The evolution of FHA mortgage rates

Since its creation in 1934, the Federal Housing Administration's mission has been to provide access to mortgage loans for lower income, first-time buyers and minorities to encourage homeownership.

Before the FHA came along, most mortgage borrowers had short-term, balloon- or "bullet-payment" mortgages with down payments that averaged about 50 percent. While mortgage rates averaged 6 percent during most of the 1920s and 1930s, when the FHA came along with fixed interest rates that they set, competition grew, driving down average interest rates closer to 5 percent.

"The FHA started as a way to help families during the Great Depression by providing long-term loans with low down payment requirements," says Raphael Bostic, is president and chief executive officer of the Federal Reserve Bank of Atlanta and a former secretary of the U.S. Dept. of Housing and Urban Development. "The early mortgage products that were available before the FHA were five-year loans with a balloon payment that required (at least) a 20 percent down payment. At the end of five years homeowners had to refinance or sell, which led to the massive loss of homes to foreclosure during the Great Depression."

Higher FHA mortgage rates

Today, most FHA borrowers have no idea that the FHA set their own interest rates until 1983, when the Housing and Rural Recovery Act mandated that FHA mortgage rates must be market-based.

"For the most part since 2000, FHA mortgage rates have been about 0.125 to 0.25 percent higher than conforming loans," says Keith Gumbinger, vice president of HSH.com. "FHA loans have greater overhead for lenders, require special certification and come with more bureaucracy, so they can cost more for lenders to originate."

(Interest rates provided by HSH.com. Mortgage Bankers Association, Freddie Mac. FHA loan volume provided by HUD.)

"FHA loans vanished during the subprime loan boom (2004-2007) because people with a weak credit profile or a lack of cash could get subprime loans," says Rick Sharga, Founder & CEO, CJ Patrick Company in Trabuco Canyon, CA, and former executive vice president at ATTOM and RealtyTrac. "FHA loans made a comeback after the subprime market meltdown because it was almost the only place that borrowers could go. The FHA prevented a deeper fall off the cliff for the housing market. Without it, there would have been even more foreclosures."

In times of stress or uncertainty in housing markets, private-market mortgages can become very difficult to come by, and even conforming mortgage markets can see credit availability become curtailed or more expensive. It's at times like these that the FHA program really shows its value.

Lower FHA mortgage rates

FHA mortgage rates began to be consistently lower than conforming loan rates by 0.125 to 0.25 percent beginning in 2010 in part because of the lack of penalties on FHA loans for having a lower credit score or a higher loan-to-value, says Gumbinger.

"One reason FHA rates could be lower than conforming-loan rates is that Fannie Mae and Freddie Mac have added 'loan level price adjustments' and guarantee fees to their loans that lenders then pass on to borrowers in the form of higher rates," says Bostic.

Had Mel Watt, director of the Federal Housing Finance Agency, not delayed fee increases on Fannie Mae and Freddie Mac loans at the end of 2013, conforming interest rates would have risen more than they otherwise would have, increasing the spread between FHA and conforming and loans, explains Gumbinger.

But after years of distorted mortgage markets coming out of the Great Recession, things began to normalize, and FHA-backed mortgages again began to more routinely see rates above those for conforming loans. As well, when the Federal Reserve was buying billions of MBS from Fannie Mae and Freddie Mac, liquidity in this portion of the market was greatly improved, and that helping conforming rates to decline further than did those for FHA-backed loans.

Future of FHA mortgage rates

Mortgage rates remain higher than they have been in many years, and that includes FHA mortgage rates. Will rates for FHA-backed loans break higher or lower than their conforming counterparts as monetary policy and financial markets return to normal again? "It's not clear if FHA rates will consistently remain above conforming rates, but they may if housing finance markets remain unstressed," says Gumbinger.

Although FHA interest rates remain affordable, the somewhat higher cost of FHA mortgage insurance premiums and the requirement that mortgage insurance must be paid for the life of an FHA loan has led many borrowers to reconsider FHA loans in favor of conforming loans.

A few years back, "The FHA increased its mortgage insurance requirements in order to shore up the cash reserves Congress requires the FHA to have," says Bostic. "FHA borrowers have a riskier profile so you'd naturally assume that the mortgage rates are higher, but the mortgage insurance requirement offsets the risk and can help keep rates lower."