The Mortgage Brothers Show
Conventional Versus FHA Mortgage. What is best for you?
When buyers start the process of getting pre-qualified, they often hear their loan officer throw out statements like these: “In your case a conventional loan would be best because you have a large down payment,” or “In your case a FHA loan is going to be best for you because your credit scores are in the mid 600’s.” Many buyers want to understand the difference between a Conventional and a FHA loan. What is the advantage of one program over the other?
Let’s get into it.
*The following transcript has been edited for clarity.
Eddie Knoell — I’m Eddie Knoell.
Tom Knoell — I’m Tom Knoell.
Eddie — Welcome everyone. This is the Mortgage Brothers Podcast. Today, we’re going to hit what I think is a really good question. We get it a lot of times when we have buyers call us. They ask us, “What’s better, an FHA or conventional loan?”
Tom — Well, let’s get into it.
Eddie— Right. I don’t want FHA, it has mortgage insurance. They have all that, I hear about all that mortgage insurance and there’s a lot of fear about FHA, especially around this FHA mortgage insurance. Conventional loans just get of course, all the good rap.
Tom — Yep. Now this may be diverting just a little bit, but we also get people that call concerned about FHA because of the appraisals. These appraisals are different.
Really, it’s a minute difference between conventional. I think that was an old school issue that used to exist. But today, the FHA appraisals should be very standard, just like conventional.
Eddie — Conventional loans, conventional appraisals, they’re identical. They’re looking for health and safety issues. Now, peeling paint is one of those things that we probably see a little bit more on FHA. But if your house has crappy paint peeling off of it, that conventional loan appraiser may say they want it painted.
Tom — A conventional or FHA?
Eddie — Conventional, because it provides a safety issue that the home would mold, leading to a deterioration of the wood. That’s probably the most common issue we see on FHA appraisals, peeling paint. But still, it’s rare. It would be definitely a small minority of appraisals that come back with that item.
Tom — Right. But again, talking about FHA.
Eddie — That’s FHA, but again, that can happen on conventional appraisals, too. Someone’s calling us and they’re saying, “Eddie or Tom, I want to buy a house, here’s my credit score, here’s my down payment.” Now for the audience, let’s just look at two comparisons. We actually have a good webpage about this. It’s conventional versus FHA loans. It’s under the loan programs tab. Anyway, the first scenario that we actually show is what we would be looking at when we’re talking to a borrower with excellent credit. The borrower calls us and then it looks at a comparison with someone with a 760 plus credit score, so excellent credit. How does FHA stack up against the conventional loan?
This hypothetical sales price is $300,000, it’s 5% down on each. This is just a hypothetical scenario. Technically FHA, right? Well, we actually can put 3%, we have a 3% down program on that and FHA has a three and a half percent minimum down. But just to make things equal, we’re just saying 5% so people can see.
What they’ll notice is that the, or Tommy, maybe you can talk here about the interest rate differences and go down maybe on what the big differences are and what’s the overall conclusion?
Tom — Yeah, and the fact that you started off with the excellent credit scores, we can go through the comparison, but really the biggest difference between FHA and in conventional really comes down to credit score, and it comes down to credit event. When you are an excellent credit score borrower with no credit event, the conventional loan hands down as –
Eddie — You mean like a foreclosure or short sale or something? Bankruptcy?
Tom — Exactly. If you don’t have any of those, which if you have good credit, typically you’re going to be outside of that grace period or seasoning that’s required for those credit events. But typically, as we are talking conventional good credit, lack of credit events, you’re going to go conventional. If you look here at this sheet that we put together it lays it out that the biggest difference is going to be the interest rate. Interest rate on the FHAs is going to be 3.25 versus on the conventional, where it’s going to be 3.875. I don’t know if we want to get into the whole upfront private mortgage insurance factor, but I usually like to talk about the interest rate in the same breath as they talk about the private mortgage insurance monthly payment.
Eddie — Yeah, I would say that we can talk about that. The FHA product does have upfront mortgage insurance and if you’re watching this online, you can actually see that in this scenario it’s about $4,900. That’s the bad thing, right? That’s a con. The great thing about conventional loans is that it doesn’t have up front mortgage insurance.
Tom — Right. It can’t be waived on FHA regardless of if you put 90% down. That does not change. It comes down because that upfront mortgage insurance is only based on the loan amount, but nonetheless, you’d still have it.
Eddie — That’s right. With FHA loans, if you put less than 10% down, the mortgage insurance is going to be on the loan forever.
Tom — If you do put more than 10% down…
Eddie — Then it’s eligible to be removed after 11 years, which is still a long time.
Tom — Eleven whopping years when the average person refinances after seven years or within seven years. Chances are you’re going to end up refinancing that prior to when it would drop off. But just something important for people to know.
Eddie — When you look at the side-by-side, the FHA loan and a $300,000 sales price, 5% down the interest rates, the total payment on the conventional loan is $38 cheaper. The FHA loan is $38 more expensive. One of the things I would point out in this scenario is obviously conventional financing is a better deal. It’s a little lower payment. But also, in this particular case there’s $85 of mortgage insurance a month that’s eligible to be removed. On a conventional loan, not only are you saving $38 now, but also in the future, that will drop off. We won’t really get into how that mechanism works yet, but we can handle that in another podcast. The $85 will fall off and –
Tom — You don’t have the up-front mortgage insurance payment.
Eddie — Then you don’t have the money up front, so really your monthly savings can go to a $120 or so.
Tom — The three big reasons why conventional is better is that right off the bat there is a lower monthly payment. Number two, the mortgage insurance will drop after that loan to value is at or about 80%. It’s usually between 78 and 80. There’s rules. Then lastly, your loan amount is not increased by the amount of the upfront mortgage insurance premium like it is on the FHA. Three big no-brainers why conventional is the way to go.
Eddie — I would say, and we can look at this comparison number two, someone who has a credit score of 660, what’s really called below average.
Tom — Boy, it sure seems like a lot of people are in that high 600 range. But yeah, I guess that’s probably a fair statement. It is below average, but still not a terrible score. 660, 680, we meet a lot of loans that do FHA and thank goodness for FHA because there’s a lot of people in that segment. But what we just got done talking about was that perfect credit. This is again a hundred points less at 660.
Eddie — The same worksheet shows a $300,000 sales price, 5% down. What you’ll notice is that the interest rate on an FHA is the same as before in the other scenario, so whether you have great credit or not, the interest rates are going to be basically identical. This shows three and a quarter percent on the interest rate on the FHA.
Tom — What I was going to say was FHA, really, anything above that 660 mark will treat the interest rate to same regardless of your credit. Anything below that, there is a little bit of a variance, but not much. Not nearly as sensitive as conventional.
Eddie — It could be a quarter of a point or something like that. If you have a 640, 625. But conventional financing is extremely sensitive to your credit scores.
Eddie — If you have a 760 score, it was 3.875. If you have a 660 it goes up to 4.99, so over a full percentage point.
Tom — Holy cow. Then people may ask, “Why is conventional so sensitive to that? Why are they not like FHA?” I think the simple answer is FHA is built with that upfront mortgage insurance to keep interest rates low.
Eddie — I would say it’s because Fannie and Freddie, they’re the conventional… Conventional financing has private mortgage insurance. It’s in the private industry of mortgage insurance. Those are privately held companies, whereas FHA has the government insurance through HUD, and the government’s going to have a higher tolerance for risk. The private sector is going to have lower tolerance.
Tom — Good. Again, we’re talking about 660-ish credit scores or below. All of a sudden FHA is looking really good compared to conventional.
Eddie — Yes, for sure. This scenario, what you’ll notice is it doesn’t matter if FHA has that upfront mortgage insurance. The payment on the FHA is $300, what did I say? $373 less.
I did the math here on and even though the FHA loan has upfront mortgage insurance at $4,900, if you take the $4,900 and divide it by the $373 a monthly savings, it would take you just a little over 13 months to break even, so very quick. Now, the conventional loan does have $308 of mortgage insurance, so it’s very high. Even if that goes away in the future, you will still be in a position where you’re paying more money.
Tom — I’m actually working with a borrower right now where they have a credit score of 634. One of the spouses has 634 and the other has 720. Because we have to use both of their incomes, we actually have to go to that lower score, 634. One of the spouses does not want FHA. There’s just a stigma. “Tom, we just don’t want that insurance because we’re putting 20% down. Doesn’t that help us?”
After I ran the numbers, even with 20% down with no mortgage insurance on the conventional, the FHA was still $40 cheaper. It was just really difficult for this borrower to come to the conclusion that FHA was the plan, or was the better play, but they finally did become resolved to understand that yes, FHA is the plan. I think what we’re going to do is we’re going to lock them into an FHA loan, get them better pricing than conventional, and over the next year, year and a half, they’re going to work on their credit where the one spouse can get her credit up to that 700, 720 mark. That’s when the conventional starts to like you and then we’ll just do a refi. Maybe by then they’ll need some cash out or whatnot, so we can work in a couple of different reasons as to why we would refi, but they loved that plan.
It’s really counterintuitive. You just don’t think, “Oh, I’ve got 20% down. We’re going to go forward.” Well, what did we say when we started the podcast? For credit score or a credit event, FHA is the way to go regardless of how much money you have.
Eddie — That’s right. Good point. Very good point. Again, we were showing examples with 5% down, but just as Tom said, even if you’re putting 20%, 30% down, if your credit scores are lower, and you have that credit event, FHA is going to beat that conventional every time. Be sure to call us, email us anytime and ask us questions regarding these programs. We’ll be happy to help.
Tom — We’re here.
Eddie — All right, well I hope that this was at least something that people enjoyed listening to, particularly if you are in the market looking for a loan. Everyone have a good rest of your week. Tom, I think we’re good.
Tom — I think we’re good. Let’s call it a day. All right, we’ll see you folks.
Eddie — See you, everyone.
Hey guys, thanks for listening to The Mortgage Brothers Show. Please let us know if you have any questions you’d like us to answer on this podcast. You can email your questions. There’s firstname.lastname@example.org, or yours truly at email@example.com. Be sure to ask us for a free quote on your next mortgage. Tom and I will personally work with you and help you through the whole process.
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