The Federal Housing Administration does not originate loans or buy them like Fannie Mae and Freddie Mac. Instead, the FHA insures mortgages, which means the FHA repays the bank's losses should your loan go into default -- just like an auto insurer pays your claim in a collision. Of course, the money has to come from somewhere. To fund its potential losses, the FHA asks borrowers to pay two types of mortgage insurance premiums: upfront MIP rolled into the loan at closing and monthly MIP paid alongside the monthly mortgage payment.
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Insurance Against Borrower Default
Unlike conventional mortgages, FHA-insured loans require a down payment of just 3.5 percent to close. This makes FHA loans a risky proposition. If home prices fall even slightly, the sale proceeds may not be enough to cover the loan costs if the bank has to foreclose. To cover its losses, the FHA collects MIPs from every borrower and pays them into a pot of cash known as the Mutual Mortgage Insurance fund. The FHA uses the MMI fund to pay the lender's losses if you default on your loan. Without this money, the FHA would not be able to insure loans with such low down payments.
MIP is mandatory on all FHA loans regardless of the amount the borrower puts down. However, borrowers with larger down payments pay MIP for a shorter period of time. So, if you put down less than 10 percent, as most FHA borrowers do, you must pay MIP for the entire life of the loan. If you put down 10 percent or more, you pay MIP for 11 years or until the end of the loan term, whichever happens first.
Upfront MIP Paid at Closing
All FHA borrowers pay upfront MIP, or UFMIP, at closing. The rate is 1.75 percent of the loan amount regardless of the term of the loan or the size of the down payment. So, if you borrow $200,000, your upfront MIP would be $3,500 irrespective of whether you have a 15- or a 30-year loan. The FHA automatically adds the payment to your loan balance at closing -- you don't have to pay cash. UFMIP is a one-time fee. Once you pay it, you won't be asked for this money again.
Annual MIP Paid Monthly
Annual MIP is more complicated as rates vary according to your mortgage term and the size of your down payment. Also, the FHA changes annual MIP rates with relative frequency, so a loan originated in 2010 will have different rates than a 2015 loan. At the time of publication, a 30-year loan with the minimum 3.5 percent down payment has an annual MIP charge of 0.85 percent of the loan amount. Borrowers with 15-year mortgages have rates ranging from 0.45 to 0.95 percent. Despite being called annual MIP, you actually pay the premium in 12 equal installments included in your monthly mortgage payment.
Canceling MIP on Older Loans
If your loan closed before June 3, 2013, the FHA automatically cancels MIP when your loan-to-value ratio, or LTV, reaches 78 percent. Your LTV is the amount you have left to pay on your loan divided by the FHA's last known valuation of your home -- this will usually be the purchase price. So, if you borrowed $200,000 to purchase a $210,000 home, your LTV is 95 percent. When you pay down the loan to $163,000, your LTV falls below 78 percent and MIP falls away. For some 30-year loans, you must pay MIP for at least 60 months before the FHA cancels the payment. On loans closed after June 3, 2013, there is no way to cancel MIP except by paying off the loan balance completely.