FHA loans are guaranteed by the federal government. Should a home owner default on her monthly payments, the U.S. Department of Housing and Urban development has committed to paying the lender a percentage of the default on the debtor's behalf. Part of the payments made on an FHA loan is based on a monthly insurance fee, otherwise known as a mortgage insurance premium (MIP).
When closing on a home using an FHA loan, all debtors are subjected to an upfront charge of the MIP in the amount of 1.5 percent of the sales price of the home. This is part of the closing costs associated with an FHA loan.
An additional insurance premium is calculated into the monthly payment on an FHA loan. Monthly MIP is calculated based on 0.5 percent of the annual premium charged at closing. This monthly fee is held in an escrow account with the Department of Housing and Urban Development (HUD) in the debtor's name.
Monthly MIPs are charged until the debtor has made five years of timely payments to a lender and has met the FHA’s loan to value requirements. This means that the balance on the loan after five years has to be 78 percent or less of the original purchase price or 78 percent or less of the original appraisal on the home. At that point, the monthly MIP charges can be eliminated.
Even though FHA requires a minimum investment of 3.5 percent for a down payment on a home, making a down payment of 20 percent or more can waive the monthly MIP.
Monthly payments on FHA loans include all property taxes, home owner's insurance, the mortgage insurance premium, in addition to the monthly principal and interest paid to the lender. Many individuals do not factor these into their budget when shopping for a home, and base a decision on the principal and interest alone.
FHA loans are a great way to finance a home if a buyer is in a situation where they have little money to put down. Closing costs, to include the upfront MIP, can be given in the form of a gift from a family member or paid by the seller.