FHA's life-of-loan premium is a bad deal for borrowers and taxpayers

Department of Housing and Urban Development officials have been raising warning signs about potential risks in the FHA single-family program since taking office in January 2017. Whether it is rising debt-to-income ratios, the increasing percentage of loans with down payment assistance or the growing share of cash-out refinances of conventional loans, HUD officials, as Secretary Ben Carson stated at his June 27 congressional hearing, "are closely monitoring these indicators as they represent added risk to FHA's economic health."

Monitoring these trends is certainly appropriate. However, there is one problem that merits the Federal Housing Administration's immediate attention — the structure of the FHA mortgage insurance premium.

Since June 2013 when HUD rescinded the automatic cancellation of the annual premium and began charging that premium (now 0.85% for most new loans) for the life of the loan, the percentage of prepayments returning as new FHA refinances (called FHA's recapture rate) has plummeted costing the fund billions of dollars of revenue.

The chart below shows the FHA recapture rate by fiscal year starting in 2009. It shows the sharp decline in the recapture rate starting at the end of FY 2013, when the policy was changed, and reaching a low of about 10% in the third quarter of this fiscal year.

In 2013, the FHA hired a second actuary comprised of Summit Consulting and Milliman Inc. to assess the financial health of the Mutual Mortgage Insurance Fund and they projected much faster prepayment speeds resulting in $12 billion of lower revenue. They also warned that FHA borrowers with stronger credit profiles dominating the portfolio "may find cheaper and still cancelable mortgage insurance options."

At that time, in its FY 2013 Annual Report to Congress, HUD was optimistic that "prepayments can and do recycle back into the FHA portfolio" limiting revenue losses for the fund. Unfortunately, as the chart indicates, that has not happened. The FHA-to-FHA refinance is becoming the mortgage product equivalent of an endangered species.

The declining recapture rate also explains the reason behind the FHA's rising share of refinances of conventional loans. It is not that conventional refinances are increasing, but rather that they are not falling as fast as FHA-to-FHA refinances are.

Mortgage prepayments, of course, are influenced by a variety of factors including normal life events (e.g., job and family changes) and fluctuations in interest rates. However, it is alarming when almost all FHA borrowers prepaying their loans do not "recycle back into the FHA portfolio" as HUD had hoped in 2013.

One only has to look at the marketing material of the private mortgage insurers to better understand why this is taking place. The PMIs emphasize that borrowers have several premium repayment options (unlike FHA) ranging from monthly premiums to a single upfront amount financed as part of their mortgages and, of course, the automatic cancellation of mortgage insurance payments when the principal balance falls to 78%.

As a reminder, the Homeowner Protection Act implemented in 1999 requires servicers of conventional loans to cancel mortgage insurance when the principal balance reaches 78% of the home's original value. The FHA followed suit and announced its insurance cancellation policy in late 2000.

The current premium structure places a significant financial burden on those homeowners who are not able to refinance out of their FHA loans. They face the unenviable prospect of having to pay about $150 per month for 30 years instead of paying off their student debts or saving so their children won't have them.

To make matters worse, the current premium structure hits those borrowers the hardest who live in areas that have not seen the house price appreciation of other housing markets around the country.

In the last two years alone, house prices have increased over 40% in the Seattle and Denver metropolitan statistical areas, according to the Federal Housing Finance Agency's house price index. On the other hand, in the Casper, Wyo., Enid, Okla., and Beckley, W.Va., MSAs, home prices have increased minimally and, in the case of Beckley, have actually declined making it much more difficult for borrowers in these areas to refinance out of their FHA loans.

Now some have proposed lowering the annual premium in the later years of the FHA mortgage. Unfortunately, that solution does not address the underlying problem in the mortgage marketplace. Said another way, would lowering the annual premium for the last 20 years of an FHA mortgage have any impact on PMI marketing material?

A more equitable solution would be to restructure the FHA premium by raising the upfront premium as necessary and eliminating the life-of-loan requirement. Making this change would slow down the early runoff of FHA loans and ensure that all borrowers who benefit from FHA mortgage insurance pay a more equitable share of FHA's expenses.

The good news is that it may not even be necessary to increase the upfront premium as the FHA's performance metrics have improved dramatically in recent years. Its portfolio serious delinquency rate, in spite of the problems caused by the 2017 hurricanes, is now at the lowest level since 2000. Claim payments are running 62% below the projected level in the first three quarters of FY 2018 after being 48% below the FY 2017 projection. Finally, FHA has rid its portfolio of the riskiest loans as the seller-funded down payment assistance loans that have cost the fund over $16 billion are now less than 1% of the FHA's insurance-in-force.

In conclusion, FHA borrowers must be charged adequate premiums to ensure the FHA's long-term sustainability. However, the current premium structure jeopardizes the health of the fund and unnecessarily penalizes millions of FHA homeowners particularly those living in areas with little house price appreciation. Eliminating the life-of-loan premium requirement will address both of these concerns.