The General Rule
In deciding between
a conventional mortgage and an FHA, the general rule is that if you
qualify for the conventional mortgage, you take it; only if you don’t
qualify for the conventional do you accept the FHA.
The rationale for
the rule is that on FHAs, borrowers pay an upfront mortgage insurance
premium of 2.25% of the loan amount, which is added to the loan balance,
and an annual premium of .055% of the balance paid monthly. On
conventional loans, in contrast, borrowers pay mortgage insurance only
if the ratio of loan amount to property value (LTV) exceeds 80%, and the
premiums are lower than those on FHAs.
Recently, I decided
to check this rule. Is it always the case that, if the borrower
qualifies for both, the conventional will be the better deal? I defined
a “better deal” as one that will cost less over the period the borrower
expects to be in the house. I used calculator 9ci on my web site to
compare the total costs.
I also wanted to
see exactly how much more difficult it is to qualify for a conventional
than for an FHA. My focus here is on differences in the minimum
allowable credit score and the maximum allowable LTV on the two types of
mortgages. I used the prices and qualification requirements posted by 20
lenders with Home-Account.com as of April 29. While mortgage prices
change from day to day, underwriting requirements and the relationship
between underwriting requirements and price, change quite infrequently.
Pricing and Underwriting Categories
I quickly realized that the home loan
market today is now divided into 5 pricing and underwriting categories.
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Conforming standard loans are for amounts up to $417,000 and eligible for purchase by Fannie Mae and Freddie Mac.
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Conforming jumbo loans are for amounts up to $729,750, the maximums varying by county, and eligible for purchase by Fannie Mae and Freddie Mac.
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Non-conforming jumbo loans are for amounts that exceed the conforming jumbo county limits, which range up to $729,750.
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FHA standard loans are for amounts up to $217,050 and eligible for insurance by FHA.
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FHA jumbo loans are for amounts up to $729,750, the maximums varying by county, and eligible for insurance by FHA.
Nobody planned this
structure, it is the consequence of multiple policy actions taken at
different times for different purposes. It has added to the information
problem faced by borrowers, and widened the information gap between them
and the professionals with whom they deal.
It also complicated
my mission by requiring 3 conventional/FHA comparisons, corresponding to
three different loan size categories.
The $200,000 Loan
On this loan, a
borrower with a 620 score has a maximum conforming LTV of 80% and a
maximum FHA LTV of 97%. Similarly, a borrower receiving the maximum LTV
of 95% on a conforming loan must have a credit score of 680 whereas a
borrower receiving the maximum LTV of 97% on FHAs can have a score as
low as 620. Hence, borrowers who can qualify only with an FHA either
have credit scores below 680 and need LTVs higher than 80%; or they need
an LTV above 95% at any credit score.
Where the borrower
qualifies for both, I found one niche where the FHA might be the better
deal. When the credit score was 640 and the LTV 80%, the conventional
rate was 5.375% and the FHA rate only 4.875%. I found the total cost of
the two options to be very close, the lower rate on the FHA just about
offsetting the mortgage insurance premium. Over periods shorter than 11
years, the conventional cost was lower, and beyond 11 years, the FHA
cost was lower. In all other niches, the conventional cost was lower.
The $400,000 Loan
As with the
$200,000 loan, borrowers who can qualify only for FHAs either have
credit scores below 680 and need LTVs higher than 80%; or they need an
LTV above 95% at any credit score.
Since FHA jumbos
are priced higher than FHA standard, in the market segments where
borrowers qualify for both conforming standard and FHA jumbos, the cost
of the conforming is lower. Indeed, in most segments, the FHA rate is
higher and combined with the mortgage insurance premium, the total cost
difference is quite large. The $400,000 borrower who can’t qualify for a
conforming standard loan pays a larger penalty going with FHA than the
$200,000 borrower.
The maximum LTV on
a conforming jumbo is 90%
rather than 95%. Borrowers who can qualify only for FHAs either have
credit scores below 680 and need LTVs higher than 80%; or they need an
LTV above 90% at any credit score.
In cases where the
borrower qualifies for the conventional as well as the FHA, the same
niche emerged with a relatively low FHA rate as with the $200,000 loan:
a 640 credit score and an 80% LTV. Over periods shorter than 11 years,
the conventional cost was lower, and beyond 11 years, the FHA cost was
lower. In all other niches, the conventional cost was lower.
In sum, the
generalization that a borrower who qualifies for a conventional should
take it rather than an FHA, holds up pretty well. I found one exception
in both the less than $217,500 and the $417,001-$729,750 loan size
groups, but it applies only to
borrowers who expect to have their mortgage a long time. The
disadvantage of not qualifying for a conventional loan is most costly to
borrowers in the intermediate loan size group, $217,500 - $417,000.
Thanks to Jack
Pritchard for helpful comments.