"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

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 percent, rather than 10 percent, and a discount rate of 8 percent as well, then the assumable mortgage will be worth $23,166 in five years with a present value of $15,549, and the mortgage insurance cost will be $7,110.

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 a buyer 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.

In sum, the assumability of FHA mortgages could have significant value to borrowers today, in some cases equaling or exceeding the cost of FHA mortgage insurance. In other cases, however, assumability could be worth little or nothing.

If the borrower has the house for 10 years before selling, the larger paydown of the balance plus property appreciation could sharply reduce the value of the low-rate mortgage to the buyer at that time. Furthermore, whatever value is there would be further reduced by the longer discount period. 

The borrowers today for whom assumability has the greatest potential value are those who expect to sell their house within three to seven years. Short of three years, it is not clear that interest rates will be significantly higher than they are today, and after seven years it is not clear that assumability will have significant value to homebuyers.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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