Why are fha rates lower than conventional

Since its creation in 1934, the Federal Housing Administration's mission has been to provide access to mortgage loans for lower income, first-time buyers and minorities to encourage homeownership.

Before the FHA came along, most mortgage borrowers had short-term, balloon- or "bullet-payment" mortgages with down payments that averaged about 50 percent. While mortgage rates averaged 6 percent during most of the 1920s and 1930s, when the FHA came along with fixed interest rates that they set, competition grew, driving down average interest rates closer to 5 percent.

"The FHA started as a way to help families during the Great Depression by providing long-term loans with low down payment requirements," says Raphael Bostic, a professor with the Price School of Public Policy at the University of Southern California in Los Angeles and a former assistant secretary of the U.S. Dept. of Housing and Urban Development. "The early mortgage products that were available before the FHA were five-year loans with a balloon payment that required (at least) a 20 percent down payment. At the end of five years homeowners had to refinance or sell, which led to the massive loss of homes to foreclosure during the Depression."

Higher FHA mortgage rates

Today, most FHA borrowers have no idea that the FHA set their own interest rates until 1983, when the Housing and Rural Recovery Act mandated that FHA mortgage rates must be market-based.

"For the most part since 2000, FHA mortgage rates have been about 0.125 to 0.25 percent higher than conforming loans," says Keith Gumbinger, vice president of HSH.com. "FHA loans require more bureaucracy and special certification, so they cost more for lenders."

Year

Loan volume

Average FHA interest rate

Average conforming rate

2000

831,5472

8.38 percent

8.26 percent

2003

1,128,934

6.07 percent

5.94 percent

2006

399,905

6.53 percent

6.50 percent

2009

1,831,320

5.33 percent

5.27 percent

2012

1,184,498

3.65 percent

3.85 percent

2015

1,116,214

3.75 percent

3.93 percent

2018

1,014,609

4.78 percent

4.54 percent

2020

1,333,176

3.36 percent

3.11 percent

(Interest rates provided by HSH.com. Mortgage Bankers Association, Freddie Mac. FHA loan volume provided by HUD.)

"FHA loans vanished during the subprime loan boom (2004-2007) because people with a weak credit profile or a lack of cash could get subprime loans," says Rick Sharga, executive vice president of Auction.com in Irvine, Calif. "FHA loans made a comeback after the subprime market meltdown because it was almost the only place that borrowers could go. The FHA prevented a deeper fall off the cliff for the housing market. Without it, there would have been even more foreclosures."

Lower FHA mortgage rates

FHA mortgage rates began to be consistently lower than conforming loan rates by 0.125 to 0.25 percent beginning in 2010 in part because of the lack of penalties on FHA loans for having a lower credit score or a higher loan-to-value, says Gumbinger.

"One reason FHA rates could be lower than conforming-loan rates is that Fannie Mae and Freddie Mac have added 'loan level price adjustments' and guarantee fees to their loans that lenders then pass on to borrowers in the form of higher rates," says Bostic.

Had Mel Watt, director of the Federal Housing Finance Agency, not delayed fee increases on Fannie Mae and Freddie Mac loans at the end of 2013, conforming interest rates would have risen more than they otherwise would have, increasing the spread between FHA and conforming and loans, explains Gumbinger.

But after years of distorted mortgage markets coming out of the Great Recession, things began to normalize, and FHA-backed mortgages again began to more routinely see rates above those for conforming loans. As well, with the Federal Reserve again buying billions of MBS from Fannie Mae and Freddie Mac, markets for those mortgages are very liquid, and that has helped conforming rates to decline further than did those for FHA-backed loans.

Future of FHA mortgage rates

Many experts have forecast a rise in mortgage rates in the coming years. While FHA mortgage rates are expected to increase right along with their conforming counterparts, "it's not clear if they will they remain above conforming rates, but they may if markets remain unstressed," says Gumbinger.

Although FHA interest rates remain affordable, the somewhat higher cost of FHA mortgage insurance premiums and the requirement that mortgage insurance must be paid for the life of an FHA loan has led many borrowers to reconsider FHA loans in favor of conforming loans.

A few years back, "The FHA increased its mortgage insurance requirements in order to shore up the cash reserves Congress requires the FHA to have," says Bostic. "FHA borrowers have a riskier profile so you'd naturally assume that the mortgage rates are higher, but the mortgage insurance requirement offsets the risk and can help keep rates lower."

The importance of FHA jumbo loans

Like Fannie Mae and Freddie Mac, the FHA saw expanded loan limits to help offset a lack of mortgage credit availability during the housing crisis, helping to keep mortgage money available to audiences outside the relatively strict confines of GSE-backed loans. Both borrowers of modest means and those who are more well-to-do have found shelter in FHA-backed mortgages, and this is likely to continue.

Despite becoming pricier, some audiences may still be strongly attracted to FHA-backed loans, says Gumbinger. “Homebuyers and homeowners in expensive markets who need a jumbo mortgage but lack the 20 percent down payment (or equity stake) that private-market lenders often require may turn to the FHA, which can back loans of up to $822,375 in certain areas. The mortgage insurance cost may be a detraction, but this may be the only avenue for low-equity borrowers to find affordable financing.”

What is the downside of FHA?

What is the biggest advantage of an FHA loan?