Nov302012

## FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium

Yesterday I described How to game the system with FHA loans for maximum advantage. Today, I want to look at the cost of that financing. It’s up to you to determine whether you believe the benefits are worth the costs.

Many have quipped that FHA has become the replacement for subprime. They have very low standards for qualification (a 580 FICO score), a very low down payment requirement (currently 3.5%), and as a result, they have become the loan-of-necessity for anyone who doesn’t have the credit requirements or the down payment necessary to obtain other financing. In other words, they have stepped into the void left by the collapse of subprime lending.

The FHA insurance premium is a direct measure of repayment risk divorced from interest rates. Ordinarily, this risk is rolled up into the interest rate, which is why subprime loans used to carry a higher rate. However, FHA loans have the same interest rate as prime customers. Since the FHA insurance premium is an added borrower cost, with a little math, we can calculate the effective interest rate on an FHA loan and show just how much borrowers are paying for it. But first, a little background.

## How Interest Rates are determined

In the Great Housing Bubble, I provided a conceptual framework for understanding how interest rates are determined in a somewhat-free market.

Mortgage interest rates are determined by investor demands for risk adjusted return on their investment. The return investors demand is determined by three primary factors: the riskless rate of return, the inflation premium and the risk premium. The riskless rate of return is the return an investor could obtain in an investment like a short-term Treasury Bill. Treasury Bills range in duration from a few days to as long as 26 weeks. Due to their short duration, Treasury Bills contain little if any allowance for inflation. A close approximation to this rate is the Federal Funds Rate controlled by the Federal Reserve. It is one of the reasons the activities of the Federal Reserve are watched so closely by investors. The closest risk-free approximation to mortgage loans is the 10-year Treasury Note. Treasury Notes earn a fixed rate of interest every six months until maturity issued in terms of 2, 5, and 10 years. The 10-year Treasury Note is a close approximation to mortgage loans because most fixed-rate mortgages are paid off before the 30 year maturity with 7 years being a typical payoff timeframe.

The difference in yield between a 10-year Treasury Note and a 30-day Treasury Bill is a measure of investor expectation of inflation, and the difference between the yield on a 10-year Treasury Note and the prevailing market mortgage interest rate is a measure of the risk premium. … The risk premium is the added interest investors demand to compensate them for the possibility the investment may not perform as planned. Investors know exactly how much they will get if they invest in Treasury Notes, but they do not know exactly what they will get back if they invest in residential home mortgages or the investment vehicles created from them. This uncertainty of return causes them to ask for a rate higher than that of Treasury Notes. This additional compensation is the risk premium. Mortgage interest rates are a combination of the riskless rate of return, the risk premium and the inflation premium.

The federal reserve controls the base rate, and they have some measure of control over inflation expectations. Our current record-low interest rate environment is an attempt by the federal reserve to lower the cost of borrowing as much as possible to raise house prices and prevent their member banks from losing billions of dollars on their bad loans from the housing bubble era. However, the federal reserve cannot ignore the risk premium. They have no control over that.

The FHA attempted to ignore the real cost of mortgage risk for years as house prices collapsed, and as a result, they are facing a government bailout. As the losses continue to mount, reality has begun to set in at the FHA, and they are continually raising the cost of their insurance to cover the losses from their bad loans. This increased insurance cost adds to a borrowers cost of financing, and it serves as a proxy for raising interest rates on borrowers using FHA financing.

The subprime business model works by charging higher interest on subprime loans to offset the losses from the higher default rates associated with lending to people who default in large numbers. The FHA has been running on the subprime business model for several years, and as their insurance premiums increase, they provide a direct measure of mortgage risk in the market.

Keep in mind as you read these examples that they assume the minimum 1.25% FHA insurance fee. If you wan to borrow up to $729,750, the fee rises to 1.6%, and the numbers below scale up accordingly.

## Current Risk Premiums are 50%!

To calculate the current risk premium, we need to examine the cost of the FHA insurance and convert that to an effective interest rate. Then by measuring the percentage increase, we can determine the current risk premium. The best way to do that is by an example.

Let’s review the borrowing costs on a $432,215 home purchase. I chose that number because it leaves a $417,000 loan after a 3.5% down payment. Any loans larger than that carry an even larger FHA insurance premium.

$432,215 Purchase price

3.5% Interest Rate

$417,000 Loan

$1,873 monthly payment

$434 FHA insurance @1.25%

$2,307 monthly borrower cost

The above figures represent what a borrower would face today. If you were to recompute the effective interest rate that would yield a $2,307 payment on a $417,000 loan, the result is 5.3%.

The risk premium in the market is 1.8% (5.3% – 3.5%). 1.8% doesn’t sound like much until you consider the base rate its measured against.

(5.3% – 3.5%) / 3.5% = 50% increase in effective interest rate!

FHA loans are quite expensive.

## Cost of additional borrowing equals a 12.4% second mortgage

During the housing bubble, lenders gave out second mortgages to anyone who didn’t have a 20% down payment. A common product was the 80/20 loan which had a conventional 80% first mortgage and a higher interest rate 20% second mortgage. Again, lenders were rolling the risk premium into the interest rate on the second mortgage. Another way to look at the cost of an FHA mortgage is to consider it a 80/16.5 mortgage because the incremental cost of the FHA insurance is only required if borrowers need to borrow the last 16.5% to complete the transaction. Let’s review our example:

$432,215 Purchase price

3.5% Interest Rate

$417,000 Loan

$1,873 monthly payment

$434 FHA insurance @1.25%

$2,307 monthly borrower cost

Now let’s compare that cost with a 20% down mortgage:

$432,215 Purchase price

$345,700 Loan

$1,552 monthly payment

The difference between the $2,307 FHA monthly cost and the $1,552 cost of the conventional mortgage is $755 per month. That’s the effective interest cost on the additional $71,301 borrowed. If you compute the interest rate on a $71,301 loan that provides a $755 monthly payment amortized over 30 years, the result is 12.4%.

**FHA borrowers are in effect taking out 12.4% second mortgages.**

That’s a mortgage premium of 8.9% (12.4% – 3.5%). With premiums that high, it’s a wonder private money hasn’t ventured back into this business. With no competition from subprime lenders, the FHA has become a loan shark. Tony Soprano would be proud.