One of the first questions home buyers ask themselves when considering how to finance their upcoming home purchase is whether to use an FHA loan or a conventional loan with private mortgage insurance (PMI).
The FHA loan was the go-to standard during the housing market crash. It offered a low down payment option in a time when lenders and PMI companies all but ceased lending without substantial money from the borrower into the transaction.
But FHA’s dominance is slowly diminishing. Many borrowers with 5% down are finding that PMI companies now offer affordable mortgage insurance, while FHA continually hikes fees.
Related: What’s Better: FHA or Conventional?
Matt Hackett, Underwriting Manager at Equity Now, a New York-based direct mortgage lender, points out just how costly the FHA loan program has become.
“There is a 1.75% charge for FHA loans which is not present on conventional loans,” says Hackett, speaking of FHA’s upfront mortgage insurance fee. He says that on a loan amount of $403,750, over $7,000 would be added to the loan.
Hackett goes on to talk about FHA’s annual mortgage insurance premium, or MI, which is broken up into 12 equal payments and paid monthly on all FHA loans. “One of the recent changes that caused FHA to be so much more expensive was making the annual MI last for the life of the loan. Conventional PMI drops off at 78% loan-to-value.”
On a $425,000 purchase price with 5% down, the borrower will save $154 per month and $50,000 over the life of the loan by choosing a conventional loan with PMI over an FHA loan, Hackett says.
In addition, private mortgage insurance companies have loosened up their guidelines to match those of Fannie Mae and Freddie Mac. In previous years, additional rules implemented by PMI companies, called overlays, kept many home buyers from using PMI.
So Why Is FHA Still Around?
The fact that PMI has become cheaper and easier begs the question: why does anyone choose an FHA loan?
According to Hackett, the borrower’s available cash has a lot to do with it. An FHA borrower is typically “someone who doesn’t have a 5% down payment as well as funds to cover the closing costs. FHA has a higher loan to value limit, requiring borrowers to only put down 3.5%, as opposed to the conventional 5% requirement.”
Credit scores also come into play. Hackett points out that a conventional loan with private mortgage insurance allows a 620 minimum score, while FHA allows a 500 score when putting 10% down. A 3.5% down payment is allowed on an FHA loan with a 580 score.
In addition, FHA may be the only choice if a borrower’s debt-to-income ratio, or the amount of his or her debt payments compared to income, is high. “A borrower whose debt-to-income ratio exceeds 50%, or in some cases 45%, may also need to apply for an FHA loan instead of conventional,” says Hackett.
In essence, anyone with good credit and income, and a 5% down payment should consider a conventional loan with PMI before assuming that FHA is the only way to go. After years of sitting on the sidelines, private mortgage insurance companies are back in the game. Hackett states, “Their changes have been to open the credit box back up to the point where they are competing for the higher credit borrowers.”