If you are thinking of refinancing to get lower mortgage payments or to change mortgage terms, you have a few loan options. Two of the most common loan types are Federal Housing Administration loans and conventional mortgages.
What is an FHA loan? The U.S. Federal Housing Administration guarantees FHA loans, allowing lenders to relax some qualifying criteria for borrowers. By contrast, no U.S. governmental body guarantees conventional loans, which conform to other lending criteria.
FHA loans and conventional loans also differ in other ways, including:
- Qualification criteria
- Fees and costs
- Mortgage rates
Choose the wrong loan type, and those differences can cost you a lot of money — for a long time. So make sure you know the details before you apply.
Comparing FHA vs. Conventional Mortgages
FHA and conventional mortgages offer distinct and important differences, and it is crucial that you make the choice that is right for you. After all, you might have to live with your decision for up to 30 years.
The most important difference between the two types of loans relates to mortgage insurance rules for each, said Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage.” With an FHA mortgage, you are stuck with the monthly mortgage insurance premium for the life of the loan. In addition, you pay an upfront fee of 1.75 percent of the loan amount when you get the loan.
“With conventional loans, if you have mortgage insurance, the lender must remove it if you bring your loan amount down to under 80 percent of the original purchase price of the home or the appraised value at the time the loan was put in place,” Fleming said.
Another key difference is the qualifying criteria for each loan type. “FHA will generally allow lower credit scores than conventional loans, all things being equal,” Fleming said. “So if you have credit bruises, then FHA might be a better alternative.”
Major credit dings resulting from bankruptcies, foreclosures or short sales are forgiven sooner with FHA loans. “For example, you must wait seven years after a foreclosure before you can get prime conventional financing, but the waiting period for FHA is only three years,” Fleming said.
Another difference is in the down payment requirement, Fleming said. The minimum down payment allowed with an FHA loan is 3.5 percent, whereas conventional loans allow a minimum of 3 percent. But that’s not the whole picture.
“The qualifying criterion for very-low-down-payment conventional loan is very high,” Fleming said. “For FHA, they are more attainable. So, unless you have excellent credit, stable income from W-2 income and some savings, it might be easier to get into a home with a low down payment with FHA.”
FHA Refinance Rates
As with other types of loans, FHA interest rates are based on current market conditions, as well as on your credit score and other factors. If you have good credit, these rates should be similar to what you would qualify for with a conventional mortgage. If you have poor credit, your rates will be higher, but the FHA applicant criteria can make it easier for you to qualify.
Pros of FHA Home Loan Refinancing
For some borrowers — especially those with less-than-stellar credit — FHA refinancing provides some attractive advantages, such as:
- Your down payment can be low. You can qualify for an FHA home loan with a down payment as low as 3.5 percent.
- The credit requirements are modest. Lenders will accept applicants with less-than-stellar credit scores. Even if your FICO score is 580 or less, you might still qualify, according to FHA.com, a private company website that provides information about FHA loans.
- The rates are competitive. FHA loans offer low, competitive rates comparable to those of conventional loans, according to FHA.com
Challenges of FHA Refinancing
FHA refinancing does come with a few downsides. Before you pursue an FHA loan, make sure you are aware of the following:
- Mortgage insurance is required. All FHA loans require the borrower to pay a monthly mortgage insurance premium. The typical annual rate is approximately 0.85 percent of the loan amount, according to mortgage market expert Dan Green of The Mortgage Reports website.
- You must make a mortgage insurance premium payment up front. FHA loans come with an additional mortgage insurance that must be paid up front — a cost sometimes called an upfront funding fee. It is 1.75 percent of the loan amount.
- The mortgage insurance premium is permanent: Unlike conventional mortgages — in which the mortgage insurance is removed when certain equity requirements are met — the FHA mortgage insurance premium lasts for the life of the loan.
Conventional Mortgage Rates
Conventional mortgage rates are established in the same way as FHA refinance rates. The Federal Reserve sets an initial rate on which banks base their interest rates. As those interest rates rise, mortgage rates often follow in the same direction.
As with FHA loans, your current credit score affects your personal loan rate. Because of the guarantees that come with an FHA loan, conventional mortgages might carry higher interest rates. However, this cost can be worth paying if it means you’re getting a loan that doesn’t require you to pay for private mortgage insurance.
Pros of Conventional Mortgages
Conventional mortgages are a great choice for many refinances. Here are a few of the advantages they hold over FHA loans.
- You don’t have to pay for PMI. If you put 20 percent or more down on your home, or you have 20 percent equity in a refinance, you will not need PMI.
- They are available for second homes. Unlike FHA loans, conventional loans can be used to purchase second homes and rental properties.
- You might have lower payments. Because you might not have to carry PMI, your monthly payment might be lower for a conventional loan compared to an equivalent FHA mortgage, which requires mortgage insurance.
Tough Requirements for Getting Conventional Mortgages
Conventional mortgages are not for everyone. Make sure you know their disadvantages and why they might not be for you. Consider the following:
- Higher credit scores are required. FHA loans are attainable with a credit score as low as 500, whereas conventional loans require a score of 620 or higher.
- Bad credit makes it tougher to get a loan. If you have had a major credit event, such as foreclosure or bankruptcy, it will affect your ability to get a conventional loan.
- Your credit score impacts the required amount of PMI. Unlike FHA loans, your credit score has a big impact on the size of your mortgage insurance obligation.
Types of FHA Refinancing Options
You can choose from more than one type of FHA refinance. So if you are considering refinancing to an FHA loan, you should know about each option.
FHA Streamline Refinance
The FHA streamline refinance is open to those who want to refinance their existing FHA mortgage with another FHA mortgage. According to the U.S. Department of Housing and Urban Development, the term “streamline” refers to the amount of paperwork involved, which is less than a normal refinance. “Streamline” does not refer to the criteria or fees and costs involved.
FHA Cash-Out Refinance
The FHA cash-out refinance is open to those with either a conventional or FHA loan. As the name implies, this refinance allows you to cash out a portion of your equity. Requirements include an 85 percent or 95 percent loan-to-value limit. If you do not know or understand what your LTV ratio is, check with a mortgage professional.
FHA No-Cash-Out Refinance
An FHA no-cash-out refinance option is available for those who do not want to take any cash out of their refinance. The limit of the loan amount is 100 percent of the appraised value of your property, including any upfront mortgage insurance premium.
FHA Short Refinance
According to HUD, the FHA short refinance option is for non-FHA loans only. If you owe more than your home is worth, this option allows you to refinance the home to align your debt more closely with your home’s current market value. Criteria are strict and include, but are not limited to, being current on your payments, having a FICO credit score of at least 500 and living in the property.
The Bottom Line: Is FHA or Conventional Better for You?
Because of the significant differences between FHA mortgages and conventional mortgages, it’s crucial to make the right decision for your situation. Fortunately, there are some clear ways to do that.
Fleming said FHA generally is the more expensive option for three reasons:
- The upfront funding fee
- The monthly mortgage insurance
- The fact that the mortgage insurance must run for the life of the loan
“For this reason, conventional is always better, if you qualify,” Fleming said.
However, he added, if your credit is not stellar or you have had a major credit incident — such as a bankruptcy or foreclosure — an FHA loan will both be easier to qualify for and might lead to a lower interest rate.
Also look into VA loans and Home Affordable Refinance Program refinances. VA loans are guaranteed loans by the U.S. Department of Veterans Affairs. They make it easier for veterans and active-duty members of the armed services to qualify for mortgages.
HARP is a government program that helps borrowers with less than 20 percent equity refinance without additional mortgage insurance.
Even if you can’t qualify for a conventional mortgage, you have several options to buy a home or make your current mortgage more affordable.