Recently, it was announced that the Federal Housing Administration would lower the annual premium on its mortgage insurance from 1.35% of the outstanding loan balance to 0.85%. While this certainly makes FHA loans more affordable, the conventional alternatives are still better, especially for first-time buyers.
The new conventional loan options
In late 2014, Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) both announced new lending guidelines, as well as new lending programs for first-time homebuyers. Under both programs, borrowers who have a credit score of at least 620 can qualify for a conventional mortgage with just 3% down.
Borrowers will have to pay mortgage insurance, but given the new FHA reduction, the rates are likely to be pretty similar. So why should buyers choose conventional loans instead of the traditional FHA low-down-payment option?
It's not just the price of the mortgage insurance
The reduced cost of FHA mortgage insurance doesn't tell the whole story. The biggest difference between an FHA loan and conventional low-down-payment options is what happens a few years down the road.
Specifically, if you put the required 3.5% down on a 30-year FHA loan, you'll be stuck paying mortgage insurance for the entire term of the loan, no matter how much of the loan you paid back. With conventional loans, you can request that your mortgage insurance be canceled once you've paid down the balance to 80% of the original value of your home. And the lender is required to terminate your mortgage insurance once you're scheduled to pay your loan down to 78% of its original value, assuming you're current on your payments and meet any other requirements your lender may have.
Generally, the "original value" refers to the appraised value of the home at the time your loan closed, but if your home's value has declined the bank can use this as a reason to reject an early PMI drop request. The rules can be a bit tricky, but at least there is the option of getting rid of it.
The cost difference can add up
Obviously, if you pay your balance down to 80% of the home's value in just a few years, the savings can be tremendous over the life of a 30-year loan.
However, let's look at a scenario in which a borrower simply makes the minimum payments. Let's say a buyer can take out either an FHA loan or a conventional loan for $200,000, and the mortgage insurance rate is the same in either case, at 0.85% of the loan balance. (The actual loan amounts would be slightly different due to the 3% and 3.5% down-payment amounts required respectively by the two loan types.)
At an interest rate of 4%, it would take the buyer just under 10 years to pay down the loan to 78% of the home's original value, according to an amortization table from Bankrate. So, with the conventional loan option, over the first 10 years, the borrower would pay about $15,500 total in mortgage insurance, based on an annual payment of 0.85% of the remaining loan balance.
However, with an FHA loan, the mortgage insurance would stick around for all 30 years and add up to more than $31,000. That means the conventional borrower would save nearly $16,000 in mortgage insurance over the life of the loan.
Who should look into FHA?
Having said all that, an FHA mortgage could still be the best option for some borrowers. For example, the FHA has looser credit score requirements and gives low interest rates to low-credit borrowers. So, if you have a low (but acceptable) FICO score -- say, 620 -- you might qualify for a conventional loan, but you'll likely pay a much higher interest rate than you would on an FHA loan.
According to myFICO.com, the national average 30-year conventional mortgage rate is more than 4.8% for borrowers in the lowest credit "tier" (scores between 620 and 639). On the other hand, as of this writing, banks are advertising FHA 30-year mortgage rates in the mid-3% range.
If your score is below 620, an FHA loan might be the only option available. You can get a 3.5% down FHA loan with a score as low as 580, and if you have a higher down payment, a score as low as 500 can qualify.
Finally, if you aren't a first-time homebuyer, the 3% down-payment option on conventional loans won't be an option for you.
The best choice for you
To sum it up, if you can qualify, a conventional loan is generally the better deal for low-down-payment borrowers. While there are some valid reasons for borrowers to pursue FHA loans, qualified buyers can save tens of thousands of dollars by going the conventional route.