The Federal Housing Administration insures approximately one-third of America's mortgages. As the world's largest government insurer of home loans, the agency protects lenders against losses if their borrowers default on payments or go into foreclosure. FHA-insured loans are considered some of the most affordable forms of home financing. The FHA insures loans for homeowners and buyers, allowing borrowers to roll some closing costs into loans.
Closing costs include fees associated with a real estate transaction, independent of the FHA's requirement for a down payment of at least 3.5 percent. "These costs can add up to between three and 5 percent of the home loan amount," says the Home Buying Institute. The costs are paid at settlement—after signing loan documents and before the transaction can fund and record with the county's land records office. They pay for but are not limited to loan, tax, title, escrow and appraisal fees.
Two types of FHA transactions exist: purchase and refinance. Purchase loans fund the acquisition of real estate. Refinances pay off an existing loan with the proceeds of a new mortgage.
Borrowers generally roll the upfront mortgage insurance premium into a new FHA-insured loan on purchases. The UFMIP, a lump sum equal to 2.25 percent of the loan amount, pays for FHA insurance.
Borrowers may roll most of their closing costs into the FHA loan on a refinancing if their home has sufficient equity to cover the costs without exceeding the FHA's maximum loan-to-value guidelines. The LTV is the ratio of debt—the amount borrowed—to the home's fair-market, or appraised, value.
The benefit of rolling closing costs into a new FHA loan is that the borrower pays less—and sometimes nothing—out of pocket at settlement. When purchasing, the buyer must contribute at least the down payment to the transaction, so although the UFMIP may be paid in cash at closing, it is not common practice. When a borrower refinances because he needs cash or wants to save money, rolling the closing costs into a refinance helps him accomplish that. His home's equity essentially pays the closing costs for him.
When a borrower finances closing costs into her loan, she will pay interest on the costs over the life of the loan. The loan balance is higher than it would be if she had paid out of pocket. She has also used part of her equity to cover the costs. Whether purchasing or refinancing, the total of the loan—including financed closing costs—may not exceed 100 hundred percent of the home's market value.
The FHA allows "no-cost" refinances, according to the Department of Housing and Urban Development. Although closing costs apply to all transactions, the borrower is not directly responsible for paying them at close: The lender is. In exchange for paying the borrower's closing costs, the lender charges the borrower a higher interest rate, through which the lender will earn back its money—and usually more. This option is also called "premium pricing," according to the FHA Handbook.