000 loan after a 3.5% down payment. Any loans larger than that carry an even larger FHA insurance premium.
$432,215 Purchase price
3.5% Interest Rate
$417,000 Loan
$1,873 monthly payment
$434 FHA insurance @1.25%
$2,307 monthly borrower cost
The above figures represent what a borrower would face today. If you were to recompute the effective interest rate that would yield a $2,307 payment on a $417,000 loan, the result is 5.3%.
The risk premium in the market is 1.8% (5.3% – 3.5%). 1.8% doesn’t sound like much until you consider the base rate its measured against.
(5.3% – 3.5%) / 3.5% = 50% increase in effective interest rate!
FHA loans are quite expensive.
Cost of additional borrowing equals a 12.4% second mortgage
During the housing bubble, lenders gave out second mortgages to anyone who didn’t have a 20% down payment. A common product was the 80/20 loan which had a conventional 80% first mortgage and a higher interest rate 20% second mortgage. Again, lenders were rolling the risk premium into the interest rate on the second mortgage. Another way to look at the cost of an FHA mortgage is to consider it a 80/16.5 mortgage because the incremental cost of the FHA insurance is only required if borrowers need to borrow the last 16.5% to complete the transaction. Let’s review our example:
$432,215 Purchase price
3.5% Interest Rate
$417,000 Loan
$1,873 monthly payment
$434 FHA insurance @1.25%
$2,307 monthly borrower cost
Now let’s compare that cost with a 20% down mortgage:
$432,215 Purchase price
3.5% Interest Rate
$345,700 Loan
$1,552 monthly payment
The difference between the $2,307 FHA monthly cost and the $1,552 cost of the conventional mortgage is $755 per month. That’s the effective interest cost on the additional $71,301 borrowed. If you compute the interest rate on a $71,301 loan that provides a $755 monthly payment amortized over 30 years, the result is 12.4%.
FHA borrowers are in effect taking out 12.4% second mortgages.
That’s a mortgage premium of 8.9% (12.4% – 3.5%). With premiums that high, it’s a wonder private money hasn’t ventured back into this business. With no competition from subprime lenders, the FHA has become a loan shark. Tony Soprano would be proud.
They doubled their mortgage like the rest of them
The former owners of today’s featured REO bought in May of 2000 and rode the equity wave and spent it along the way. They paid $270,000 on 5/25/2000 using a $192,499 first mortgage and a $77,501 down payment. The refinanced in 2002 for $243,000 and went Ponzi on 6/8/2004 when they refinanced with a $386,750 Option ARM.
They extracted nearly $200,000 from the property, and then let it fall into foreclosure.
Wouldn't you be embarrassed to overpay by $100,000? Only fools buy houses without knowing neighborhood values. Don't be a fool. Don't suffer the pain of an underwater mortgage. The surest way to lose your house is to overpay for it. Our reports identify overvalued and undervalued neighborhoods. Use it to broaden or narrow your search area. Savvy buyers work with us to find bargains. We've saved thousands from financial ruin. Let us save you too. If you want peace of mind while shopping for your next home, sign up for our monthly market newsletter.
We're sorry, but we couldn't find MLS # S718666 in our database. This property may be a new listing or possibly taken off the market. Please check back again.
Proprietary OC Housing News home purchase analysis
33641 BAYPORT Way #19 Dana Point, CA 92629
$514,900 …….. Asking Price
$270,000 ………. Purchase Price
5/25/2000 ………. Purchase Date
$244,900 ………. Gross Gain (Loss)
($21,600) ………… Commissions and Costs at 8%
============================================
$223,300 ………. Net Gain (Loss)
============================================
90.7% ………. Gross Percent Change
82.7% ………. Net Percent Change
5.1% ………… Annual Appreciation
Cost of Home Ownership
——————————————————————————
$514,900 …….. Asking Price
$18,022 ………… 3.5% Down FHA Financing
3.45% …………. Mortgage Interest Rate
30 ……………… Number of Years
$496,879 …….. Mortgage
$141,093 ………. Income Requirement
$2,217 ………… Monthly Mortgage Payment
$446 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$129 ………… Homeowners Insurance at 0.3%
$518 ………… Private Mortgage Insurance
$335 ………… Homeowners Association Fees
============================================
$3,645 ………. Monthly Cash Outlays
($469) ………. Tax Savings
($789) ………. Equity Hidden in Payment
$20 ………….. Lost Income to Down Payment
$84 ………….. Maintenance and Replacement Reserves
============================================
$2,491 ………. Monthly Cost of Ownership
Cash Acquisition Demands
——————————————————————————
$6,649 ………… Furnishing and Move In at 1% + $1,500
$6,649 ………… Closing Costs at 1% + $1,500
$4,969 ………… Interest Points
$18,022 ………… Down Payment
============================================
$36,288 ………. Total Cash Costs
$38,100 ………. Emergency Cash Reserves
============================================
$74,388 ………. Total Savings Needed
The property above is available for sale on the MLS.
Contact us for a comparative market analysis, a cost of ownership analysis, or information on how you can make an offer today!
OC Housing News FREE Guides!
Click on the book cover for more information.
Nearby Foreclosures
Gain a competitive advantage over other buyers. By locating distressed properties -- before they hit the MLS -- you can discover where tomorrow's REOs and short sales will appear. Most of these properties are not listed on the MLS, but they will be soon. Research properties in advance and get a jump on your competition. Don't miss out on another deal because you couldn't act quickly. Use this tool to your advantage! The red properties are already bank owned. As soon as REO asset managers prepare them for sale, they will be on the MLS. Get ready! The green and blue properties have owners who are not paying their mortgages. They may be offered as short sales, or they may go through foreclosure and become REO. Either way, they will also likely be available on the MLS soon. Find your next home! Be prepared to offer on these properties by researching them in advance or risk losing out to buyers who are have done their homework. Start your research today! To find distressed properties, enter your desired location and press search. Scroll through list by pressing "next."
21 Responses to “FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium”
Sorry, the comment form is closed at this time.
The mainstream media is starting to channel the fantasies of lenders.
Rising Prices Could Lift 3.5M Homeowners Out of Negative Equity
While almost one-quarter of homeowners remain underwater, rising home prices over the past year have some economists hopeful negative equity could begin to diminish in coming months.
“The negative equity problem is still crippling many homeowners and the wider economy,” Capital Economics stated in a report.
In addition to the almost one-fourth of homeowners who owe more on their mortgage loans than their homes are worth, almost half of homeowners do not meet the 80 percent loan-to-value ratio required for a standard refinancing.
While “[a]dmittedly, the recovery is still in its infancy,” Capital Economics sees the potential for 3.5 million homeowners to move out of negative equity positions over the next 12 months.
CoreLogic reports prices have risen 5 percent over the past 12 months, and Capital Economics reports the greatest movement is occurring in the same locations that experienced the greatest price declines and highest instances of foreclosures and negative equity during the housing crisis.
For example, about 40 percent of homeowners in Arizona and Florida are underwater. However, home prices have risen 18.7 percent and 6.3 percent, respectively, in these two states over the past year.
While Capital Economics is sticking to its prediction that house prices will rise about 5 percent next year, the economists admit “the upside risks to that forecast are clearly rising.”
So far this year, rising home prices have helped 1.3 million households rise out of negative equity, according to CoreLogic.
If home prices were to rise by 10 percent next year, about 3.5 million borrowers would be lifted out of negative equity and 6 million would become eligible for standard refinancing after seeing their loan-to-value ratios fall back to or below 80 percent.
“The faster prices rebound, the quicker the negative equity problem will be resolved,” Capital Economics stated.
With home prices still about 27 percent below their 2006 peak, 10 percent under-valued compared to current rental rates, and 20 percent under-valued compared to per capita incomes, Capital Economics sees no need for concern over another bubble as prices continue to rise.
” it’s a wonder private money hasn’t ventured back into this business. With no competition from subprime lenders, the FHA has become a loan shark. Tony Soprano would be proud.”
In fact, FHA changed a rule this week that allow into mixed used developments easier. FHA is not contracting, but it’s actually growing into different housing markets.
Also, congress whats to increase the G-fees to pay for other government programs. How can Fannie and Freddie be privatize when the US needs tax revenue from people paying their mortgages?
These changes slowly tells me that status quo (federal monopoly of the lending markets) will be around for some time.
If they can continue to get 12.4% or higher interest rates on the money they insure, I’m not surprised they are expanding. They should. It’s the only way they will make the fund solvent again.
I expect private money to reenter this space once they believe house prices have stabilized. The profits are very enticing. The reentry of private money will cause the FHA not to make money they were counting on in the future to save them from a larger bailout.
Markets crash, consolidation commences, ownage = future income streams. Same model for CRE. Doubtful much private capital will ever be allowed back in.
“These changes slowly tells me that status quo (federal monopoly of the lending markets) will be around for some time.”
Well said Mike. The writing is on the wall.
I hate to agree, but that’s how I see it as well.
That’s not to say that lenders aren’t eager to start loosening standards and making Alt-A and subprime loans again. (The OC Register recently interviewed Anthony Hsieh and he stated as much. Although he didn’t use those terms.)
The major barriers preventing a private market are Dodd-Frank QRM uncertainties, Fannie/Freddie/Ginnie buybacks, and the institutional dumb money (aka pension funds) that still have fresh memories of being burned.
As soon as they believe prices are going up again, they will bring back all the products that inflated the last bubble believing it will be different this time. I won’t be.
Tony breaks legs for non-payers but does file a negative credit report except to his friend and business associate. FICO remains the same.
FHA allows them to squat then walk away with a lower FICO and no broke leg.
Resales up due to increase in foreclosures
The Pending Home Sales Index (PHSI) jumped 5.2 percent in October to 104.8, its highest level since March 2007, the National Association of Realtors (NAR) reported Thursday. Economists had expected a smaller increase to 100.5.
The September index was revised up to 99.6 from the originally reported 99.5.
On Wednesday, the Census Bureau and HUD reported jointly new home sales—the equivalent of the PHSI—had declined an ever-so-slight 0.37 percent in October. Both reports measure contracts for the purchase of a home.
The PHSI and new home sales report usually move in the same direction—each has increased in all but three months this year—but the magnitude and timing of the changes can vary. The movement in opposite directions in October suggests the PHSI was boosted by sales of foreclosed homes, which would mean continued struggles for homebuilders as buyers sift through foreclosed properties, which are counted as existing home sales.
Year-over-year, the PHSI is up 13.2 percent, making October the 18th straight month of year-over-year increases.
Lawrence Yun, NAR chief economist, explained the jump in the PHSI by suggesting buyers are responding to favorable market conditions, noting “[w]e’ve had very good housing affordability conditions for quite some time, but we’re seeing more impact now from steady job creation, and rising consumer confidence about home buying now that home prices have clearly turned positive.”
The PHSI does not distinguish distressed or short sale from other home sale transactions in the report.
PHSI data are generally reflected in the report on existing home sales two months out, meaning the October PHSI points to stronger growth in completed homes sale transactions reported for December.
Regionally, the October PHSI improved in two of the four Census regions, increasing 15.6 percent to 104.4 in the Midwest and 5.5 percent to 117.3 in the South. The index slipped 0.1 percent to 79.2 in the Northeast and fell 1.1 percent to 105.7 in the West. Year-over-year, the index is up in all four regions.
The index is based on a large national sample, representing about 20 percent of transactions for existing-home sales. An index of 100 is equal to the average level of contract activity during 2001, which was the first year to be examined as well as the first of five consecutive record years for existing-home sales; it coincides with a level that is historically healthy.
Modern Monetary Theory + an economic model based-on academic case studies =
http://confoundedinterest.files.wordpress.com/2012/11/m2v_max_630_378.png?w=630
tic..tic..tic…
What do you think it would take to increase the velocity of money? I suspect it would take elimination of the debt overhang.
Agreed. The problem is systemic. 1) bad theory = bad models; 2) still corrupt from within. Restructuring the big banks would be a good start.
This might be a stupid question: But isn’t what is sort of happening by refinancing all these underwater loans into sub 4% interest rates loans. Or does the debt need to be written off the banks books completely.
This news is not a big deal, but if the feds control large segments of the mortgage industry they can tax it easier. I just see this as evidence has privatization won’t happen for sometime.
MBA questions g-fee hike to help pay immigrant visas
By Kerri Ann Panchuk November 29, 2012 • 1:28pm
vid Stevens, CEO of the Mortgage Bankers Association, is pushing back against a House proposal to extend g-fee hikes on government-backed mortgages to cover costs related to an immigration bill.
The MBA says the hike was proposed in a manager’s amendment associated with House Bill 6429. The bill aims to provide 55,000 visas for workers who are qualified in the areas of science, technology, engineering and mathematics.
The proposal would extend g-fee hikes enacted last year. Initially, the 10-year hike was intended to cover lost revenue associated with tax cuts. But the MBA says the manager’s amendment wants to extend the fee increase another year to cover expenses associated with HB 6429, an immigration bill.
The latest proposal would extend those g-fee hikes, which are set to expire on Oct. 1, 2021, to October of 2022. The House Rules Committee adopted the amendment for inclusion in the bill’s full text Thursday, with the House expected to consider the legislation on Friday.
“Fannie and Freddie’s guarantee fees are supposed to be used to help offset the risk inherent in providing mortgages, and any increases to those fees should be used for that purpose,” the MBA’s Stevens said in a public statement. “Dipping back into the housing piggybank to pay for unrelated policy items on the backs of America’s homebuyers sends the wrong message at a time when the housing market is starting to show signs of recovery.”
Stevens is asking Congress to reconsider using g-fees for any purpose unrelated to the fees’ role in the agency housing market.
“Increasing the cost of most mortgages will only add to the uncertainty that is plaguing the mortgage market and holding back a more a robust housing recovery,” Stevens said in a statement.
kpanchuk@housingwire.com
[...] FHA financing carries a big cost. In Friday’s post FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium, I measured the cost of this insurance, and it is having the opposite effect of lower interest [...]
[...] math) FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium – OC Housing News ————How to game the system with FHA loans for maximum advantage [...]
[...] Read the whole article: FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium » OC Housing News. [...]
[...] Roberts just posted analysis on the cost of FHA insurance. The current cost of insurance is a 50% effective increase in the cost of interest rates for the [...]
[...] FHA financing carries a big cost. In Friday’s post FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium, I measured the cost of this insurance, and it is having the opposite effect of lower interest [...]
[...] The FHA has become a replacement for subprime lending. That isn’t how it’s supposed to function, and it explains much of why it will require a government bailout. Overhaul Plan [...]