When you're ready to apply for a mortgage, should you follow the crowd and go with conventional financing or be among the approximately 20 percent of borrowers who choose a federally-insured mortgage backed by the Federal Housing Administration (FHA)? Your choice depends in part on the size of your down-payment and your credit profile.
If you're making a down-payment of 20 percent or more, conventional financing will be less costly because you won't need to pay mortgage insurance. If you're making a down-payment of less than 20 percent, have a low credit score or a high debt-to-income ratio, it's best to compare loan programs.
"Typically, FHA is cheaper, with lower interest rates and cheaper mortgage insurance, though this is not always the case," says Henry Brandt, branch manager of Planet Home Lending in Irving, Texas. "However, you have the chance to remove private mortgage insurance on a conventional loan one day without refinancing. With FHA, you can only remove mortgage insurance by refinancing your home to a non-FHA mortgage."
Private mortgage insurance (PMI), required for conventional loan borrowers who make a down-payment of less than 20 percent, automatically ends when your loan-to-value reaches 78 percent. PMI rates vary according to your credit score and the size of your down-payment.
FHA loans require both upfront mortgage insurance and annual mortgage insurance, which is paid monthly as part of your mortgage payment. In 2018, the upfront mortgage insurance premium, which can be wrapped into your loan balance, is 1.75 percent of the loan amount. For loans under than conforming loan limit of $679,650, the annual mortgage insurance premium is .85 percent of the loan amount. Loans with a balance above that amount require an annual insurance premium of 1.05 percent.
Conventional vs. FHA financing: Which is better?
FHA loans appeal to borrowers because they only require 3.5 percent down, have less-stringent credit qualifications and currently allow seller concessions of 6 percent of the purchase price. Conventional financing caps seller contributions for closing costs at 3 percent on purchases with a down-payment of 10 percent or less.
While some borrowers assume conventional loans require a big down-payment, many lenders offer these loans with as little as 3 or 5 percent down. The median down-payment for first-time homebuyers was five percent in 2017, according to the National Association of Realtors' Profile of Home Buyers and Sellers.
"About 20 percent of the loans I do now are conventional loans with 5 or 10 percent down-payments," says Doug Benner, a senior loan officer with Sandy Spring Mortgage in Annapolis, Md. "PMI has become much less expensive in the past few years, with more competition in the marketplace. The key is having a good credit score, as the cost of PMI is directly related to your credit score."
FHA loans allow a credit score as low as 580, says Brandt, while conventional loans generally need a score of at least 660. FHA loans allow a debt-to-income ratio as high as 55 percent, he says, while conventional loans are usually capped at 45 percent. A debt-to-income ratio compares your monthly gross income with the minimum payment on your total debt.
Unlike FHA loans, interest rates and PMI premiums on conventional mortgages are determined by risk-based pricing. Borrowers with lower credit scores generally have higher mortgage rates and PMI premiums.
Compare mortgage options for both loan programs
The FHA loan option is more affordable than it was five years ago, says Benner, since monthly mortgage insurance premiums have been lowered.
Borrowers making a down-payment of less than 10 percent should have a lender compare both an FHA and conventional loan. Not all lenders realize they should look at both loan options, so borrowers need to be proactive and ask for this comparison.
For example, Brandt says a borrower putting down 5% and buying a $250,000 property would pay $1,293 with an FHA loan and $1,351 with a conventional loan. He says that unless you have a larger down-payment, an FHA loan may often have a lower overall payment.
"Regardless of whether someone goes with FHA or conventional financing, rates are still at an all-time low when you look at where rates have been over the last 30 years," says Brandt. "And it's hard to explain to someone what it feels like when you're a homeowner compared to a renter. Homeownership is a much better feeling."
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