FHA's Solvency Plan Isn't Fair

The government insurer, which may or may not be in need of a bailout, plans to generate $10 billion by locking middle class borrowers into high fees for decades.

Consumers who don't have a lot of cash to put down when buying a house usually have to pay a higher rate than typical borrowers for the first few years of their mortgage. Now, thanks to a change at a government program, they will have to pay that elevated rate for as long as 30 years.

This is apparently how the Federal Housing Administration plans to shore up its finances.

Lenders generally require borrowers to take out mortgage insurance when they don't put down 20% of a home's purchase price or have 20% equity when refinancing their mortgage. The FHA is the nation's largest insurer of low down payment home loans.

Starting next month, the FHA will begin requiring borrowers who take out their insurance to pay premiums as long as they have their mortgage. For the past decade, the FHA has allowed borrowers to cancel the policy when their loan balance drops to 78% of the value of their home, therefore eliminating the need for mortgage insurance.

At today's rates, with a 5% down payment, that would take 7 years.

The change is part of a broader plan to boost the finances of the FHA, which some say is deeply in the hole. Last month, the FHA raised its insurance premium. Now someone getting a loan with FHA mortgage insurance on average pays a 4.7% interest rate for a 30-year fixed rate loan, vs. 3.4% for borrowers putting down 20%.

But the biggest boost to FHA's finances will come from making its insurance premium permanent. FHA officials recently estimated that change would have locked in $10 billion in additional fees for the FHA on mortgages it has insured in the past three years alone. That's also the additional amount borrowers will have to pay over the life of their loans.

The problem is the FHA is going to be forcing borrowers to pay for the insurance long after they need it. Private mortgage insurers are required by law to cancel borrowers' policies once they have hit the 20% home ownership threshold. But the FHA is specifically exempted from the law.

And it's not even clear the FHA needs the money.

Recently, the Obama administration estimated in its budget that the FHA might need about $943 million in the next fiscal year to cover its expenses. That excludes any gains the agency may have from legal settlements, which have been significant recently. But almost all of that $943 million is for expected losses in the FHA's reverse mortgage program, which is not affected by the extension of the premium payments.

With home prices rising again and the economy improving, the finances of the FHA's traditional lending program have improved dramatically. They could continue to improve ... if not for the fact that the FHA may now be stuck with the riskiest borrowers and all of the losses thanks to the premium hikes. Indeed, private mortgage insurance companies have already started advertising campaigns around the FHA's recent increase in rates, saying borrowers can get a better deal elsewhere.

Nonetheless, some argue that the FHA should do whatever it can to improve its finances, even just to eliminate the perception that the agency needs a bailout.

"Rebuilding the FHA's capital base is the fairest thing you can do for borrowers," says Bill Apgar, a Harvard University professor and former FHA commissioner who was at the agency in 2001 when it began automatically canceling borrowers' policies. He notes that despite problems, the FHA weathered the financial crisis better than its rivals. "Modeling FHA to what private insurers do might not be a relevant benchmark."

But the FHA has more private competitors than it once had. Also, throughout most of the 1970s, 1980s and 1990s, borrowers who took out loans with FHA insurance could refinance into new loans after a few years, eliminating the insurance and lowering their monthly payments. With interest rates at historic lows it's unlikely that option will be available to FHA borrowers today.

The biggest problem we have today in the housing market, and perhaps the economy in general, is that despite the drop in prices, first-time home buyers remain relatively rare. Making it even harder to get on to the entry ramp for the housing market won't help the economy or the FHA's finances.