Buying a home with a down payment of less than 20 percent can be expensive, but it just got cheaper for some home buyers. Many private mortgage insurers have dropped the rates they charge high quality borrower. Combined with historically low mortgage rates, this change could unlock ownership and improve affordability for many borrowers.
The Cost of Insurance
While most people focus on mortgage rates, mortgage insurance can add significantly to the cost of borrowing. Fannie Mae and Freddie Mac (the GSEs) require borrowers who puts down less than 20 percent to pay for private mortgage insurance (PMI). The GSEs also charge separate fees called loan level pricing adjustments (LLPAs) for particular borrowers including those who put down less than 20 percent. These two fees, PMI and LLPAs, constitute insurance that low down payment borrowers are charged for conventional loans. Likewise, mortgages backed by the Federal Housing Administration (FHA) are charged a mortgage insurance premium. These mortgage insurance fees can add significant costs to the monthly payment for a home.
Why Are the Fees Changing?
Fannie Mae and Freddie Mac buy loans from lenders, package them into mortgage back securities (MBS), and then sell the MBS to investors with a guarantee that if anything bad happens, the buyer of the MBS will still get their money. This guarantee makes the GSEs insurers against anything that might go wrong including losses on loans greater than what the private mortgage insurers cover or if the private mortgage insurer goes out of business.
During the recent crisis, most insurers took significant losses as loans went bad. Absorbing losses is the insurers’ job, though. Insurers charge fees and use these fees as capital to pay claims as loans go bad. Some insurers did not hold enough capital and subsequently went out of business. When those claims went unpaid or insurers went out of business, those losses had to be paid by the GSEs. To prevent losses like this in the future, the GSEs set up new rules requiring best practices as well as higher amounts of capital of the private insurers with whom they do business.
Furthermore, the GSEs specified that the private mortgage insurers must hold specific amounts of capital against borrowers with particular characteristics. This type of system is called risk-based pricing where riskier borrowers, those with lower credit scores or smaller down payments or other characteristics, pay more. Historically, the GSEs used pooled or average-cost pricing where all borrowers paid the same fee, which reflected the average borrower’s risk.
Who Benefits and Who Loses?
Borrowers with a down payment greater than 10 percent or a credit score greater than 739 will benefit the most from the recent changes. However, borrowers with credit scores under 700 and down payments less than 10 percent will pay more. As depicted below, a borrower with a 760 credit score and a 3 percent down payment will pay $83 less each month, while a borrower with a 630 credit score would pay $128 more.
The FHA made headlines in 2015 after reducing its annual mortgage insurance premium from 1.35 percent to 0.85 percent. This change drew many new borrowers into the market but also attracted some higher quality borrowers from the GSEs. As depicted below, the recent reduction in private mortgage insurance premiums will make GSE-backed loans cheaper for those with the highest credit scores. This change will draw some of the best qualified borrowers back to the GSEs from the FHA. Borrowers facing PMI increases will likely remain with the FHA. Some borrowers might pay more for PMI than FHA insurance but will switch to the GSEs because private mortgage insurance is extinguished when the loan-to-value rate reaches 78 percent, while the FHA’s insurance must be paid for the life of the loan.
A steady, stable flow of affordable credit is important for the housing market. The cost of both private and government supported insurance programs has improved since 2014, while still providing sufficient capital to maintain long-term soundness of insurers.
The increases in PMI fees for weaker borrowers will reinforce the FHA’s recent premium cuts retaining these borrowers at the FHA. Reduced fees for stronger borrowers will draw a small share of the FHA’s business to the private sector. As a result, the FHA is likely to remain a significant player in the market for low down payment borrowers. Retaining some of the stronger borrowers is important to keep insurance costs down in the FHA’s average cost model and to reduce any potential impact to tax payers. Thus, in the years to come as lenders reduce overlays on the FHA’s program and weaker borrower re-enter the market, the stronger borrowers in the FHA’s book of business will help to offset the cost of weaker borrowers.
First time buyers as well as buyers in high cost markets will benefit from improved mortgage insurance pricing in 2016. These changes reflect stronger capital rules intended to strengthen the financial health of the market, but they will also help to save consumers money.