Get into a house for just 3.5% down By AnnaMaria Andriotis Smart Money 10-22-2009

Get into a house for just 3.5% down
Dangerous subprime lending might be history, but you can still buy a home with little money down -- if you qualify for an FHA-backed mortgage. Is one right for you?
By AnnaMaria Andriotis
Smart Money
October 22, 2009

The days of putting little money down to buy a home aren't over.

Fixed-rate or adjustable mortgage?
After years of risky mortgages backed by small down payments, most lenders aren't underwriting loans without significant sums upfront and high credit scores. But a decades-old program can still put homebuyers in houses for next to nothing.

Mortgages insured by the Federal Housing Administration allow borrowers to get approved with down payments as small as 3.5%, without high credit scores.

As millions of Americans now realize, getting into a house with little money down has its disadvantages. Borrowers who have pumped scant equity into their homes are often more willing to walk away during lean times that keep them from making payments. This risk is further elevated when home values decline and troubled borrowers are unable to refinance or sell at a price that covers their losses.

Still, FHA-insured mortgages are far less risky than the subprime mortgages that lenders originated before the housing bust. FHA-insured mortgages require documentation and proof that the borrowers are capable of making the monthly payments. (Most subprime mortgages didn't require such proof.)

Compared with the terms of traditional home loans, the looser terms of FHA-insured mortgages have helped make them more popular. Today, FHA-insured mortgages make up about 25% of the mortgage market, up from 3% in 2006, FHA Commissioner David Stevens said. The FHA insured nearly 1.95 million loans in fiscal 2009 -- up 62.3% from a year earlier.

Here's how to determine whether an FHA-insured mortgage is right for you.

Do you meet the qualifications?
Most borrowers of FHA-insured mortgages have stable incomes and need more flexibility with their credit histories and debt loads than conventional mortgages might allow, said Lemar Wooley, a spokesman for the Department of Housing and Urban Development, of which the FHA is a part.

"When analyzing the borrower's credit, we expect lenders to examine the overall pattern of credit behavior rather than isolated occurrences of poor performance or relying solely on a credit score," Wooley said. This includes a borrower's rental or mortgage payment history, debts, collections, previous foreclosures and bankruptcies. Borrowers with credit scores lower than 500 must make 10% down payments to be eligible, he said.

Today, 78% of FHA-insured purchase mortgages belong to first-time homebuyers, thanks to looser requirements and the comparatively small 3.5% down payment, Wooley said. Another perk is that borrowers are permitted gift assistance for the down payments from their families or their employers or from a government entity -- but not from the seller.

Rigorous documentation requirements mitigate the risk associated with making a small down payment -- in stark contrast to the glory days of subprime mortgages, when documentation was rarely required and verified, said Nicholas, of the CMPS Institute. FHA borrowers must prove that they have the cash to close the mortgage by presenting their most recent bank statements. They also must show W2 statements and pay stubs to prove that they can repay the mortgages.

In addition, borrowers' total mortgage payments (including principal, interest, taxes and insurance) cannot exceed 31% of their gross monthly income, and total debt-to-income ratio (total mortgage payment plus all other debts) cannot exceed 43% of their gross monthly income.

Can you afford the costs?
Interest rates on FHA mortgages are generally half a percentage point to three-quarters of a point higher than those on non-FHA mortgages. Thirty-year fixed-rate FHA-insured mortgages had an average rate of 5.86% on Oct. 22, compared with an average rate of 5.15% for similar non-FHA mortgages.

In addition, there are unique fees that accompany an FHA-insured mortgage. A borrower is required to pay 1.75% of the loan amount upfront, or that fee can be financed into the mortgage. FHA-insured mortgages also require a 0.5% annual premium based on the outstanding loan balance, which is financed into the mortgage. These fees pay for the FHA insurance that makes the loan possible, HUD spokesman Wooley said.

A borrower who has a high credit score -- typically, a minimum of 720 -- and a 20% down payment is often better off with a traditional, non-FHA mortgage, which carries fewer fees. However, the math gets tricky when a borrower has a high credit score but a down payment of less than 20%. In those cases, the borrower will have to pay for private mortgage insurance (PMI). Depending on your situation, PMI can cost less, the same as or more than FHA fees.

Crunch the numbers here to see how much you would pay in PMI.

What protections are in place for the lender?
Lenders are comfortable providing FHA-insured mortgages because they don't bear the loss if a borrower defaults and goes into foreclosure -- the FHA does.

In such a scenario, the FHA pays the lender an insurance claim equal to the sum of the unpaid principal balance of the loan, the foregone interest and a portion of the foreclosure expenses, Wooley said. The FHA pays for these losses by dipping into its insurance fund, which holds the insurance fees borrowers pay, Nicholas said.

What about for the borrower?
When borrowers are unable to keep up with mortgage payments, lenders are required to work with them to avoid foreclosure, Wooley said. This is part of the FHA's loss-mitigation program.

Now mortgage servicers can use this program to reduce monthly mortgage payments to 31% of the borrower's monthly gross income, said Keith Gumbinger, a vice president at HSH Associates, which tracks mortgage data. To qualify, borrowers must be unable to keep up with their mortgage payments but cannot be more than 30 days delinquent.

Although this program can help prevent foreclosures, it doesn't guarantee that borrowers ultimately will be able to hold on to their homes, Gumbinger said.

Who is taking the biggest risk?
Under certain circumstances -- primarily, rampant FHA-insured mortgage underwriting and declining home values -- these mortgages present a significant risk to the economy. When home values decline, a borrower who has little equity in a home and is falling behind on payments is more likely to walk away from the property than a borrower who has more invested in a home, said Dean Baker, a co-director at the Center for Economic and Policy Research in Washington, D.C.
Fixed-rate or adjustable mortgage?

If a significant number of FHA-insured mortgage borrowers go into foreclosure, the FHA insurance fund could become depleted, and the government might have to bail it out, Nicholas said. Those losses could ultimately be borne by taxpayers or get added to the country's debt, Baker said.