Finding value in loan assumptions

"Does the assumability option on FHA loans offset their high mortgage insurance premiums?"

That is a 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.

Loans insured by the Federal Housing Administration (FHA) 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-insured loan 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.

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 fixed-rate mortgage at 5 percent with no mortgage insurance and an FHA loan at 5 percent with mortgage insurance, and, of course, assumability.

The FHA has an upfront mortgage insurance premium of 1.5 percent of the loan, and a monthly premium of 0.5 percent. The purchaser expects to have the house for five 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 percent.

I have a spreadsheet on my Web site that values the 5 percent mortgage to a buyer relative to the 10 percent 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 (six years), and on the "investment rate" -- the rate the buyer could earn on her savings, which I set at 4 percent.

On these assumptions, the value of the assumable 5 percent loan, relative to the alternative 10 percent loan, is $49,012. The present value at 4 percent 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 percent, which is $4,525, for a total of $7,525. This suggests that the value of the assumability option on an FHA loan could outweigh the mortgage insurance cost by a wide margin. For a number of reasons, however, this calculation overstates the value of assumability. ...CONTINUED

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