FHA is often thought of as a "first time home buyer" loan program. And while it has been used by first time buyers quite a bit since the mortgage meltdown in 2008 there are reasons why a first time buyer, or move up buyer for that matter (because FHA is not only for first timers), should carefully compare FHA to a comparable Conventional loan program, even when the down payment is only 5%.
There are definitely several specific reasons why some home buyers will go with FHA, and there will be buyers who don't really have a choice since FHA is more flexible when it comes to FICO scores and past credit issues like bankruptcy or foreclosure. So, when is a Conventional loan better than FHA? It depends on a few things. If a buyer has 20% down payment then there is little reason to go FHA. If a buyer has good credit and is not "pushing" their debt to income ratios to the limit then Conventional will come out better in most cases.
The biggest reason someone would rather choose a Conventional loan over FHA has to do with mortgage insurance. While FHA only requires a 3.5% minimum down payment, there is a 1.75% Up Front Mortgage Insurance Premium (UFMIP) tacked onto the loan. For example, let's assume an FHA buyer purchasing a condo in Irvine, CA for $400,000 with 5% down. The "base" loan amount would be $380,000 ($400,000 * 95% = $380,000). The UFMIP would be $6,650 (1.75% * $380,000 = $6,650). The total FHA loan would be $386,650. On top of the UFMIP is the monthly Mortgage Insurance, or "Annual Mortgage Insurance Premium". For a loan with 5% down the factor used is 1.3% of the average FHA loan balance for 12 months. (It is 1.35% if the down payment is less than 5%). A quick way to estimate the monthly mortgage insurance is to just multiply 1.3% by the loan amount of $386,650 and divide by 12, which equals $418. (This is an estimate. The actual monthly MI is based on the 12 month average loan balance which is a far more involved calculation). And the big negatives about FHA mortgage insurance is that it will remain on the loan forever.
A Conventional loan with 5% down would not have an UFMIP added to the loan. So the loan remains at $380,000. Also, the monthly mortgage insurance would be much lower, depending on the FICO score. Using the Radian Guaranty Mortgage Insurance Calculator a buyer with a 720 FICO would have an MI factor of .62, or $196 per month ($380,000 * .62%/12=$196). That is a $221 monthly savings in mortgage insurance over FHA, and without the UFMIP of $6,650. At a 680 FICO the PMI factor is .89, or $281 per month. ($380,000 * .89% /12 = $281). And at a FICO of 620 the PMI factor is 1.15%, or $364 per month. ($380,000 * 1.15% /12= $364). And whereas FHA mortgage insurance remains on the loan for life, mortgage insurance on a Conventional loan could be removed a few years later if property values increase.
One of the old advantages to FHA had been the allowance for a gift down payment. While this is still true, it is now possible to get a gift for the down payment on a 5% down Conventional loan using Freddie Mac guidelines. Under the old Freddie Mac guidelines, when the total down payment was less than 20% then at least 5% of the purchase price had to come from the borrowers own funds. Now, Freddie Mac allows for the entire 5% down payment to be gift. Another advantage FHA had was the allowance for "blended" debt to income ratios when using a non-occupying co-borrower. However, now Freddie Mac guidelines allows for using blended ratios at 95% loan to value, although this does mean the buyer can't have a gift for their 5% down payment.
A 5% Down Conventional Loan is better than FHA when:
- The buyer has not had a Chapter 7 bankruptcy discharged in the past 4 years
- The buyer has not had a Chapter 13 bankruptcy discharged in the last 2 years
- The buyer has not had a foreclosure in the past 7 years
- The buyer has not had a short sale in the 2 years if at 80% loan to value, 4 years if at 90% loan to value, or 7 years if above 90% loan to value.
- The buyer is buying a condo - this is because do get an FHA loan on a condo the project must be FHA approved. This will limit the inventory available for the buyer since FHA's approved condo list is fairly small in Orange County and lately is a moving target.
- The buyer does not have a CAIVRS claim in the last 3 years.
There are many things to consider when deciding which type of financing to use for your new home. Besides the savings in mortgage insurance it will be important to analyze the differences in interest rate. There are many different underwriting idiosyncrasies that need to be sorted through, which is why it is so important to work with an experienced Orange County loan officer early in the home search process. The loan officer should be able to prepare multiple custom loan scenarios with details in the total purchase price, loan amount, closing costs, and total amount needed to close.
Authored by Tim Storm, a California Mortgage Loan Officer MLO 223456 – Please contact my office at the Home Point Financial. Direct line at 949-640-3102. www.OCHomeBuyerLoans.com