Primer on the Difference Between an FHA Loan and a Regular "Conventional" Mortgage Loan

It is in every borrower’s best interest to understand the difference between a Conventional and an FHA loan, especially if they owe more than 80% of their home’s value or are interested in purchasing a home with less than 20% down payment.

First FHA will allow a borrower who wants to refinance, or purchase a home, the opportunity to borrow up to 96.5% of their home’s value. This is also known as LTV or the “loan to value” ratio. If it is a refinance, and they want to borrow 96.5% LTV, then the borrowers are not allowed to take out any cash. The only refinance that will be accepted is one where the borrower benefits with a reduced monthly payment from a lower interest rate.

A borrower can work with a Conventional loan if they only have to borrow 95% or less LTV. It’s usually financially better to secure a Conventional loan than an FHA loan because of the 1.75% up front fee that FHA requires. This can be a significant extra fee if the loan amount is three or four hundred thousand dollars. For example, the extra fee on $300,000 is actually $5,250.

So if you have at least a 5% down payment on a purchase, or have at least 5% equity in your home when you are ready to refinance, you might qualify for a Conventional loan and forgo the 1.75% up front fee. If you can afford a 10% down payment, or have 10% in equity when you are ready to refinance, you have an even better chance of securing a Conventional loan. This is because there are several restrictions on Conventional loans between 90% and 95% LTV and many borrowers will not be strong enough financially to qualify. For example, the credit score must be exceptional (over 720 points) to get a loan over 90% LTV.

One advantage to an FHA loan is the cost of their Mortgage Insurance Program. Mortgage Insurance is an extra fee that must be paid alongside the regular monthly Mortgage Payment. Regardless if it is a Conventional or FHA loan, anytime a borrower needs a loan that is over 80%, they will be required to add a Mortgage Insurance Premium to their monthly payment.

FHA’s mortgage premium is a standard .50% of the loan amount. In other words it does not matter if you borrow 81% or 94%, if you borrow over 80%, the Mortgage Insurance Premium would be the same at .5%. A .50% Mortgage Insurance premium on $200,000 would be $200,000 x .50%, which equals $1,000. This is an annual premium and so it needs to be divided by 12. Therefore, the Mortgage Insurance Premium on an FHA $200,000 loan would cost an extra $83.33 per month ($1,000 divided by 12 = $83.33).

With a conventional loan there are different percentages associated with different LTV’s. For example a borrower who needs a loan that is over 80% but under 85% LTV will have a smaller Mortgage Insurance Premium than someone who needs to borrow 90% or 95%.

The Mortgage Insurance Premium payment under 85% LTV is about the same as the FHA premium, but the Mortgage Insurance Premium (also known as MIP) on a 90% or 95% LTV loan is much higher than FHA. So where as the FHA loan asks for a large upfront fee of 1.75% and a smaller monthly Mortgage Insurance Premium, the Conventional lender does not ask for an upfront fee, but collects a larger Mortgage Insurance Premium during the life of the loan. A good loan officer can crunch the numbers and figure out which type of loan is in your best interest.

I hope that this explanation clarifies the differences between the two loans and shows the advantages and disadvantages of each type.

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