The FHA lending program is an excellent one for property owners, offering high loans to value and interest rates significantly below market.
But the process is totally opaque – with convoluted application and approval processes requiring as much as eight months to complete (compared with no more than three months to obtain Fannie Mae or Freddie Mac loans), punctuated by demands for cumbersome and frustrating paperwork.
As a result, many borrowers simply close their eyes and surrender to being fleeced.
The other way to go – much more satisfying, I can tell you – is to educate yourself about the ins and outs of the FHA loan process, and arm yourself with the details you need to negotiate an FHA loan on more favorable terms that can save you tens of thousands of dollars, usually more, on the overall cost of the loan.
The Crowd Gives In
The vast majority of property owners who want an FHA loan simply shop among the 20 or 30 MAP program lenders in the U.S., wait for an offer sheet, and accept it at face value.
I used to do this, too. But after I took the time to find and hire some experts who could show me how to dissect the terms of the loans I was offered, I realized I was routinely being asked to pay some $200K in loan fees for a $2 million loan.
Those exorbitant costs are not openly disclosed. They’re hidden by common practice and by law. For example, HUD lenders are not required to disclose the margins on the loans they offer. This puts potential borrowers at a distinct disadvantage.
Let’s face it: After spending six figures to apply for a loan, and waiting eight months for approval to come through, it’s the rare property owner who can say ‘No’, no matter what the offered terms.
Separate Yourself From The Crowd
Once I found out what was going on behind the curtain, however, I learned to separate myself from the crowd. You can, too. You’ll find out it’s empowering, and profitable, to feel comfortable countering the lender’s original offer or even sidestepping the points game and asking for a fixed fee.
One of the darkest secrets, for example, is that for every 20-basis-point increase in the proposed loan’s underlying interest rate, the originator of the loan generally pockets an additional 1% of the loan amount. This premium declines a little as the interest rate increases, but only a little.
Find The Par Rate
To find the “real” (or “par”) interest rate on a proposed FHA loan, look at the 10 year swap rate, which is the fixed rate the market asks from a worthy borrower who wants to swap from a floating rate to a fixed rate loan. It’s publicly available at lots of locations, including http://www.swap-rates.com/USSwap.html
The 10 year swap rate usually trades a little higher than the “risk free” 10 year Treasury rate, because the swap rate includes a premium to compensate for the risk that the borrower will not make all its promised payments on schedule.
The par rate on FHA loans tends to float in tandem with the 10 year swap rate: about 30 basis points higher, with another 13 basis points added to cover the Ginnie Mae servicing fee plus another 12 basis points to cover the lender’s servicing fee.
While outsiders can’t know the FHA par rate with complete precision, this calculation works pretty well. For example, on a recent day, the 10 year swap rate was quoted as 2.240%. When you add the additional 30 basis points, plus 25 basis points for servicing fees, the total comes to 2.79%, “close enough for government work” to that day’s FHA loan par rate of 2.8%.
The Lender’s Rake-Off
Now let’s look more closely at the lender’s offer sheet, calculate how much the lender expects to make on the loan, and arm ourselves for negotiating a cheaper FHA loan.
On a hypothetical $2,500,000 loan, there’s an immediate “loan fee” of 75 basis points, which on this loan is worth $18,750.
There’s also a 1% servicing fee, and a 1% Ginnie Mae servicing fee, each of which brings the lender another $25,000 on this loan, adding another $50,000 to the borrower’s costs.
The quoted interest rate for this hypothetical loan is 3.4%. However, we have figured that the par rate is actually in the neighborhood 2.8%. That’s a difference of 60 basis points, worth a premium of 3% to the lender, or $75,000 in fees not disclosed to the borrower.
Now we add the HUD application fee of $7,200, and the lender’s own “processing” fee of $5,000 (can vary from one lender to another), plus the government’s Permanent Placement Fee of $12,000.
Add all that up, and you can see the lender is proposing to pocket a cool $167,950 of your money, before you even begin to calculate interest payments on the principal.
With the additional $45,000 or so you’re likely to spend on various required third party reports and two sets of legal fees, you’re being asked to pony up $212,950 on a $2.5 million loan. That’s better than 8.5% in borrowing costs.
How Much Is The Loan Worth?
Having separated yourself from the crowd of borrowers, however, you’re no longer gawking at a simple, unexplained interest rate of 3.4%. You know all these back-room numbers, and that greatly strengthens your ability to negotiate with the lender.
Instead of meekly accepting the offered loan, you can now look inward, or at least at the property’s pro forma, and ask yourself: “How much am I willing to pay a lender to do this loan?”
Because you know the lender is looking at receiving $212,950 to provide you with this loan, you can counter with a lower figure. Simpler and more elegantly than individually negotiating each of the percentages and premiums, you can offer the lender a fixed fee on the loan, perhaps as low as $125,000.
What’s more, your fixed fee offer need not even be based on size of loan. After all, it’s no more work for the lender to process and approve a $5 million loan than a loan half that size.
In all fairness, remember that for each loan a lender must fill in and process a great deal of paperwork. They are entitled to get paid for that work. And never forget the market contains lots of unsophisticated borrowers willing to be fleeced. In this environment, the savvy borrower who knows the back-room numbers can’t bring all that much pressure on lenders to discount too heavily their normal fees.
But they do want your business, and you will find there is some give in the first round of pricing.
Non-Negotiable Budget Items
In addition to the above, you’ll pay some additional fees on your negotiated loan, most notably a non-negotiable 45 basis points to insure the loan, which is required by HUD.
You’ll also have to pay for an annual audit, done by a CPA, which can run about $4,500, or more if you’re buying them one at a time.
Another item that impacts your budget is the Physical Needs Assessment Report (PNAR). This is a comprehensive schedule of when the various assets and components in your property will have to be replaced, including everything from major HVAC equipment to carpeting in individual units. To qualify for your FHA loan, you will have to budget for all these replacements, and set aside the money to be available when each item is due to wear out.
Lastly, you will have to schedule and complete all required “immediate” repairs to the property, everything that needs to be fixed now and in the near future. Your operating budget must reflect the costs of these repairs and the money must be set aside.
There’s a lot of pain and frustration associated with this complex process, but it is usually more than compensated by the advantages of the loan. You get to borrow up 83% of the property’s value, along with 83% your closing fees, plus 83% of the money you need for immediate repairs.
What’s more, you will be getting a loan for 35 years, not for 10, and paying about 1% to 1.5 % less interest than you’d pay on any other mortgage. In addition, should you ever decide to sell, the loan is assumable. You also retain the ability to get a second mortgage on the property as it appreciates.
For most property owners, this is an excellent loan.
Although you cannot negotiate away is the amount of time, and the level of frustration that’s involved in closing your FHA loan, you can mitigate it. Should you want my help on your next FHA loan, I’ll be happy to serve as your consultant and do my best to streamline the process and trim your costs significantly.