October 22, 2017

Do FHA Low Down Payment Loans Make Financial Sense?

Home ownership rightfully remains the goal of many Americans and a plethora of government loan programs run by agencies such as the  FHA, VA and USDA all provide mortgage programs with little or no down payment requirements.

Before buying that dream home, however, a borrower should analyze whether or not it makes financial sense to buy a home as soon as possible or to wait until a larger down payment can be accumulated.

Let’s take a look at the numbers on a home purchase through the FHA, which is the most popular financing option for first time home buyers.  The FHA has always had high mortgage insurance premiums, but the recent large rate increases warrant a close look at the benefits of waiting to buy a home while accumulating a larger down payment in order to avoid mortgage insurance.

As an example, let’s examine the purchase of a $500,000 home using FHA mortgage financing with the minimum 3.5% down payment of $17,500.

  1. The upfront FHA mortgage insurance premium (UFMIP) of 1.75% calculated on the base loan amount will be $8,444 which is added to your loan amount.  On a 30 year mortgage, you will be paying the UFMIP back with interest over the next 30 years.
  2. The yearly mortgage insurance premium (which is paid monthly along with your mortgage payment) will be $6,031.  Over 5 years this will take $30,151 out of your pocket.  Looking at a ten year period, the cost of monthly mortgage insurance and the upfront mortgage insurance would total $68,754, a very considerable sum for most people.
  3. The estimated monthly mortgage payment along with property taxes and insurance will cost $3350 on your $500,000 home.  This monthly payment does not include the cost of any repairs and maintenance that will be required on your home.  In most parts of the country, it is possible to rent a nice home for around $2,000 per month.  The additional payments for owning versus renting will cost you an additional $81,000 over five years.

Over five years, the cost of purchasing your new $500,000 with a low down payment starts to add up to a considerable amount as shown below.  The tax benefit on mortgage interest and property taxes has been ignored in this example, but there has been tax reform talk of eliminating the home mortgage deduction.

   Cost of UFMIP                            $8,444

 Cost of Monthly MIP                    $30,151

Cost of owning vs renting               $81,000

Total                                             $119,595

Over 5 years, a borrower would have saved $119,595 by delaying the purchase of a home.  Since in this example, the borrower already had a 3.5% down payment of $17,500, the amount saved by postponing a purchase for 5 years provides more than enough to make a 20% down payment with a conventional mortgage loan and completely avoid the cost of mortgage insurance.  In addition, the borrower would have a mortgage balance $100,000 less by making the larger down payment.

Adding further complexity to the dilemma of when to buy is the fact that no one knows if housing values will recover at some point, stay depressed for decades as happened in Japan or continue to decline.  It is easy to ignore the future costs of housing when caught up in the excitement of buying that first new “perfect” house which is why I stress that everyone considering the purchase of a home should first talk to a qualified financial adviser.

What do you think?