Why You Should Refinance Your FHA Loan
When you bought your home, your life circumstances were different. You were younger and poorer. Maybe you were just starting out in your career. But you knew you were tired of paying rent and wanted a monthly payment for housing to build toward something other than making your landlord’s house payment. Unfortunately, you couldn’t qualify for a conventional loan at the time, so you opted for an FHA-backed mortgage.
But now your income has gone up and you’re older and wiser. You appreciate that without the FHA you might not own a home, but some of the constraints of the loan are preventing you from doing other things you want to do. You think refinancing might be a good idea, but you aren’t sure of your options or if it is the right decision for you. Knowing the pros and cons of refinancing can help you decide if this is a viable option for you.
Quick Review of an FHA Loan
The Federal Housing Administration (FHA) loan program is offered by the U.S. Department of Housing and Urban Development. It helps individuals and families with low to moderate income but fair to good credit scores buy a home. The down payment requirement, as well as the income requirement, is lower than with a conventional loan. The FHA agrees to back the loan, which lessens the risk that lenders take in lending to borrowers with lower incomes and less-than-perfect credit. This assurance from the FHA allows more people to get on the path to homeownership. In return, the borrowers agree to stipulations that are okay at first but can be limiting or downright stifling later.
The Pitfalls of an FHA Loan
When a borrower takes out an FHA loan, they agree to the usual loan stipulations such as making on-time payments, keeping the property insured, and maintaining the property. Because the FHA is taking on a risk, they require some assurances from the borrower. One such assurance comes in the form of two insurance policies. The first is called the Upfront Mortgage Insurance Premium or UMIP. The insurance is paid when you close the loan, and its cost is 1.75% of the loan amount. If you have a $150,000 30-year fixed-rate FHA loan, the UMIP is going to cost $2,625. You must either pay this amount while sitting at the closing table or have it rolled into the loan. On top of that is the monthly premium called the mortgage insurance premium or MIP. The combination of the two premiums can add a hefty chunk to your mortgage payment. And both are required for the life of the FHA loan.
Is Refinancing the Right Thing for You?
Let’s say you're having some problems making your FHA loan payments. You haven’t missed a payment, but you’ve come close to making a payment late. You don't want to jeopardize your home, but you realize something has to change, and soon. Short of getting a new job with a bigger salary or hitting the lottery, refinancing your mortgage is probably your best option. There are also other reasons to refinance, and the decision can have significant benefits for you down the road.
Qualifying and Applying for a Refinance
If you think the process of applying for a refinance home loan is easier than the first time, this, unfortunately, isn’t true. The process is pretty much the same. You’ll need to gather all the same information as you did the first time: pay stubs, bank statements, income or employment verification, etc. Your credit history will again be pulled, and lenders will also look at the payment history on your current mortgage. Conventional loans require higher credit scores and income levels than FHA loans do, so you’ll want a credit score in the mid- to high 600s. Your total debt-to-income ratio can’t exceed 45%, but the lower it is, the better.
Got an ARM?
An adjustable-rate mortgage (ARM) can leave many homeowners sitting on the edge of their seats, gripping their wallets with their fingers crossed. An ARM loan starts with a fixed-rate period, generally between two and five years. After the fixed-rate period ends, the interest rate on the loan is adjusted, depending on the margin set for the loan and the index the lender chooses to follow. The interest rate on the mortgage rarely if ever goes down, so homeowners find themselves bracing for the hit, and sometimes it’s substantial. Refinancing from an ARM to a fixed-rate loan eliminates that particular worry. The mortgage payment will no longer fluctuate. If you have an ARM and are worried that you’re one rate adjustment away from having difficulty making your mortgage payments, a refi to a fixed-rate loan might be the solution to your problems.
The Elimination of MIP
If you can refinance from an FHA loan to a conventional mortgage, one of the biggest benefits is that the need to carry MIP is no longer an issue. Even if the interest rate on the conventional loan is slightly higher, removing the larger insurance payment from your monthly mortgage should result in a payment that is decently lower. If at the time of the refi you don’t have a 20% equity stake in your home, mortgage insurance will still be required, but instead of it being for the life of the mortgage, Private Mortgage Insurance (PMI) is automatically canceled once you reach a 78% loan-to-value ratio. Even if that happens a year or so from the point of refinancing, that’s better than paying it for the entire life of the loan.
If you’re in a position to refinance from an FHA loan to a conventional loan, that means either you’ve increased your income and credit score to an attractive level for lenders and want a conventional loan with better terms, or you’ve met the equity threshold and need to lower your monthly payments. Either way, paying less each month for your home is the ultimate goal. Refinancing from an FHA mortgage to a conventional mortgage will provide that opportunity.
Is one reason you’re considering a refinance so you can afford to make improvements to your home? During the refinancing, you might be able to utilize the cash-out option. This is where the first loan is completely paid off by your new mortgage, then the remains of the new loan, after closing costs, are cut as a check to you at closing. That balance of the monies is yours to do with what you wish. Make home improvements, pay off existing debt, take a vacation. Just keep in mind that if you use that extra cash for anything other than making upgrades to your home, you may lose some of your mortgage interest rate deduction come tax time.
Another Option Other than Conventional
As was mentioned previously, the qualifications for a conventional loan are different than those for an FHA loan, so there’s still a chance that you won’t meet the criteria. If this is the case, an FHA Streamline loan might be an option. The application process is easier than for a conventional refi, and the credit and income requirements are lower as well. And since the program was designed to help homeowners avoid loan defaults, this program is ideal for anyone who wants to lower their mortgage payment to a more manageable level. There are some guidelines, though:
You cannot be behind on your mortgage payments.
You must already have an FHA-backed mortgage.
The cash-out option is not allowed.
You need six months of on-time payments to qualify. If you’ve missed payments, you have to wait 210 days before applying.
Potential borrowers are required to show proof that the FHA Streamline will actually help them. This is called the Net Tangible Benefit. The refinance must either (1) lower the borrower’s principal and interest amount plus the annual mortgage insurance by 5%, or (2) allow the borrower to refinance from an adjustable-rate mortgage to a fixed rate.
It’s also important to note that with this option, MIP is still required but the UMIP is often absorbed into the principal of the loan.
Regardless of the refinancing option you choose, you’ll be responsible for closing costs. This amount could be several thousand dollars. So be prepared to either have those costs financed into the loan, pay them at closing, or ask if the lender is willing to rebate the costs.
Deciding whether or not to refinance your FHA loan can be almost as tough a decision as deciding to get the initial loan was. But if you are looking for a way to lower your monthly payments, you’re fearful that your current payment amount will put your home in jeopardy, or you are just tired of worrying about the interest rate on your adjustable-rate mortgage, refinancing is probably something you should seriously consider. If you still have questions, contact a mortgage lender and explain your situation. They can help you go over your options and determine the best course of action for you.