FHA interest rates have fallen during the past year as mortgage costs have generally declined. These new low rates raise a question: instead of a 30-year mortgage, maybe it's time to think in terms of 15-year financing.
With falling rates, the idea of what's affordable and what's not may have shifted for many borrowers. In the particular case of FHA financing, a shift to a 15-year term could result in two forms of saving: a lower interest rate and a smaller mortgage insurance premium.
FHA loans allow borrowers to purchase homes with little down, typically 3.5 percent. Lenders are willing to make FHA loans with little down because the FHA program is an insurance plan; if something goes wrong with the loan, the lender can recover its losses with a claim to the FHA.
Where there's insurance, there are premiums, and the FHA has two forms: first, there's an up-front mortgage insurance premium, generally 1.75 percent for most FHA borrowers. Second, there's an annual mortgage insurance premium (FHA MIP) which in January was reduced from 1.35 percent for most borrowers to .85 percent.
The January premium reduction costs the annual cost of FHA financing but it only applies to 30-year loans. There was no change in the annual MIP for loans with a 15-year term.
If the annual MIP has not changed for 15-years loans, why is shorter-term financing attractive?
The answer is that 15-year FHA mortgages already had lower fees -- just .70 percent for most FHA borrowers.
So what does this mean for borrowers?
Let's look at a $150,000 FHA loan with 3.5 percent down. We'll use the fixed interest rates posted by Freddie Mac at the end of January 2014 and January 2015 for purposes of comparison. Fees and points are extra.
First, because of lower FHA interest rates, the 2015 cost for principal and interest is reduced by $57.03 per month or $685 per year.
Second, lower rates also help the 15-year borrower: monthly costs for principal and interest are down $34.86 or $418 annually.
Third, the potential interest cost over the life of the loan falls sharply when borrowers move from a 30-year term to 15 years.
Fourth, to get the benefits of a 15-year mortgage, borrowers must pay more each month because there are fewer months available to repay the debt -- 360 with a 30-year loan versus 180 with a 15-year schedule.
Fifth, the substantial reduction with annual up-front MIP from 1.35 percent to .85 percent will help many borrowers. HUD estimates that savings with the new annual MIP will average $900 annually for the typical FHA borrower.
Sixth, if an annual MIP of .85 is better than 1.25 percent, .70 percent is better still.
Does it Make Sense to Get a 15-year Loan in Today's Market?
The chart shows that the shorter the loan, the lower the overall interest cost. The chart also shows that to get that shorter loan term, the borrower must make larger monthly payments for principal and interest.
One way to look at this question is to think of larger monthly payments as a form of enforced savings. You have to repay the debt one way or another, so why not pay it faster?
What if you sell the house before the end of the loan term?
Imagine that you sell the house after eight years. With a 15-year loan, more of the debt will have been repaid, so you will owe the lender less at closing, and that could result in a larger check from a home sale.
How much of a difference with a $150,000 mortgage? After eight years with a 30-year mortgage at 3.66 percent, the borrower will owe $124,444 while the borrower with a 15-year loan at 2.92 percent will owe just $78,173.
Yes, there are other ways to save $46,271 over eight year, but have you saved $46,271 over the last eight years? If not, forcing yourself to save money through your mortgage might be the right idea.