How to Choose Between an FHA and Conventional Mortgage

FHA vs. conventional loan

Looking to buy a home, but not sure if you can manage it? You’re not alone.

According to a survey conducted by Apartment List, 80 percent of millennial renters want to buy a home or condo. But saving up a 20 percent down payment on a home is a major obstacle to homeownership.

If you are willing to pay mortgage insurance premiums, you can speed up the homebuying process by making a smaller down payment with either an FHA loan or a conventional mortgage.

Here’s what to consider when you’re comparing FHA versus a conventional loan.

Start with the interest rate — but don’t stop there

One of the first things many borrowers look for is the interest rate. When you’re shopping around for a home loan, getting the best mortgage rate is top of mind.

If all you do is look at the interest rate, the FHA loan is often seen as the preferred choice, said Casey Fleming, a 20-year veteran of the mortgage industry and author of “The Loan Guide.”

“In many cases, the interest rate on an FHA loan will be lower because the wholesale cost is lower,” said Fleming. “With the FHA backing the mortgage, there’s no risk for lenders, so they can take a slightly lower yield.”

But Fleming doesn’t think that’s the only thing to consider when choosing between an FHA loan and conventional mortgage. “You might see a lower interest rate with the FHA loan, but in the long run it could actually cost you more.”

Consider your mortgage insurance costs

Conventional versus FHA comes down to more than interest rates. In fact, Fleming said the insurance cost is one of the biggest issues.

“First, you have an upfront fee with an FHA loan,” said Fleming. “Then, there is also monthly mortgage insurance.”

When you get an FHA loan, you are required to pay 1.75 percent of the loan amount as an upfront fee, according to the U.S. Department of Housing and Urban Development. This fee can be rolled into the loan amount, said Fleming. Of course, that means you’re paying interest on the fee since it becomes part of the loan.

Not only that, but you still have to pay a monthly mortgage insurance premium (MIP) with an FHA loan.

“Your MIP is driven by your loan-to-value ratio with the FHA loan,” said Fleming. “You don’t get a break for good credit like you might for a conventional mortgage.”

Loan-to-value (LTV) is the amount of money you owe on your home in relation to how much the home is worth. With an FHA loan, your MIP is dependent on how big of a down payment you make.

Fleming pointed out that your MIP on an FHA loan might never be canceled. For example, if your LTV is more than 90 percent, the annual mortgage premium will be collected through the end of your mortgage term, or 30 years, whichever comes first.

If you put down at least 10 percent, resulting in an LTV of less than or equal to 90 percent, your insurance premiums will be collected until the end of the loan term or 11 years, whichever comes first.

“Most people who get FHA loans do so with a small down payment, and so end up paying MIP for their entire loans,” Fleming said. “At least with a conventional loan your mortgage insurance is canceled when your LTV reaches 80 percent.”

WalletHub did an analysis and found that mortgage insurance savings can be significant when choosing a conventional loan over an FHA loan:

Image credit: WalletHub

Depending on the size of your down payment and your credit score, the three-year savings can potentially amount to thousands of dollars if you stick with a conventional mortgage as opposed to an FHA mortgage.

When to choose a conventional mortgage

Fleming insists that, most of the time, conventional mortgages are better than FHA loans.

“If I had to say which is better, I’d say that a conventional loan makes more sense 99.99 percent of the time,” he said. “A conventional mortgage might have a slightly higher interest rate, but overall the costs are lower, especially if you have a bigger down payment and good credit.”

Here’s why a conventional mortgage might work better:

  • Private mortgage insurance (PMI) cancels when your home reaches 80 percent LTV. In some cases, you can’t cancel MIP on an FHA loan.
  • You can find or negotiate lower PMI. With FHA loans, you’re stuck with a set MIP.
  • You can waive some of your mortgage costs. You can’t avoid the 1.75 percent upfront fee on FHA loans.

When to choose an FHA loan

The FHA versus conventional mortgage battle isn’t just about cost, though. Sometimes it’s about what’s possible in your financial situation.

“Let’s be honest. The reason FHA loans exist is for people who can’t qualify for conventional financing,” said Fleming. “If your credit score is too low or if you have some credit events that prohibit you from being able to do conventional financing, the FHA takes care of it.”

Maybe you want to buy a home before housing prices and mortgage rates rise further. But what if you can’t get a conventional loan due to a low credit score, or because you have a recent foreclosure?

“Most mortgage lenders won’t qualify you for a loan if your score is below 620, no matter your down payment,” said Fleming. “On the other hand, you can get the 3.5 percent down payment option with an FHA loan with a credit score of 580.”

Lenders might be reluctant to give you a mortgage if you have a foreclosure or bankruptcy in your recent credit history. Although these events could make it harder to get an FHA loan, you still have a better chance when you get the government-backed loan as opposed to the conventional loan, Fleming said.

“For someone bent on owning a home, the FHA program makes it possible — even if you couldn’t qualify otherwise,” he added.

Additionally, the FHA loan can “win” during a tight credit environment. Right after the housing market crisis, said Fleming, lenders tightened their standards. It was hard to get a loan — even for someone with good credit — without at least 5 or 10 percent down.

Following the housing market crash, as lenders became wary of issuing mortgages, more borrowers turned to FHA loans. The FHA percent share by dollar volume shot up in 2008 and 2009, according to the Office of Policy Development and Research at the U.S. Department of Housing and Urban Development:

Image credit: HUD.gov

Now that lenders are loosening their requirements, said Fleming, FHA loans are less common.

However, if another economic shock comes, Fleming thinks it’s possible that FHA loans could become more popular again.

“If you want to buy a home and lenders are making it difficult for you to qualify for a conventional mortgage, you might have little choice but to choose an FHA loan,” he said.

FHA vs. conventional: Which should you choose?

In the end, choosing between an FHA and conventional loan depends on your priorities and situation.

If you are interested mainly in keeping a lid on your long-term mortgage costs, and you have good credit, a conventional mortgage is probably your best bet, said Fleming.

On the other hand, if you are more interested in getting into a home and your credit isn’t the best, an FHA loan could make more sense. If you feel like you will miss out by waiting to save up a bigger down payment or to get your credit cleaned up, an FHA loan can make becoming a homeowner easier — but you have to be willing to pay the cost.

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Published in Buying a House, Mortgage