6 Reasons Why FHA is Better Than Conventional
Somewhere along the line, FHA loan got a real unfair reputation as being a loan option that you should avoid.
What’s even worse, is that some real estate agents will have a bias against FHA financing, because of a bad experience they had many years ago.
I’m not saying there is a right loan option, or a wrong loan option, I am just saying that there are usually multiple options, and you should not discount a FHA loan as a viable consideration.
One of the biggest knocks on FHA was “mortgage insurance”. If you have 20% down payment, or equity in the home, then it is less likely that FHA is high on the options list.
FHA Underwriting Advantages
With a recent tightening of Conventional and Private Mortgage Insurance (PMI) guidelines, FHA financing is emerging as a front runner in a variety of situations, for instance:
- Lower interest rates
- Larger closing cost credits
- More flexible debt to income ratios
- Shorter waiting period after BK, foreclosure, or short sale
- Low down payment requirement
- Competitive mortgage insurance premiums
- Manual underwriting with compensating factors
- Credit scores under 620 allowed
A good guide for determining whether or not you should seriously consider FHA is if your credit score is under 700, and your down payment is 5% or less.
FHA MIP vs Conventional PMI
FHA requires mortgage insurance regardless of the amount of down payment you have. FHA does offer a discount on it’s mortgage insurance premium with 5% down, or 95% Loan to Value.
FHA Mortgage Insurance works a little differently from private mortgage insurance, so let’s take a minute to break them down.
Unique to FHA Mortgage Insurance
- 1.75% Upfront Mortgage Insurance financed into loan
- .85% Mortgage Insurance 95.01% LTV or Higher
- .80% Mortgage Insurance 95% LTV or Lower
- Required for life of loan
- Same premium rate at 95% loan to value or lower
Unique to Conventional Private Mortgage Insurance
- No Upfront Mortgage Insurance
- May be removed in future
- Mortgage Insurance premium changes with Loan to Value
- Mortgage Insurance premium changes with FICO
FHA Interest Rate Secret
If you look at FHA interest rates compared to conventional rates, you’ll notice a significant difference. When comparing apples to apples in terms of LTV and credit scores, FHA is more cost effective from a mortgage insurance perspective at 5% down payment with a minimum 680 credit score.
If you have a middle credit score at or above 700, or if you have greater than 5% down payment, you would need more than interest rate as a reason to choose FHA over Conventional.
FHA Closing Cost Credit Limits
Also known as seller concessions, broker credit, lender credit, interested party contributions, it all means the same thing – a credit that can be used to buy down your interest rate, buy out mortgage insurance, cover all closing costs.
FHA and Conventional guidelines know this as Interested Party Contributions, and their guidelines are different.
The table below provides the Interested Party Contributions (IPC) limits for Fannie Mae, Conventional mortgages.
FHA allows up to 6% interested party contributions up to 96.5% loan to value (3.5% down payment).
These contributions can be used to buy out upfront mortgage insurance (only if it covers the entire amount), buy down the interest rate, or pay recurring and non-recurring closing costs.
How Long Do I Have to Keep MIP or PMI?
With a FHA home loan, the mortgage insurance is required for the term of the loan for all loan terms greater than 15 years.
The rules for removing non-FHA, private mortgage insurance are more flexible. Between 80% and 78% loan to value, the lender can, at it’s discretion, remove the mortgage insurance. At 78% loan to value, private mortgage insurance should be removed by your servicer automatically.
NOTE: loan to value is measure by the principal being paid down from the original loan balance, NOT an increase in equity. This is often misunderstood. Most lenders will not accept an appraisal as proof of a new loan to value calculation.
It will take approximately 11 years on a normal 30 year amortization loan, to pay the principal balance down below 80% loan to value if you put the minimum 3.5% down payment when you buy.
Most homeowners will refinance for other reasons before 11 years, so the removal of mortgage insurance is not usually the right question.
The right question is, how long are you going to have this loan?
Everyone is always so concerned about paying mortgage insurance, and it doesn’t make much sense to me. Mortgage insurance is a valuable and necessary tool that allows homebuyers with less than 20% down, an opportunity to become a home owner.
Any chance you have to keep your money in your own pocket should be seriously considered when weighing your options. Paying a little more each month, in exchange to keeping your nest egg, in the nest, is a strategy that many lenders don’t know how to explain.
Need Flexible Underwriting?
Conventional underwriting seems to me to be tightening up a bit in these last couple of updates. It’s not so much that it’s harder to qualify, but it’s harder to get exceptions, or “breaks” when you get close to hitting tolerances.
FHA is much more flexible in many ways. Here are some of the most common reason why buyers will use FHA financing:
FHA debt to income ratios allow for 46.99% housing payment (front end DTI), and 56.99% debt to income ratio including credit cards, auto loans, student loans, and anything else showing up on your credit report.
Even though Fannie Mae recently changed it’s guidelines to allow the maximum loan limit financing with as little as 5% down, approvals at 95% loan to value or higher are very challenging to come by.
FHA regularly will approve up to the maximum loan amount (in my County, Orange County, CA – the maximum loan limit is $625,500)
Buy Again Sooner After Hardship
If you have a bankruptcy, foreclosure, short sale, or deed in lieu of foreclosure, then FHA typically will mean that you can buy sooner, than waiting out Conventional timelines.
I often advise that homebuyers buy as soon as you can with FHA, and refinance into Conventional in the future. The benefits of homeownership almost always outweigh the minimal cost of FHA mortgage insurance.
Buy Again After Bankruptcy
- Chapter 7 BK – FHA 2 Years | Conventional 4 Years from discharge date
- Chapter 13 BK – FHA 1 Year | Conventional 2 Years from discharge date
Buy Again After Foreclosure
- FHA 3 Years | Conventional 7 Years*
*If mortgage debt is discharge in BK, and a foreclosure, short sale, or deed in lieu occur, the lender should use the Bankruptcy waiting periods, and may disregard the date the title transferred out of your name.
Buy Again After Short Sale or Deed in Lieu of Foreclosure
- FHA Short Sale – 3 Years | Conventional 4 Years from discharge date
- FHA Deed in Lieu – 3 Years | Conventional 4 Years from discharge date
Taking Control of Your Loan Approval
Don’t be afraid to ask questions about the differences between FHA and conventional financing when you’re exploring your home financing options.
If you have questions, ask them! The biggest mistake that homebuyers make is to not ask enough questions. Do not be intimidated or overly impressed by your lender or loan officer.
An experienced, grizzled veteran of the mortgage industry is there to be your guide, to help you ask the questions you didn’t know you should be asking, and helping you find your own personal path to homeownership.
If you do not have a lender that you trust, feel free to ask this grizzled veteran any question you have about qualifying for a home loan. Leave a comment below, and start a conversation, or shoot me an email directly if your question is of a sensitive nature.