FHA vs. conventional: What Should You Pick?
Which loan type—FHA or conventional—is preferable? This is not a scientific inquiry. According to my calculations, a bad decision can cost as much as $33,000 over the course of a $200,000 loan and as much as $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. Although FHA loans have a lower interest rate, they typically (but not always) end up costing the borrower more because of the high insurance premiums they require.
Do you Qualify for Both?
Only if you are eligible for both conventional and FHA loans 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. In order to use an FHA loan, borrowers who are ineligible for conventional loans have no choice but to do so, so the first step is to ascertain your eligibility for both. For instance, if your down payment capacity is only 3.5%, you will only be eligible for an FHA loan. The same holds true if your down payment capacity is only 5% and your credit score is below 660.
There are several other scenarios where borrowers can only qualify for an FHA because eligibility criteria can change depending on the loan’s objective and the type of property. For example, because an FHA loan requires a much smaller down payment than a conventional loan does, qualifying for a conventional loan may not be an option for a borrower looking to buy a four-family home.
There is a significant exception to the general rule that FHA qualification requirements are less stringent than conventional requirements. The FHA will never approve loans used to buy a property for investment purposes rather than for occupancy.
Pricing Categories
FHA loans currently have two price lists from lenders, while conventional loans have three lists. On FHAs, they differentiate 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.
Regarding conventional loans, they differentiate:
Conforming standard loans, which are for amounts up to $417,000 and eligible for purchase by Fannie Mae and Freddie Mac.
Conforming jumbo loans, which are for amounts up to $625,500, the maximums varying by county, and eligible for purchase by Fannie Mae and Freddie Mac.
Non-conforming jumbo loans, which are for amounts that exceed the conforming jumbo county limits and cannot be purchased by They are Freddie Mac and Fannie Mae.
The FHA/conventional cost comparisons must be performed separately for various loan amounts due to these pricing structures. The amounts I use are $200,000, which captures the pricing of conforming standard versus FHA standard; $400,000, which captures the pricing of conforming standard versus FHA jumbo; and $600,000, which captures the pricing of 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 accounts for lender fees and mortgage insurance premiums but excludes fees from other third parties, such as title insurers, who have no bearing on the type of mortgage. Total cost is calculated as the sum of monthly principal, interest, and mortgage insurance payments, points and other upfront lender fees, lost interest on upfront and monthly costs at 2%, and upfront costs paid in full. This amount is then subtracted from the loan balance reduction over the course of the loan’s life.
I compared the costs for each of the three loan amounts at 36 comparisons total, including 4 loan-to-value ratios (80%, 85%, 90%, and 95%), 3 credit scores (640, 740, and 800), and 3 time periods (5, 10 and 15 years).
The Results
The cost of the FHA was significantly higher than that of the conventional in all 36 comparisons 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 outcomes for the $600,000 loan are conflicting. A borrower with a credit score of 640 is ineligible for a conventional loan of $600,000. With loan-to-value ratios of 90 or less, conventional loan costs are lower at 740 and 800, but they are higher at a ratio of 95. Any loan amount over $417,000 would yield this inconsistent result.
