First, the good news: Borrowers who obtain home loans backed by the Federal Housing Administration don't have to pay for private mortgage insurance, or PMI. Now the bad news: People who take out FHA loans still have to pay mortgage insurance — just not the private kind. Instead, their mortgage insurance goes to the FHA itself.
How FHA Loans Work
An "FHA loan" is not actually a loan from the Federal Housing Administration. Uncle Sam doesn't write mortgages. Rather, it's a loan from a private lender that has been guaranteed by the FHA. If the borrower quits making payments, the FHA will reimburse the lender. The money to back up those guarantees comes from the mortgage insurance premiums that FHA collects from borrowers. (With PMI, by contrast, the premiums go to a private insurer chosen by the bank, rather than the government.) In general, people get FHA loans because they don't qualify for a conventional loan. They may not have enough money for a down payment, for example, or they may have weak credit. FHA still has standards for the loans it guarantees; they just have more wiggle room than conventional standards.
Most borrowers with FHA loans must pay two kinds of mortgage insurance premiums: an upfront premium, paid at the time they take out the loan, and annual premiums. As of mid-2012, the upfront premium was 1.7 percent of the total loan amount. So if you borrowed $100,000, you'd pay $1,700. FHA allows you "roll" your upfront payment into your loan — meaning you'd actually borrow $101,700, with $100,000 going to buy the house, and $1,700 going for insurance.
The amount of your annual mortgage insurance premiums depends on a couple factors. One is the length of the loan term. Loans of 15 years or less require lower premiums than loans of more than 15 years. The second factor is "loan-to-value" ratio, or LTV -- that is, how much you currently owe as a percentage of the home's value. (Warning: Math.) FHA requires down payments of at least 3.5 percent, meaning you can't finance more than 96.5 percent of the home's value. As of mid-2012, annual premiums ranged from 0.35 percent of the loan balance (for loans of 15 years or less with an LTV of 90 percent or less) to 1.25 percent of the loan amount (for loans of more than 15 years with LTV over 95 percent). FHA also was tacking on an extra 0.25 percent for loans over $625,000. All premium rates are subject to change by Congress or FHA itself.
Paying and Stopping Premiums
Though they're called "annual" premiums, you really pay them on a monthly basis. Divide your annual premium by 12, and there's your monthly premium. So if you owed $150,000 on a 30-year loan, and your LTV was 96 percent, your annual premium would be 1.25 percent of $150,000, or $1,875. That's $156.25 a month. Your premiums are included in your monthly mortgage payments; your lender forwards them to the FHA. As you make your mortgage payments, your LTV shrinks, and your premiums go down. You must pay premiums for at least five years; after that, you can cancel FHA mortgage insurance once the amount you owe is less than 78 percent of the home's value.