President Obama’s recent announcement that mortgage insurance premiums for Federal Housing Administration (FHA) mortgages will decrease from 1.35 percent to 0.85 percent is welcome news for prospective FHA borrowers. This half-a-percentage-point reduction is particularly meaningful because it comes as mortgage rates are once again approaching record lows. The potential for cost savings and the resulting shift in borrower behavior could impact the mortgage market in four important ways in 2015.
- Savings for borrowers. The Administration expects these lower premiums to save more than 2 million FHA borrowers an average of $900 annually. By other estimates, more than 3 million current FHA borrowers stand to benefit from reduced premiums upon refinancing. Our analysis, released in our January chartbook, shows that an FHA borrower with a 96.5 percent loan-to-value (LTV) on a $250,000 home will save roughly $100 in monthly payments under the new premium regime. And for mortgages with LTVs above 96.5 percent, FHA financing should generally be more cost effective than financing obtained from Fannie Mae or Freddie Mac (the GSEs) with added private mortgage insurance (PMI)—regardless of borrower credit score (see chart). But this doesn’t mean all borrowers with LTVs above 96.5 percent will opt for an FHA mortgage. In choosing between the two types of loans, borrowers must consider other factors such as additional fees, area loan limits, level of down payment, and the fact that FHA’s annual premiums run for the life-of-loan, whereas those for PMI expire when the LTV falls below 80 percent.
- More low-income and first-time FHA borrowers. Low-income and first time borrowers, who seek homeownership but could not afford higher premiums under old FHA pricing, may now find the math more favorable. This is especially valuable for borrowers with lower FICO scores, who might not have been able to get GSE financing, and therefore were shut out of the market. With this move, the Administration expects 250,000 borrowers to purchase their first home over the next three years.
- Influx of borrowers with higher credit scores to FHA. Lower premiums will also make FHA loans more attractive for certain high-FICO borrowers who previously would have found GSE loans more cost effective. Unlike FHA, which charges the same premium rate regardless of FICO score, GSEs and PMIs vary their fees with FICO scores, with higher- FICO borrowers generally paying lower fees. Therefore as one moves up the FICO spectrum, there comes a “break-even FICO score” above which GSE loans become cheaper than FHA’s. As a result, high-FICO borrowers have generally opted for GSE loans, a form of adverse selection that leads to lost revenues and a more costly credit mix for FHA. But the latest premium cut should reverse some of this. For example, at 96.5 percent LTV, many high-FICO borrowers would now prefer FHA execution. Even at 95 percent LTV, the break-even FICO has risen from 680 to 740—allowing FHA to capture additional high-FICO borrowers in this segment. While it is difficult to predict volumes, it seems likely that FHA will gain some market share in the higher-FICO segment.
- Increased competition between FHA and PMIs. Perhaps most significantly for the mortgage market, this premium reduction alters the current industry dynamic by making FHA pricing more competitive relative to PMI—a development that could result in changes in market shares and eventually increased competition between these two executions.
The longer term effect of the distribution of market share between FHA and the PMIs remains unknown, as the Federal Housing Finance Agency is set, in the months to come, to release new guarantee-fees for the GSEs, and a set of new eligibility requirements for PMIs to do business with GSEs. These two variables, along with decisions by PMIs about their acceptable rate of return, will determine where pricing in that channel ultimately lands. This, in turn, will determine which channels make the most economic sense for which borrowers. But the recent move by FHA has certainly stirred the pot.