Question: We want to buy our first house with FHA financing, but the cost of mortgage insurance is shocking. Don’t you agree that the cost of interest and FHA mortgage insurance together is too high?

Answer: Imagine that you want to buy a home for $200,000. With a conforming mortgage, you will put down 20 percent or $40,000. Because of the down payment size there’s no requirement to buy mortgage insurance. You borrow $160,000 and with a 4.25 percent interest rate fixed over 30 years with monthly payments on principal and interest at $787.10.

With an FHA loan, the numbers for the same $200,000 property look like this:

• You put down put down 3.5 percent ($7,000). You agree to finance $193,000. This is the “base” loan amount.

• You then pay a 1.75 percent up-front mortgage insurance premium (the up-front MIP). The total cost is $3,377.50. You can pay the up-front MIP at closing, but to save cash most will add it to the debt. The result is a final mortgage amount of $196,377.50, but we’ll round it to $196,378.

• With the FHA program you also pay an annual mortgage insurance premium (the annual MIP). At the time this article was written, the annual MIP is calculated at .85 percent of the outstanding mortgage balance.
• The monthly payment for principal and interest is $966.06. The monthly expense for the up-front MIP is $136.71. The total monthly cost is $1,102.77.

If we look at the two options, we can see that if we buy with 20 percent down our monthly cost is $787.10 versus $1,102.77 with FHA financing. Closing costs for both loan options are extra.

No doubt, the monthly FHA loan cost is higher. But is it somehow unfair?

If we take a careful look at the two options we can see some interesting distinctions.

First, if we buy with 20 percent down the initial loan amount is $160,000 versus $196,378 for the FHA borrower. Since we’re borrowing an additional $36,378, this explains one reason for the higher cost of FHA financing,.

Second, we have not assigned any value to the $36,378 NOT paid by the borrower who puts down 20 percent.

Let’s imagine that we can invest $36,378 into a five-year certificate of deposit (CD) that pays 1.85 percent annually, roughly the rate as this is written. The account will earn $672.99 annually or $56.08 per month.

Now we can see that a borrower who puts down $40,000 really has a higher economic cost than just the mortgage payment. The real cost of the loan with 20 percent down is the monthly mortgage payment, $787.10, plus any lost monthly interest, $56.08, or a total of $843.18. Now the cost of conforming and FHA are somewhat closer.

There are a few points to be made here.

First, the typical FHA borrower doesn’t have the option of financing with 20 percent down because he or she simply doesn’t have $40,000 in cash, not including cash for the closing costs.

Second, without $40,000 downpayment a buyer cannot buy with a conforming loan. Unless they can buy now it, means a potential purchaser loses out if home values rise – plus they cannot lock-in today’s prices. By not purchasing, an individual may also face higher housing costs if rental rates increase.

Third, mortgage insurance has value. In this case, it enables a purchaser to buy with 3.5 percent down instead of the traditional 20 percent. FHA insurance also protects lenders in the event of default, the reason they are willing to accept a far lower down payment.

Fourth, with fixed-rate financing at today’s rate, the FHA borrower has locked in a bigger loan than the borrower who pays 20 percent up front. The individual who pays 20 percent up front has invested an additional $33,000 for the downpayment in our example.

Without refinancing, the buyer cannot capture a better return if interest levels for savings increase nor use the money for other purposes such as funding business or paying tuition.

The bottom line: There’s risk in every transaction, whether it is real estate, stocks, bonds or any other type of investment. We don’t know if home values, interest rates and rental costs will rise or fall in the future.

However, we do know is this: The FHA mortgage program gives individuals without 20 percent down the opportunity to buy real estate at today’s prices. In exchange, the FHA borrower pays an insurance premium.  

It’s up to each individual to see if FHA financing and real estate ownership make sense. Given their needs, finances and personal preferences, each home buyer should do what’s in their best interest.