The Mortgage Professor

Assumability: A hidden potential value to FHA loans

By Jack Guttentag
Saturday, February 20, 2010

Does the assumability option on Federal Housing Administration loans offset their high mortgage insurance premiums? That is a great and very timely question. The value of assumability is as high as it is ever likely to be because of the broad consensus that interest rates in future years will be higher than they are now.

Loans insured by the FHA are assumable; conventional loans, with a few exceptions, are not. That means that a home buyer who finances the purchase with an FHA-insured loan and who sells the 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 the FHA, the buyer would assume all the obligations of the mortgage upon the sale of the property, and the seller would be relieved of liability. It would just as if the loan had been made to the buyer.

The major force behind assumptions is the ability of buyers to get financing at an interest rate lower than that currently charged by lenders. If the home seller has a mortgage with a rate below the market rate, having the buyer assume the seller's loan can be better for both. The buyer enjoys a lower rate and avoids the settlement costs on a new mortgage.

Say, for example, that a home buyer today taking a $200,000 mortgage on a $250,000 house is offered the choice between a conventional 30-year, fixed-rate mortgage at 5 percent, with no mortgage insurance required, 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 amount and a monthly premium of 0.5 percent. The purchaser expects to have the house for five years, at the end of which, when it is time to sell, the mortgage balance will be $183,657. Let's suppose for the moment that the market rate at that time will be 10 percent.

I have a spreadsheet on my Web site that compares the 5 percent mortgage (which can be assumed) with the 10 percent mortgage available in the market for a new buyer. In addition to the factors in the preceding paragraph, the spreadsheet requires an assumption about how long the new buyer expects to have the mortgage (six years) and about the "investment rate" -- the rate that buyer could earn on her savings, which I set at 4 percent. Based on those assumptions, the value of the assumable 5 percent loan, relative to the 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.

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 would be worth $23,166 in five years, with a present value of $15,549, and the mortgage insurance cost would be $7,110. That is still more than 2-to-1, and it does not include the savings on mortgage settlement costs.

Second, the savings to the new buyer from assuming the existing mortgage would be reduced if the buyer has to supplement the existing loan balance with a 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 the sale negotiations, the value of the assumable mortgage would be shared in some unknown proportion. 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 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 home buyers.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

© 2009 Jack Guttentag

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