Pricing FHA Mortgage Default Insurance

Abstract

The fair premia on FHA mortgage default insurance contracts are computed under alternative assumptions regarding the expected house price inflation rate and its variance and homeowner's default costs. The contracts considered vary by amortization schedule (15 and 30 year level-payment mortgages and two graduated-payment mortgages) and initial loan-to-value ratio (80 to 95.8percent) .The results indicate a wide variation in fair insurance premia. Because FHA charges all borrowers the same premia, large cross-subsidies exist within the program, with borrower's obtaining low loan-to-value or rapidly amortizing loans subsidizing borrowers with high loan-to-value or negative amortizing loans. Moreover, the movement toward insuring riskier loans --graduated payment, price-level adjusted and adjustable rate -- without increasing insurance premia seems almost certain to lead to significant overall losses for the program.