USDA, FHA and VA loans have several things in common. They are all considered “government backed” because of an inherent guarantee made to the lender issuing the loan. As long as the lender approved the loan using the proper guidelines established by each agency, should the loan ever go into default, the lender is compensated for all or part of the loss. VA loans are available for those who have served or are serving in the military and eligible reserves. If you aren’t eligible for a VA loan, let’s then look closer at the USDA and FHA options and see what they have in common.
First, when you apply for either, you make an application with the lender, not the federal agency. For example, should you choose a USDA loan to finance a home in Florida, you apply with a lender directly who will approve the loan using lending guidelines established by the USDA. Similarly, with an FHA loan, you provide a loan application to the lender and check the box marked “FHA.” But how does the guarantee part work?
USDA Mortgage Insurance
We’re not talking about the type of insurance that protects your home but the insurance policy taken out in favor of the lender. Both USDA and FHA have their own form of insurance and it could really be said that the USDA and the FHA are more a type of insurance company than a mortgage program. And in a sense that’s exactly right.
The FHA program requires two mortgage insurance policies, called an “upfront mortgage insurance premium” and an “annual” premium that is paid in monthly installments. The upfront premium is 1.75% of the loan amount and the borrowers can pay that premium out of pocket but most roll the premium into the mortgage. On a $200,000 loan, that works to $3,500. Additionally, the annual premium will vary based upon the term of the loan and the amount of down payment but a common annual premium is 0.85%, or $1,700 for the first year. As the loan balance is paid down, the annual premium is reduced accordingly. The annual premium is paid monthly, so with this example the first year’s monthly premium is $141.
USDA loans also require a form of mortgage insurance called the “guarantee” fee and just like the FHA program, there is an upfront premium and an annual one paid monthly. The upfront fee is 1% of the loan amount and an annual premium of 0.35% of the loan balance. The upfront premium can be rolled into the loan amount and the annual premium is paid in monthly installments.
Conventional loans, those underwritten to Fannie Mae and Freddie Mac also require mortgage insurance if the amount borrowed is greater than 80% of the value of the home and there is no second mortgage. These loans have various payment options and while most premiums are borrower-paid, there are options for the lender to pay the mortgage insurance. With USDA and FHA loans, the borrowers pay the premium.
It is in fact the case that borrowers have the option to pay the upfront premium and guarantee fee out-of-pocket but in almost every instance the amount is rolled into the loan. It’s permissible for the seller to pay 1% of the loan amount as a seller credit but in all likelihood that’s never happened. If the seller were to pay 2.75% of the buyer’s closing costs, including the guarantee fee, the borrowers should take the seller credit to standard closing costs and roll the premium into the loan.
Likewise, the annual premium is made in monthly installments to the lender. Each month, the lender collects the fees and pays the annual premium on behalf of the borrowers. This process works the very same for both the USDA loan as well as an FHA mortgage. This insurance alleviates the risk associated with placing a loan on a property that will immediately have little to no equity. Without this mortgage insurance premium, the USDA and FHA loan programs simply wouldn’t exist.