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PMI Pain: Why an FHA Mortgage Might Not Be Your Best Option

Are you thinking about taking out an FHA loan to buy your first home? You might want to reconsider.

While there are still a few advantages (mainly, the low down payment and the ease of qualifying), the costs of mortgage insurance on an FHA loan are getting expensive. In most cases, your alternatives might be the better bet.

What is an FHA loan?
The FHA, which is the Federal Housing Administration, provides government insured loans to FHA-approved lenders in the United States. The purpose is to help individuals buy their first home when they might not have been able to do so otherwise.

An FHA loan requires two forms of private mortgage insurance, or PMI. This protects lenders if homeowners default on their mortgages.

Benefits of FHA loans
Here's why an FHA loan might make sense for a first-time homebuyer:

  • An FHA loan requires a low down payment of 3.5%, so on a $200,000 home, this would be $7,000. With conventional financing, lenders tend to require at least 20% down, and in this case, putting $40,000 down might be impossible for a first-time homebuyer. By putting less money down, you'll have more funds available for moving costs, emergencies, or other expenses.
  • With an FHA loan, you are allowed to use other sources of cash for the down payment, including gifts from a family member, a down payment assistance grant, or a community redevelopment program.
  • Most of the closing costs and fees can either be included in the loan or covered by the home seller. Closing costs can range from 2% to 5% of the purchase price of a home. For a $200,000 home, this can run from $4,000 to $10,000.
  • FHA loans come with less stringent qualification requirements, making it easier for those with poor credit to qualify.

Although an FHA loan is a popular option for first-time homebuyers, there are some downsides.

Disadvantages of FHA Loans
When you put down less than 20% to buy a home, the lender requires that you buy PMI, to protect the lender if you default on the mortgage.

With an FHA loan, you're required to buy two forms of PMI, which can be more expensive than for other mortgages. First, you'll pay an upfront mortgage premium of 1.75% of the purchase price of the home. For a $200,000 home, this would cost $3,500, but you can add this to the loan, so you don't have to pay out of pocket.

You'll also be required to pay an annual mortgage premium. For a mortgage of $625,500 or less with a down payment of less than 5%, you'll pay 1.35% of the total loan balance. For a $200,000 mortgage, this works out to $2,700 a year, or $225 per month.

On conventional mortgages with down payments of less than 20%, annual PMI ranges from 0.3% to 1.15%.

PMI costs increasing
The costs of PMI can add up over time. On a $200,000 mortgage with 3.5% down, you'll pay $3,360 in an upfront premium, plus $214 every month. Over five years, you'll have paid $15,708 in mortgage insurance, and over the life of the mortgage, you'll pay a whopping $49,479.

In addition, the cost of PMI has been increasing each year. On April 1, 2013, FHA mortgages saw an annual PMI increase of 0.10%, to 1.35%. For a $200,000 mortgage, this means PMI increased from $2,500 a year to $2,700. There is no telling where the costs of PMI will be in a few years.

What's worse is that you can no longer cancel PMI once you reach 20% equity in your home. The FHA now requires most borrowers to continue paying annual premiums for the life of the mortgage.

For mortgages with a starting loan balance higher than 90% of the appraised value, you can no longer remove the annual PMI. For example, if you bought a home through the FHA for $200,000 and put $10,000 or less down, you would be required to pay PMI every year. For mortgages with a starting loan balance lower than 90% of the appraised value, you must pay PMI for 11 years.

What are your other options?
Thankfully, first-time homebuyers have other financing options available:

VA loan: This loan, which is guaranteed by the Department of Veterans Affairs, allows you to purchase a home with no down payment. Veterans, spouses of a veteran, or an active-duty member of the military qualify for this loan. Another plus: VA loans don't come with a PMI requirement.

USDA loan: The loans offered by the Department of Agriculture are designed for rural homebuyers who have low to moderate incomes. You qualify for this loan if the home you are purchasing is located in an eligible rural area. You also must have a household income that does not exceed the USDA established limits where the home is located.

Although USDA loans require mortgage insurance, the rate is often lower than PMI for an FHA loan. Currently, the annual premium rate is 0.40% of the loan balance. For a $200,000 mortgage, it would cost $800 a year, or $66.60 a month.

HomePath: You can buy a Fannie Mae-owned property through HomePath.com and put as little as 5% down. The advantage of buying through HomePath is that no mortgage insurance is required for any HomePath loan. In addition, no appraisal is required, and HomePath allows sellers to cover all or part of the buyer's closing costs.

The downside to buying a foreclosure through HomePath is that your options are limited to the homes on the website. Interest rates on a HomePath mortgage also tend to be a quarter to a half percent higher than on conventional mortgages.

Conventional mortgage with a "piggyback" loan: You might consider getting a conventional 30-year fixed mortgage with a 20% down payment, and then getting a second loan to cover part of the down payment. The second loan is called a "piggyback" loan.

The advantage is that you will avoid paying for part or all of PMI. For example, you might save money going with a conventional mortgage for 20% down with a piggyback loan to cover 10% of the down payment instead of a mortgage with 10% down with PMI. A word of caution: Make sure you don't pay a high interest rate for the piggyback loan.

Get an FHA loan, and then refinance: Although FHA mortgages with less than 10% down require PMI for the life of the loan, this doesn't mean you'll have to pay PMI as long as you live in your home. You can simply refinance into a new mortgage.

To avoid paying PMI on your new mortgage, this strategy makes the most sense once you've reached 20% equity in your house. Just be sure to take into account all of the costs associated with refinancing.

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