Who does FHA mortgage insurance cover, the buyer or the lender?

Reader question: “I have been learning about FHA loans because I plan to use one to buy a house. I’ve learned that borrowers who use these loans have to pay for a mortgage insurance policy that isn’t required for regular home loans. My question is, who and what does FHA mortgage insurance cover? Does it protect the buyer or the lender?”

FHA mortgage insurance covers the lender. It is designed to protect the lender in the event that the home buyer / borrower ends up defaulting on the loan. If the borrower stops paying, the lender will be reimbursed for their losses (up to a point) by the Federal Housing Administration (FHA), which is part of the Department of Housing and Urban Development.

Mortgage insurance is often required on conventional or “regular” home loans as well. Basically, anytime a borrower uses a loan to cover more than 80% of the property value, some form of insurance will be required. The difference with FHA is that the policy is provided by the federal government, as opposed to a third-party company in the private sector. This is why a lot of people choose to put at least 20% when buying a house (those who can afford it, anyway). It’s a way to avoid the added cost of insurance.

Read: Relationship between PMI and down payment

FHA Mortgage Insurance Covers the Lender

But getting back to the question at hand: Who does FHA mortgage insurance cover? It covers the lender, not the borrower.

The entire FHA program revolves around government insurance. That is the central piece that makes the whole program work. All of the benefits offered by FHA loans (smaller down payment, easier qualifications, etc.) stem from the fact that they are federally insured against certain losses. But that coverage is designed to protect the lender in particular.

It is a common misconception that FHA mortgage insurance covers the buyer involved in the transaction. After all, it’s the buyer / borrower who has to pay for the policy. So it only makes sense that they should be protected by it, right? Wrong. In fact, this is one of the only insurance-related scenarios where the person paying for coverage receives no coverage at all. Welcome to the wonderful world of mortgage lending!

Government Insurance Brings ‘Side Benefits’ for Borrowers

While buyers are not directly covered by FHA mortgage insurance, it does bring some benefits. The down payment is one of the key benefits. These loans allow for smaller down payments when compared to conventional (not government-insured) mortgage loans. It’s the government’s insurance backing (via the FHA) that makes this all possible.

Lenders who normally wouldn’t allow a down payment as low as 3.5% will do so when making FHA loans, because they know they are covered by the mortgage insurance fund. If the borrower defaults, the government steps in with reimbursement for losses.

The same goes for credit scores and other qualifications. Lenders are generally more lenient with FHA borrowers, due to the federal insurance backing they receive.

To recap: Who does FHA mortgage insurance cover? It covers the lender. Who pays for it? The borrower pays for it. Does it benefit the borrower in any way? Indirectly, yes. When lenders know they are covered by government-backed mortgage insurance, as is the case with the FHA home loan program, they will allow things they wouldn’t otherwise allow … such as lower down payments and credit scores. So it’s a tradeoff.

No Need for Taxpayer Funding

It’s also worth noting that the FHA is funded entirely from the revenues generated through its mortgage insurance program. According to the HUD website:

FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing. The proceeds from the mortgage insurance paid by the homeowners are captured in an account that is used to operate the program entirely.

So while the mortgage insurance covers the lender, and not the home buyer, it does benefit borrowers in general. Without those premiums, there would be no FHA program. And without the program, all borrowers would have to qualify for conventional home loans — which typically require larger down payments, higher credit scores, less debt, etc. So in essence, all of the home buyers / homeowners who pay for mortgage insurance premiums are keeping the FHA afloat and open for business.