First Time Home Buyer - Why NOT use FHA Insured Loan?
Plano, TX · Member since 2014 · 6 posts · 3 votes
I'm a potential home buyer who is looking for a property to purchase as a residence. I have not yet talked to a mortgage broker on the availability of an FHA loan. I have, however, asked the advice of people in my life whose opinion I value.
One person in particular advised that it's always best to put at least 20% down and people who can't afford that have no business buying a house. He cites that the housing collapse a few years ago is partly because of irresponsible lending. Should I heed this advice and wait until I can put down a considerable amount?
There must be something I am missing in regards to an FHA loan. Are there any catches or stipulations (besides PMI) that I should be aware of? Why wouldn't I want to take advantage of this opportunity?
The First aspect to look at:
The mortgage insurance gross monthly expense....
- conventional financing - the MI can be customized since the Mi is offered through private companies you can chose to pay it via monthly premiums, single premium upfront, a split premium which is a hybrid of upfront portion followed by a lower monthly than just purely paying monthly premium only.
- FHA is 1.75% upfront and from 1.35% to 1.55% annually (paid monthly) depending on what your loan amount is and the limits in your area. This often times is much more expensive than conventional financing unless if you have great credit then conventional can be a much better choice with regards to mortgage insurance.
The second aspect to look at:
Putting your self at risk with a larger down payment ....
A larger down payment really only serves one benefit to make your payment smaller so the monthly cash out flow is more manageable by either reducing the loan amount borrowed or avoiding the mortgage insurance payment. For some that is a good thing but for others they realize that their money is at risk first at the top of the pile of money. Behind your down payment is the banks money the 80%, 85%, 90% or even 95% loan in the example of a 5% down single family purchase for primary occupancy.
95% loan to value or LTV is cutting it pretty close for the bank because they know they only have 5% buffer (your down payment/your equity) before their collateral ( your home) is going to be worth less than their loan. Their play is to pray you amortize or pay down your loan fast while the value of homes go up on average so that their asset (your loan) is not at risk of not being paid back. As long as its backed by 1 parts loan to 1 parts real estate value or more they are happy, the more the better in their mind.
A third aspect to look at:
The net effect of what you're actually paying.... investing skin deep
Mortgage insurance in 2014 is no longer deductible (consult a tax pro) so if you pay monthly MI and you'll have to use after tax dollars on this expense of owning a home which may dramatically increase the cost of borrowing. It expired at the end of 2013 and has not been renewed yet as far as I know. An example would be the 1.35% FHA MI at the 40% fed & state bracket, not being able to deduct this MI would equate to paying 2.25% annually on top of whatever your mortgage note is at. The goal is to convert these "non tax deductible," items into deductible items by financing it into the loan, or by using conventional financing and using the interest rate to cover your mortgage insurance cost so that you have in effect converted non deductible MI into deductible mortgage interest.
A fourth aspect to look at:
The opportunity cost of your down payment...
What if by putting that 20% down you missed an opportunity to earn much higher than what you would have saved by putting that down payment down. What if an opportunity to find 15% cash on cash return was available following the purchase of your primary in which you were saving 4.5% interest by putting 20% down, you would lose the delta/spread of 10.50 per year that could not only pay the difference of a higher mortgage from your primary but also simultaneously provide you an additional revenue per month to cover your other expenses...
Just a couple of items I usually discuss with investors I work with on the financing end, as always theres more to consider as well depending on your particular scenario.
I understand your friends conservative approach, but I disagree. If you wait to save up a 20% down payment, you will likely pay a higher price for the property.
Every person has their own "strategy". "One" of my strategies is to use personal property's (lower interest rate and down payments) to purchase primary's that will become rentals when we leave. Therefore we tend to buy short sales, foreclosures and fixer uppers. Our houses tend to be 15% under the market right off the back and therefore our "safety" net. Although they do have "pmi" and therefore a higher monthly payment. Again since these are going to be long term rentals as long as we can pay the mortgage now and the rent will cover it later. Than we were able to by a rental with little down.
I also forgot to mention the fact that in our areas the prices as dramatically increased. People who waited to to put more down, are basically paying their entire down payment at the higher market rate. Again if you make sure you don't bite more off than you can chew. Than not putting as much in should be okay.
Good luck.
If you have a good job and good credit, you'll be able to borrow more than 80% at a lower rate. Keep your cash for when something breaks in the house, you want to remodel or maybe buy some furniture. I would never tell someone to wait until they could put 20% down.
The one thing about the FHA loan is that the PMI stays on forever now.
If you can afford the 5-10% to go conventional, ask for a one-time / up front MI, this will remove the need for a monthly PMI payment and then fighting to remove that requirement later. In terms of cost, this will be better for you after about 2 years.
It depends what kind of property you are buying but I would rather you use an FHA loan than saving up 20%. The main downside to FHA is that the PMI is outrageously high compared to conventional and it stays for the life of the loan. If you can qualify for a conventional loan you can get in with 5% down but it must be owner occupied.
What got people in to trouble was the use of adjustable rate, interest only loans and all the low doc/no doc loans. When interest rates rose and when people had to make principal payments, suddenly they couldn't afford too. Less then 20% down payments didn't cause the crash.
Great stuff guys!
I like how @Elizabeth Colegrove mentions a "safety net". That was my main reasoning with putting money down -- I would have instant equity in the house that would keep me from getting in under water. On the other hand, if I bought smart, under market value, in a good area, and forced appreciation with some rehabbing, I could also build equity that way, right?
I don't want to dog your friend but be wary of advice using "broad generalizations" as some sort of fact. In my opinion, a decision to buy a home is comprised of so many factors that you cant boil it down to whether or not a person has a 20% down payment or not. The factors are just too unique to each individual buyer. Since you are here on BP, I can only assume you have an interest in REI. Are you buying this home with the intent of renting it later? Whether you go FHA with ~3.5% or Conventional with ~20%, neither will provide safety you if you don't buy right in the first place (buying right is a whole other story, ha ha ha). I would think about what I want my end game to be and work backwards from there to determine what will put me on the path most likely to lead to my desired result.
Obviously you don't want to overpay, but I wouldn't worry about this "safety net" that your friend speaks of. IMO, 10k cash in the bank is better than another 10k of equity in a property any day of the week.
As you implied, doing work to make the place better actually creates value. Putting more money down creates no value at all; it just reduces your liquidity.
I'm in a similar situation as you being young and looking for a first time purchase. I think if you have a good, steady job that can pay the mortgage, it is a no-brianer going with the FHA. This way you can afford to have some money ICE and to cushion yourself. If you wanted to rehab, you could also take out a 203k loan, which has similar requirements to the FHA and includes fix-up costs.
If you are planning on buying a multi-family that you live in and rent out, the money you save on the down payment can be your fund in case of vacancy or other major unforseen expenses. Good luck and let us know what you do!
The First aspect to look at:
The mortgage insurance gross monthly expense....
- conventional financing - the MI can be customized since the Mi is offered through private companies you can chose to pay it via monthly premiums, single premium upfront, a split premium which is a hybrid of upfront portion followed by a lower monthly than just purely paying monthly premium only.
- FHA is 1.75% upfront and from 1.35% to 1.55% annually (paid monthly) depending on what your loan amount is and the limits in your area. This often times is much more expensive than conventional financing unless if you have great credit then conventional can be a much better choice with regards to mortgage insurance.
The second aspect to look at:
Putting your self at risk with a larger down payment ....
A larger down payment really only serves one benefit to make your payment smaller so the monthly cash out flow is more manageable by either reducing the loan amount borrowed or avoiding the mortgage insurance payment. For some that is a good thing but for others they realize that their money is at risk first at the top of the pile of money. Behind your down payment is the banks money the 80%, 85%, 90% or even 95% loan in the example of a 5% down single family purchase for primary occupancy.
95% loan to value or LTV is cutting it pretty close for the bank because they know they only have 5% buffer (your down payment/your equity) before their collateral ( your home) is going to be worth less than their loan. Their play is to pray you amortize or pay down your loan fast while the value of homes go up on average so that their asset (your loan) is not at risk of not being paid back. As long as its backed by 1 parts loan to 1 parts real estate value or more they are happy, the more the better in their mind.
A third aspect to look at:
The net effect of what you're actually paying.... investing skin deep
Mortgage insurance in 2014 is no longer deductible (consult a tax pro) so if you pay monthly MI and you'll have to use after tax dollars on this expense of owning a home which may dramatically increase the cost of borrowing. It expired at the end of 2013 and has not been renewed yet as far as I know. An example would be the 1.35% FHA MI at the 40% fed & state bracket, not being able to deduct this MI would equate to paying 2.25% annually on top of whatever your mortgage note is at. The goal is to convert these "non tax deductible," items into deductible items by financing it into the loan, or by using conventional financing and using the interest rate to cover your mortgage insurance cost so that you have in effect converted non deductible MI into deductible mortgage interest.
A fourth aspect to look at:
The opportunity cost of your down payment...
What if by putting that 20% down you missed an opportunity to earn much higher than what you would have saved by putting that down payment down. What if an opportunity to find 15% cash on cash return was available following the purchase of your primary in which you were saving 4.5% interest by putting 20% down, you would lose the delta/spread of 10.50 per year that could not only pay the difference of a higher mortgage from your primary but also simultaneously provide you an additional revenue per month to cover your other expenses...
Just a couple of items I usually discuss with investors I work with on the financing end, as always theres more to consider as well depending on your particular scenario.
Just a little food for thought. With a 20% down payment, you won't have to pay PMI and your mortgage payments themselves will be much lower as well. If you do decide to rent out the place down the road, this will provide you with a little more rental income every month, or room to offer less expensive rents. This is the strategy I am using on my home purchase.
Yet another way to look at it: Think about the total amount you will pay over the life of a loan. The more you finance, the higher the total is, obviously. When it's your own house, it comes out of your pocket. When you own a rental, your tenants pay that for you. So my tendency would be to go for higher leverage on investment properties, less on my home.
Now that I own my home outright now I can have a larger Heloc, and I can call on that for investment. When I'm not using it, I don't pay anything. But I can use that money to get into an investment property, then refinance with a loan on the new property- and let the tenants pay for it :)
If you have a good job and good credit, you'll be able to borrow more than 80% at a lower rate. Keep your cash for when something breaks in the house, you want to remodel or maybe buy some furniture. I would never tell someone to wait until they could put 20% down.
The one thing about the FHA loan is that the PMI stays on forever now.
If you can afford the 5-10% to go conventional, ask for a one-time / up front MI, this will remove the need for a monthly PMI payment and then fighting to remove that requirement later. In terms of cost, this will be better for you after about 2 years.
Hi Fran,
We bought our first investment in Philly earlier this year and are wanting to do it again (multi-unit). We did it conventionally and are considering FHA. However, I was also curious if you could recommend a lender in the area that would do 5-10% down payment...that would be my preference to avoid lifelong PMI. Thanks!
Alex,
There is a number of reasons to not use FHA if you don't need to. Lending guidelines change per location, so I can only speak to the Philadelphia-area market, but FHA standards are pretty much the same anywhere.
First, you will pay mortgage insurance for the life of your FHA loan. If you refi into a different product down the line, this may change, but that is counting on rates being lower than your rate at acquisition.
Secondly, in the Philadelphia-area, many lenders are offering conventional loan products with no PMI and 5% down. There is a very good chance that this is the case where you live, too. The difference between 3.5% and 5% down payment may not be significant to you, but the difference in paying MI and not paying MI should be.
Hope this helps,
Hilary
Depending on your circumstances, you could also get a conventional loan with 5% down and have the PMI monkey on your back until the loan gets to 78/22. If you end up using that residence for a rental later on, you could always pay down the loan to 78/22 and end up with a nice 10-15% annualized advantage (depending on your monthly PMI) by getting rid of the PMI and the portion of the loan you will no longer be charged interest on. Just a different way of looking at it.
I personally prefer the conventional 5% down because there is no funding fee and the pmi fall off. Everyone has their own opinion regarding houses and how not to get stuck with an underwater house. We personally prefer to put as little down as possible but everyone has their "opinion".