Conventional loans increasingly slipping awayby Peter Miller
For instance, the Wall Street Journal tells us that “conforming mortgages, or those that can be bought by Fannie Mae or Freddie Mac, commonly require higher down payments than FHA loans require. The catch to an FHA-insured loan is that you’ll pay more in fees.”
Later the Journal explains that “borrowers don’t face those costs on a conforming mortgage with 20% down.” (See: FHA Powers What’s Left of the Home Market, March 6, 2011)
Well, sure, but how realistic is this comparison for most borrowers?
Apples & apples
Let’s begin with the assumption that you’re a rational borrower seeking the lowest mortgage rates. This means that while mortgage rates are important, so too are the availability of cash and the cost of mortgage insurance — if any.
You can borrow from the FHA with as little as 3.5 percent down, but if you do, you’ll need insurance — 1 percent of the loan amount up front plus an annual mortgage insurance premium (MIP) equal to 1.15 percent of the outstanding loan balance.
Alternatively, if you borrow with 20 percent down and get a conventional loan, there’s no mortgage insurance requirement.
So, for purposes of illustration and easy math, let’s say you can borrow $300,000 at 5 percent. The monthly cost for principal and interest over 30 years will be $1610.46.
If you borrow $300,000 from the FHA, you will have the 1 percent up-front charge ($3,000) plus an annual MIP equal to roughly $3,450 — a total of about $6,450 in the first year.
Get that conventional $300,000 loan with 20 percent down and you pay nothing for mortgage insurance.
So, obviously, the conventional loan is the “better” deal. Or is it?
20 percent down
Although the loan amounts are the same the two deals are radically different. A $300,000 FHA loan equaled the purchase price of the property less 3.5 percent down. The actual cost of the home was $310,881. With a conventional loan, the $300,000 in financing equaled 80 percent of the purchase price, or $375,000.
To make the conventional loan work in our example, you first need $75,000 in cash plus closing costs. This requirement means conventional loans without mortgage insurance (you put 20 percent down) are off limits to most borrowers. Here’s why:
The National Association of Realtors reported in its 2010 survey of buyers and sellers that 75 percent of all homes are bought with less than 20 percent down. The average median home price at the end of 2010 was $170,600. Translation: Most buyers did not have the $34,120 in cash it would take to get a conventional loan without mortgage insurance.
The right comparison
But why not a comparison between conventional and FHA loans that really works?
Compare a conventional mortgage with 5 percent down and an FHA mortgage with 5 percent down. The conventional loan will require private mortgage insurance and the FHA loan will require insurance as well.
Which is better? It depends on the prices and terms at the time the loans are being originated — a good reason to speak with mortgage lenders and compare both up-front and monthly costs.
Also, be precise when using that term “better.” FHA loans are insured by the federal government and if you get into financial trouble the FHA will try to work out a settlement of your loan rather than a foreclosure. In fact, HUD boasts that 73 percent of its delinquent loans were cured and not foreclosed in fiscal 2010, a comforting thought in today’s financial world.
But while FHA loans may be “better” in some cases they’re not always preferred. Conventional loans work just fine for many borrowers. They are, after all, conventional mortgages — meaning there are no gotcha clauses or hidden costs. As always, shop around and defend your interests.