Which One is a Better Choice for You?
A frequent conversation I have with clients is whether a Conventional loan or an FHA Loan is the
better choice. The answer is not a one-size-fits-all; rather is depends heavily on each borrower’s
specific profile. In particular, the credit score and loan-to-value (LTV) ratio are the two biggest
drivers of the economics. This article outlines the key diƯerences, financial considerations, and
lesser-known features that can help you make the best decision for your home purchase or
refinance.
Background
A conventional loan is defined as a loan that is not insured by the U.S. government. Most
conventional loans are “conforming”, meaning they meet the standards set by Fannie Mae and
Freddie Mac, both of which are government-sponsored enterprises (GSEs). For purposes of this
article, we are referring to a conventional loan as a conventional conforming loan. While Fannie &
Freddie do not directly insure loans against borrower default, they do guarantee that investors who
purchase the underlying mortgage-backed securities (MBS) will receive timely payment of the
principal and interest payments.
Government loans include FHA loans, VA loans, and USDA loans. But this article will solely focus
on FHA loans, since these are the most common and there are specific limitations for the other
types. FHA loans are explicitly insured by the U.S. government, and protect both the investor and
the lender against borrower defaults. Government loans have more lenient underwriting
guidelines than conventional loans, and permit lower credit scores, higher loan-to-values (LTV),
and higher debt-to-income (DTI) ratios. However, FHA guidelines only permit owner occupied
loans, whereas conventional loans allow second homes and investment properties.
Interest Rates
Holding all things constant, FHA loan interest rates are generally 0.375% – 0.50% lower than
conventional loan rates. This is a generality and is dependent on a borrower’s specific credit score
and the LTV. So why are FHA rates comparatively lower? Since FHA loans are insured by the full
faith of the U.S. government, lenders face less risk of financial loss in the event of a borrower
default. Therefore the risk premium is less, resulting in a lower rate. But, as we will discuss
shortly, the interest rate is only one piece of the puzzle and focusing only on rate will result in
flawed decisions.
Mortgage Insurance
Conventional loans require mortgage insurance (MI) if the loan amount divided by the home value,
commonly referred to as the LTV, exceeds 80%. Therefore, for LTVs 80% or below, mortgage
insurance is not required. Mortgage insurance on conventional loans is referred to as “private
mortgage insurance (PMI) since the companies insuring are one of several private insurers. The
amount of the insurance is expressed as a factor, and is dependent on the LTV and the borrower’s
credit score. Higher LTV are associated with higher MI factors, whereas higher credit scores are
associated with MI lower factors. The insurance is added to the monthly payment, thereby
increasing the total monthly payment. Generally speaking, conventional loan’s PMI is significantly
lower than FHA mortgage insurance factors for most LTV / credit scores combinations.
All FHA loans, regardless of the LTV, have two types of mortgage insurance:
1) Upfront mortgage insurance premium (UFMIP). An insurance premium of 1.75% of the
loan amount is payable at closing. (Note: The UFMIP for an FHA Streamline Refinance is
0.01%.) Typically, this premium amount is lumped into the loan amount, though if
preferred it can be paid for at closing. Sometime a seller concession is used to cover this
expense.
2) Annual mortgage insurance premium (MIP). MIP varies by loan term, loan amount, and LTV.
While the factors are expressed as an annual percentage, the insurance amount is added
to the monthly payment
The chart below compares the diƯerence between the FHA MIP and Conventional loan MIP, for a
$750,000 home purchase price. The horizontal axis is the LTV, and there are separate lines for
credit scores. A value above zero indicates the FHA insurance is more expensive, and vice versa.
For credit scores 700 or above, conventional loan PMI is lower for all LTVs. For the 660 and 620
credit scores FHA MIP is lower for LTVs above 90%.
Another detail to be aware of with mortgage insurance is the duration for which its required. For
conventional loans, once the LTV drops below 80%, the borrower can request the MI to be
removed. What would cause the LTV to drop? Either appreciation in the home’s value or principal
payments lowering the loan balance. For FHA loans, if the original LTV is greater than 90%,
mortgage insurance is required for the life of the loan. Therefore, even if the borrower makes a
large principal payment, whereby the new LTV is 25%, or if the borrower is 20 years into the loan,
MIP is still required. If the original LTV is 90% or below, insurance is required for 11 years.
Total Monthly Payment (Principal, Interest, Mortgage Insurance)
Arguably the single most important factor to consider when evaluating whether a conventional or
an FHA loan is the better choice for you is the diƯerence in the total payment. For purposes of this
analysis, the total payment is defined as principal, interest, and mortgage insurance. Property
taxes and hazard insurance is not included since not all loans have impounds.
The chart below compares the diƯerence in the total monthly payment, whereby a positive
number indicates a conventional loan has a lower payment, whereas a negative number indicates
an FHA loan has a lower total payment. A home value of $750,000 was arbitrarily used for
calculating the numbers. As we can see, which option is better is highly dependent on both the
LTV and the credit score. For LTV’s 80% or below, conventional loans were the better choice
across all credit scores analyzed. For credit scores of 660 and 620, FHA loans had a lower
payment for LTVs above 80%. For credit scores of 800, 740, 700 the diƯerences are more subtle
and depend on the specific LTV.
Discount Points / (Lender Credit) & Upfront MIP
An additional factor to consider is the diƯerence between the discount points or lender credit as
well as the upfront mortgage insurance. This is separated from the total payment analysis since
the payment is a monthly amount, whereas this item is a one-time payment. As noted earlier, it is
commonplace to lump the UFMIP into the loan amount, but it is still an upfront cost; its just being
financed.
As we can see below, the one-time costs are higher on an FHA loan. This is largely due to the
FHA’s UFMIP. But the disparity shrinks as the credit score goes down. The reason is due to the
risk-based loan-level price adjustments charged by Fannie Mae and Freddie Mac, which get
progressively higher as the credit score decreases.
Additional Factors Borrowers Should Consider
Assumability
FHA loans are assumable, meaning a future buyer can take over your loan, assuming they
qualify — potentially a huge advantage if interest rates rise. Most conventional loans are
not assumable.
Ease of Refinance
FHA loans oƯer the FHA Streamline Refinance, which requires no appraisal, income
documentation, or credit verification. Conventional refinances, in contrast, require a full
underwriting review.
Appraisal Standards
FHA appraisals are generally more strict and may require repairs before closing.
Conventional loans generally oƯer more flexibility with property condition.
Property Use Flexibility
Only owner-occupied properties are eligible for FHA financing. In contrast, conventional
loans can be used to finance second homes and/or investment properties.
Long-Term Cost Planning
FHA loans may carry higher lifetime costs due to permanent MIP (at high LTVs), whereas
PMI on conventional loans can be canceled once enough equity is built.
Conclusion: How to Decide Between FHA and Conventional
Bottom line is the “better” loan type for you ultimately depends on your specific credit profile, LTV,
and long-term plans. Here’s a quick guideline:
Borrower Profile Likely Better Option
High credit score (700+) and/or LTV ≤ 80% Conventional
Low credit score (≤ 660) and/or low down payment FHA
Planning to keep the loan long-term Conventional (for cancelable PMI)
Short-term ownership or future rate drop likely FHA (for streamline refinance or assumability)
Still unsure? I’m happy to run side-by-side comparisons personalized to your situation so you
can feel confident you’re choosing the loan that saves you the most money — both now and long-
term.
Website:https://IntegrityCa
