When it was announced that the Federal Housing Administration would extend its mandatory monthly mortgage insurance premiums to a minimum of 10 years up to as long as the life of its 30-year loans depending on the size of the down payment, many market observers were incredulous. Others felt that it was a political move to shore up the FHA’s books in the short term only to be reversed in the long term as the financial pressures on the agency abated. However, given long-term prospects for the mortgage market, this change due June 3rd is wiser than first blush, likely to stay and it may benefit some consumers and the market. On the other hand, others will be hurt and more should be done to limit the impact on borrowers who would hold these loans to term.
Rise of the Assumable Mortgage
In the past, the mortgage insurance on a 30-year fixed rate mortgage backed by the FHA would phase out after the mortgagee had reduced their loan-to-value ratio to 78% through principle reduction. For a mortgagee with a 3.5% down payment [1] and a $200,000[2] 30-year fixed rate mortgage at a rate of 4%, the LTV would fall to 78% after a little more than 9 years. In addition, there would be an annual mortgage insurance premium rate of 1.35%, which is $2,700 extra paid annually or $225 per month.
Over the last three decades, the average 30-year fixed mortgage rate fell steadily from a peak of 16.63% in 1981 to 3.66% in 2012. As a result, fewer mortgagees waited to pay down their mortgage to release the mortgage insurance. Rather, as prices appreciated, they took advantage and refinanced into a lower rate mortgage without the mortgage insurance. The falling rates led to faster pre-payment of loans. Furthermore, the average tenure on a home hovered at just six years for nearly two decades, rising in recent years in part due to the large number of underwater owners, weak job prospects, tight credit standards, and price uncertainty.
However, mortgage rates are expected to rise over the next decade thanks to economic pressures, with the cessation of MBS and Treasury purchases by the Federal Reserve, and due to the large amount of government debt outstanding. As long term mortgage rates rise, holders of FHA mortgages will find that they hold a unique and valuable asset: an assumable mortgage. Mortgages financed by the FHA are assumable by another homebuyer, so long as the second person can qualify for FHA financing. Thus, a buyer in the future who is facing a market rate of 5.0% on a mortgage could assume an FHA mortgage of 3.5% for the bulk of the financing and pay cash for the rest or use a second mortgage.[3] The number of mortgages issued by the FHA ballooned in recent years and the FHA estimates that a higher than average share its 30-year fixed rate mortgages will be held for the full 30-year term. What’s more, this trend is forecast to rise again with originations after 2013, precisely when rates are forecast to rise.
What Does this Mean to the Buyer?
Assuming a lower rate loan reduces the cost of borrowing in an environment of rising interest rates. Assuming that home values rise at the historical 3% average, that $207,250 home would be worth roughly $247,500 after six years when the owner decides to sell. The next buyer could assume the remaining balance of roughly $172,000 and a second mortgage for the $83,000 balance at a hypothetical retail rate of 5.0%. The difference in the monthly payment for the new homeowner is nearly $72 dollars with the assumed mortgage versus if the entire sum were financed at the retail rate. However, if rates were to rise further, the difference is even larger reaching more than $900 a month if rates rise to an unlikely 12%.
How Does the Original Owner Benefit from this Deal?
The homeowner who sells their home has an asset in the assumable loan. In today’s market, you can pay your mortgage broker roughly 1% of the value of the loan to buy down the rate by an eighth of a percentage point (e.g. from 4% to 3.875%)[4]. If that pricing held in the future, the original mortgagee in the above example would have an asset worth $13,747 ([5% – 4%]/0.125% X 1% X $172,000) and the value would rise if the difference between the rate on their mortgage and the market rate increased. Furthermore, if the FHA did not continue to collect mortgage insurance, the benefit would be even greater.
For the future home seller, these extra monies could be used as equity for trade-up or to buy an assumable mortgage on another home. It could also be used to entice reticent buyers in a slow market or to offset costs of selling.
But How Does the Assumability of the Mortgage Help the FHA?
It doesn’t. In fact, it actually creates a problem for the FHA as it raises the risk to the agency when the second mortgagee takes over the loan and the mortgage insurance is released when the LTV hits 78%; just four years after the second transaction. The FHA would take on new credit risks without offsetting compensation. The second owner could then resell the loan to a third person who pays no mortgage insurance at all to the FHA, but still poses a risk to the FHA. Thus, the FHA’s new permanent mortgage insurance policy makes sense in this respect. Given the historic tenure term of six to seven years, an FHA 30-year mortgage could be used by four or even five different homeowners, each with different risk characteristics and propensities to default and each facing different economic stresses.
The FHA also benefits from the permanent mortgage insurance policy as it helps to boost the FHA’s earning on each loan. This would support the company’s current book of business in the present, lifting it closer to its statutory reserve requirements and back into the black. However, the fund could be hurt by the large volume of mortgages issued in recent years that may be assumed by new borrowers in the future without compensating mortgage insurance. The FHA benefited from tighter underwriting and better performance from 2007 to present, but mortgagees who assume these loans in the future might not have the same low risk characteristics.
Selection bias might also benefit the FHA. A buyer who is aware of the benefits of an assumable loan may be more financially savvy. Furthermore, the lower monthly payment would soften the blow of a loss of employment or other financial hardship that could trigger a default.
Finally, the overall housing market will benefit from assumability, though the mortgage industry might lose on compensation. Borrowers will have a means to mitigate increases in mortgage rates that are anticipated in the coming years, softening any erosion of affordability or flat income growth. Furthermore, borrowers served by the FHA, the credit and savings impaired, are more likely to be impacted by marginal changes in affordability.
Someone Must Get Hurt
The one group that loses from permanent mortgage insurance is those borrowers who put down less than 10% and hold the loan for 30 years or those who hold for more than 10 years and sell but don’t allow their loan to be assumed. At the extreme, those borrowers would pay an extra $56,700 in mortgage insurance over the life of the 30-year loan; monies that could be used to pay down principle, student loans or some other more productive use. The permanent mortgage insurance is an onerous change for this group. For this reason, the FHA might re-think the mechanics of its mortgage insurance policy so that it releases after 78%, but kicks in again if the loan is assumed. In this way the program is protected from the risks of assumption without overcharging the consumer.
The FHA faces many challenges going forward. Rising mortgage rates and a changing regulatory landscape may alter the typical borrower’s profile as well as the agency’s market share. Mortgage assumability will also impact the type of borrower the FHA receives, so it is with keen foresight that the agency changed its policy to shore up its books against future risks. Furthermore, the consumer gains an asset, which will help keep the market fluid in an environment of rising mortgage rates. However, many households will over pay with permanent mortgage insurance. More should be done to protect consumers who are likely to hold these loans to term.
[1] Under the new FHA policy, the FHA releases the MI requirement after 11 years if the borrower puts down 10%. Why is the mortgage insurance not for the life of these loans? After, 11 years, the borrower’s LTV falls to roughly 68%. However, a borrower who puts down 10% in the FHA program is likely credit impaired, unlikely to shift to private financing, and more likely a trade-up buyer who is less likely to re-sell (70% of first time buyers put down less than 10%). [2] The initial home value is $207,250. I rounded for simplicity in this example. [3] Second mortgage may be more difficult to use in the future under the final Basel III and Qualified Mortgage Rule, but these regulations are as yet unfinished and financial innovation could step in to fill the gap. [4] The current rate charged by brokers for the buy-down changes over time, but the example is just an illustration of how this benefit can and is quantified on a regular basis.
