“Does the assumability option on FHA
loans offset their high mortgage insurance premiums?”
Great question, and
very timely. The value of assumability right now is as high as it is
ever likely to go because of the broad consensus that interest rates in
future years will be higher than they are now.
Meaning of Assumability
FHA loans are
assumable while conventional loans, with a few exceptions, are not. That
means that a home purchaser today who finances the purchase with an FHA,
and who sells his house later when interest rates are higher, will be
able to offer a potential buyer the right to assume his low-rate FHA
loan. After approval of the buyer by FHA, on sale of the property, the
buyer will assume all the obligations under the mortgage, just as if the
loan had been made to her, and the seller will be relieved of liability.
The major driving
force behind assumptions is the lower interest rate on the assumed
mortgage relative to current market rates. If the home seller has a
mortgage with a rate below the current market rate, both buyer and
seller can be better off if the buyer assumes the seller’s loan. The
buyer enjoys a lower rate and also avoids the settlement costs on a new
mortgage.
Estimating the Value of
Assumability: An Example
Assume a home
purchaser today taking a $200,000 mortgage on a $250,000 house who is
offered the choice between a conventional 30-year FRM at 5% with no
mortgage insurance, and an FHA at 5% with mortgage insurance, and of
course assumability. The FHA has an upfront mortgage insurance premium
of 1.5% of the loan, and a monthly premium of .5%. The purchaser expects
to have the house for 5 years, at the end of which the mortgage balance
will be $183,657. Let’s assume for the moment that the market rate at
that time will be 10%.
I have a
spreadsheet on my web site that values the 5% mortgage to a buyer
relative to the 10% mortgage available in the market. In addition to the
factors in the preceding paragraph, the spreadsheet requires an
assumption about how long the buyer expects to have the mortgage (6
years), and on the “investment rate” – the rate the buyer could earn on
her savings, which I set at 4%. On these assumptions, the value of the
assumable 5% loan, relative to the alternative 10% loan, is $49,012. The
present value at 4% is $40,141, without considering the savings in
settlement costs on a new loan.
The cost of the FHA
mortgage insurance is the upfront premium of $3,000, plus the present
value of the monthly premium discounted at 4%, which is $4525, for a
total of $7525. This suggests that the value of the assumability option
on an FHA could outweigh the mortgage insurance cost by a wide margin.
For a number of reasons, however, this calculation overstates the value
of assumability.
Qualifying the Estimated Value
of Assumability
First, we ought to
be more conservative in our interest rate assumptions. If we assume a
future market rate on a new mortgage of 8%, rather than 10%, and a
discount rate of 8% as well, then the assumable mortgage will be worth
$23,166 in 5 years with a present value of $15,549, and the mortgage
insurance cost will be $7110. That is still more than 2 to 1, and it
does not include the savings in mortgage settlements costs to the buyer.
Second, the savings
to the buyer from assuming the existing mortgage would be reduced if the
buyer has to supplement the existing loan balance with a new second
mortgage at a higher rate. This could well be the case if the house has
appreciated during the period since the mortgage was taken out. The
value of assumability to a buyer strapped for cash would be much lower
than to one who has the cash to pay the difference between the sale
price and the balance of the old loan. The borrower today has no way to
anticipate the financial status of the person who buys his house years
later.
Third, the borrower
today cannot expect that when he sells and offers an assumable loan with
the house, that the price of the house will include the full value of
the assumable mortgage. In their negotiations, the value of the
assumable mortgage will be shared in some unknown proportions. This
further increases the uncertainty in the value of assumability to a
borrower today.
Bottom Line
The borrowers today
for whom assumability has the greatest potential value are those who
expect to sell their house within 3-7 years.
For these borrowers, the value of
assumability could equal or exceed the cost of FHA mortgage insurance.
Short of 3 years, it is not clear that interest rates will be
significantly higher than they are today, and after 7 years it is not
clear that assumability will have significant value to home buyers.