Are FHA Mortgages Really Insurance?

Is An FHA Mortgage Really Insured?Question: Is the FHA mortgage program really insurance? Or is it a guarantee? What’s the difference and how does the distinction impact mortgage borrowers?

Answer: The FHA mortgage program sure seems like insurance but there’s also a case to be made that it isn’t.

First, a little explanation is in order.

An “insurance contract” can generally be seen as an agreement where one party (the insured) pays premiums to a second party (the insurance company). In return, if there’s a “fortuitous event” which hurts the insured the insurance company is then required to pay out such benefits as are described in the contract.

With a guarantee there are generally three parties instead of two: the party who pays the premiums, the party who collects the premiums, and a third party who is paid in case of one of those fortuitous events takes place.

FHA Mortgages

When you buy a home lenders would very much like you to purchase with 20 percent down. That’s a problem because most buyers — especially first-time purchasers — do not have such cash and with good reason: According to the National Association of Realtors the typical existing home sold for $219,400 in April. Twenty percent of that price is almost $42,000 and in addition to down payment cash buyers also need money for closing and moving.

The alternative is to buy with less cash up front. With an FHA-backed loan borrowers can purchase with as little as 3.5 percent down plus closing costs.

Borrowers can finance real estate with small down payments because in place of more cash they instead get FHA backing. If the property is foreclosed the lender files a claim against the FHA for any losses. With support from the FHA lenders are happy to accept qualified borrowers with 3. 5 percent down.

The FHA charges an up-front mortgage insurance premium (MIP), now 1.75 percent of the loan amount. In addition, the FHA gets .85 percent with the annual mortgage insurance premium — down from 1.35 percent in 2014.

Notice that the fee charged by the FHA is called a “mortgage insurance premium.” That sure sounds like a charge for the purchase of insurance coverage. But, actually, there’s an argument to be made that the FHA is really a guarantee plan.

If you look at how FHA mortgages are structured you can see that the borrower pays the premium costs — but in the event of default all claims are paid to the lender. The borrower does not get a dime. Compare this with homeowners insurance: You pay the premiums and in the event of a loss the insurance company pays you — the premium payer — for repairs and replacements.

FHA Lender Guarantees

For lenders the FHA is really a guarantee program because they get the benefit of coverage paid for by the borrowers, coverage that lenders require as a condition of making the loan. The go9d news for lenders is that the FHA covers 100 percent of most losses.

Does this make any difference to borrowers? Nope, not really. The important point is that with FHA financing a qualified borrower can purchase real estate with 3.5 percent down instead of waiting years to accumulate 20 percent up front. Call it insurance, call it a guarantee, the bottom line is that the FHA program has helped more than 40 million borrowers.

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