When you're ready to apply for a mortgage, should you follow the crowd and go with conventional financing or be among the approximately 10 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 for private mortgage insurance (PMI). 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 less costly 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 PMI 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 loan's your loan-to-value ratio reaches 78 percent. PMI costs vary according to your credit score and the size of your down payment.
Related: Are FHA mortgage rates lower than conventional rates?
FHA loans require both upfront mortgage insurance and annual mortgage insurance, which is paid monthly as part of your mortgage payment. Currently, the upfront mortgage insurance premium, which can be wrapped into your loan balance, is 1.75 percent of the loan amount. With less than a 5% down payment, a 30-year loan under the conforming loan limit of $766,550 carries an annual mortgage insurance premium of .55 percent of the loan amount (0.50 percent with a downpayment of 5% or greater). Thirty-year loans above $766,550 with less than a 5% down payment have a 0.75% annual MI premium (0.70% with 5% down or more).
Most home buyers don't take shorter loan terms, but MIP costs for those loans are even lower.
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 up to 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 6 percent in 2022, according to the latest "Profile of Home Buyers and Sellers" from the National Association of Realtors.
"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 620. FHA loans can technically allow a debt-to-income ratio as high as 50 percent, he says, while conventional loans are usually capped at 43 percent. Typically, FHA loans utilize 31% housing debt and 43% total debt ratios, but HUD says that the "back-end ratio" can be higher "if significant compensating factors are documented and recorded on Form HUD-92900-LT". 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.
Buyers with high credit scores but small down payments may fare better with conventional financing, since PMI costs for the highest-credit borrowers are not only competitive with FHA MI premiums but also may be canceled at some point. Conversely, borrowers with lower credit scores but higher down payments may do better with an FHA loan, since FHA doesn't penalize borrowers for less-than-stellar credit. A good way to compare FHA loans versus conventional loans is to use HSH's FHA loan and low-downpayment mortgage comparison calculator, which shows these costs and tradeoffs side-by-side.
For example, Brandt says a borrower with fair credit (e.g. FICO 720) putting down 5% and buying a $250,000 property would pay $1,621 with an FHA loan and $1,715 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, interest rates are still fairly low when you look at where mortgage rates have been over the last 30 or 40 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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