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The Equity Equation

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Posted On: 12/01/2010

QUESTION:

I bought a home with FHA financing. The property was appraised at $200,000, but I paid $160,000. Since I have 20-percent equity, why do I have to pay the FHA's mortgage insurance premium?

ANSWER:

When you get FHA financing you have a loan that is insured by the government. If something goes wrong, the government will have an obligation to make up lender losses. Since the FHA is an insurance program, borrowers must pay a mortgage insurance premium.

In your situation two factors stand out.

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First, when you get an FHA-backed loan you must make mortgage insurance premium payments for the first five years of the loan, regardless of how much equity you have.

Second, you don't have 20-percent equity.

Mortgage loans are made on the basis of the sale price or the appraised value, whichever is less. In your case you have a lofty appraisal but a sale price that is significantly lower. For qualification purposes the appraisal is important to have, but it's not less than the sale price.

To lenders your transaction looks like this: You bought a property for $160,000. You most likely put down $5,600, the 3.5-percent minimum FHA down payment, plus closing costs. The remaining loan balance is $154,400. To lenders, and to the FHA, the loan-to-value ratio is 96.5 percent.

Let's look at it this way. If the property was really worth $200,000 then a rational owner would have been able to get that price; that didn't happen.

If the property was worth $200,000 and you put down 20 percent you would have needed $40,000 at closing, plus settlement costs. You didn't bring that much cash to closing.

You could not finance this transaction with little down and a conventional mortgage unless you also got private mortgage insurance. Again, the same concepts for showing equity would apply, and with little down you would be paying for insurance coverage.

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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