FHA vs. conventional financing Which One Should You Pick?
Which loan type—FHA or conventional—is preferable? This is not a research-related query. According to my calculations, making the incorrect decision could end up costing you $33,000 over the course of a $200,000 loan or $66,000 over the course of a $400,000 loan.
Don’t assume that the mortgage with the lower interest rate is always the better option. FHA loans have a lower interest rate, but they typically (but not always) cost the borrower more because of their high insurance premiums.
Do you Qualify for Both?
Only if you are eligible for both the FHA and conventional mortgages do you have a choice. If you can correctly identify which one that is, you can choose the one that will cost you the least over the course of holding it. The first step is to ascertain whether or not you qualify for both, as borrowers who are ineligible for conventional loans are forced to use FHA loans as their only option. For instance, if your down payment is only 3.5%, you can only get an FHA loan. The same is true if your down payment is only 5% and your credit score is below 660.
There are several additional circumstances where borrowers can only qualify for an FHA because eligibility criteria can change depending on the loan’s objective and the type of property. Because the down payment needed for an FHA loan is much lower than it would be for a conventional loan if the borrower wanted to buy a 4-family home, for instance, qualification might only be possible with an FHA loan.
There is a significant exception to the general rule that FHA qualification requirements are less stringent than conventional requirements. Under no circumstances is it permissible for a loan to be used to buy a property for investment purposes rather than for personal use.
Pricing Categories
Currently, lenders have two price lists for FHA loans and three lists for conventional loans. On FHAs, they distinguish between:
FHA standard loans, which are for amounts up to $271,050
FHA jumbo loans, which are for amounts up to $625,500, the maximums varying by county.
They distinguish between conventional loans in:
Conforming standard loans, which are for amounts up to $417,000 and eligible for purchase by Freddie Mac as well as Fannie Mae.
Conforming jumbo loans, which are for amounts up to $625,500, the maximums varying by county, and eligible for purchase by Freddie Mac and Fannie Mae.
Non-conforming jumbo loans, which are for amounts that exceed the conforming jumbo county limits and cannot be purchased by Fannie Mae and Freddie Mac.
FHA/conventional cost comparisons for various loan amounts must be conducted separately in order to comply with these pricing structures. I use the following figures: $200,000, $400,000, and $600,000, which respectively capture the pricing of conforming standard versus FHA standard, conforming standard versus FHA jumbo, and conforming jumbo versus FHA jumbo.
Measuring the Cost to the Borrower
A borrower should consider the cost of a mortgage over the course of their mortgage. There is always a chance that one mortgage will have lower costs over a particular time period while the other will have lower costs over a different time frame, either longer or shorter. I measure cost over three time periods because the mortgage life is not known in advance: 5, 10 and 15 years.
My cost measure includes lender fees and mortgage insurance fees, but excludes fees from other third parties like title insurers that are unrelated to the type of mortgage. Total cost is calculated as the sum of monthly principal, interest, and mortgage insurance payments, upfront points and other lender fees, and lost interest on upfront and monthly costs at 2%, less the amount of the loan balance that has been paid off over the course of the loan.
I compared the costs for each of the three loan amounts at four loan-to-value ratios—80%, 85%, 90%, and 95 percent—as well as three credit scores—640, 740, and 800—and three time periods—five, ten, and fifteen years. This resulted in a total of 36 comparisons.
The Results
In all 36 comparisons, the FHA’s cost was significantly higher than the conventional loan’s cost for both the $200,000 loan and the $400,000 loan. For loans up to $417,000, this conclusion would be valid. Prospective borrowers can safely assume that for loans up to $417,000, they are better off with the conventional than with the FHA.
However, the results are conflicting for the $600,000 loan. A borrower cannot be approved for a $600,000 conventional loan with a credit score of 640. When the loan-to-value ratio is 90 or less, the cost of a conventional loan is lower at 740 and 800, but it is higher at a ratio of 95. Any loan amount over $417,000 would yield this inconsistent result.
