In deciding between a conventional mortgage and an FHA-insured mortgage, the general rule is that if you qualify for the conventional mortgage, you take it; only if you don’t qualify for the conventional do you accept the FHA.

The rationale for the rule is that on FHAs, borrowers pay an upfront mortgage insurance premium of 2.25 percent of the loan amount, which is added to the loan balance, and an annual premium of 0.055 percent of the balance paid monthly.

On conventional loans, in contrast, borrowers pay mortgage insurance only if the ratio of loan amount to property value (LTV) exceeds 80 percent, and the premiums are lower than those on FHAs.

Recently, I decided to check this rule. Is it always the case that, if the borrower qualifies for both, the conventional will be the better deal? I defined a "better deal" as one that will cost less over the period the borrower expects to be in the house. I used calculator 9ci on my website to compare the total costs.

I also wanted to see exactly how much more difficult it is to qualify for a conventional than for an FHA. My focus here is on differences in the minimum allowable credit score and the maximum allowable LTV on the two types of mortgages.

I used the prices and qualification requirements posted by 20 lenders with Home-Account.com as of April 29. While mortgage prices change from day to day, underwriting requirements — and the relationship between underwriting requirements and price — change quite infrequently.

Pricing and underwriting categories: I quickly realized that the home loan market today is now divided into five pricing and underwriting categories.

  • "Conforming standard loans" are for amounts up to $417,000 and eligible for purchase by Fannie Mae and Freddie Mac.
  • "Conforming jumbo loans" are for amounts up to $729,750, the maximums varying by county, and eligible for purchase by Fannie Mae and Freddie Mac.
  • "Nonconforming jumbo loans" are for amounts that exceed the conforming jumbo county limits, which range up to $729,750.
  • "FHA standard loans" are for amounts up to $217,050 and eligible for insurance by FHA.
  • "FHA jumbo loans" are for amounts up to $729,750, the maximums varying by county, and eligible for insurance by FHA.

Nobody planned this structure — it is the consequence of multiple policy actions taken at different times for different purposes. It has added to the information problem faced by borrowers, and widened the information gap between them and the professionals with whom they deal.

It also complicated my mission by requiring three conventional/FHA comparisons, corresponding to three different loan size categories. Specifically:

  • Loans smaller than $217,500 can be either conforming standard or FHA standard. I assume a $200,000 loan.
  • Loans between $217,500 and $417,000 can be either conforming standard or FHA jumbo. I assume a $400,000 loan.
  • Loans between $417,000 and $729,750 can be either conforming jumbo or FHA jumbo. I assume a $600,000 loan.

The $200,000 loan: On this loan, a borrower with a 620 score has a maximum conforming LTV of 80 percent and a maximum FHA LTV of 97 percent. Similarly, a borrower receiving the maximum LTV of 95 percent on a conforming loan must have a credit score of 680, whereas a borrower receiving the maximum LTV of 97 percent on FHAs can have a score as low as 620.

Hence, borrowers who can qualify only with an FHA either have credit scores below 680 and need LTVs higher than 80 percent, or they need an LTV above 95 percent at any credit score.

Where the borrower qualifies for both, I found one niche where the FHA might be the better deal. When the credit score was 640 and the LTV 80 percent, the conventional rate was 5.375 percent and the FHA rate only 4.875 percent.

I found the total cost of the two options to be very close, the lower rate on the FHA just about offsetting the mortgage insurance premium. Over periods shorter than 11 years, the conventional cost was lower, and beyond 11 years, the FHA cost was lower. In all other niches, the conventional cost was lower.

The $400,000 loan: As with the $200,000 loan, borrowers who can qualify only for FHAs either have credit scores below 680 and need LTVs higher than 80 percent, or they need an LTV above 95 percent at any credit score.

Since FHA jumbos are priced higher than FHA standard, in the market segments where borrowers qualify for both conforming standard and FHA jumbos, the cost of the conforming is lower.

Indeed, in most segments, the FHA rate is higher and combined with the mortgage insurance premium, the total cost difference is quite large. The $400,000 borrower who can’t qualify for a conforming standard loan pays a larger penalty going with FHA than the $200,000 borrower.

The $600,000 loan: The maximum LTV on a conforming jumbo is 90 percent rather than 95 percent. Borrowers who can qualify only for FHAs either have credit scores below 680 and need LTVs higher than 80 percent, or they need an LTV above 90 percent at any credit score.

In cases where the borrower qualifies for the conventional as well as the FHA, the same niche emerged with a relatively low FHA rate as with the $200,000 loan: a 640 credit score and an 80 percent LTV. Over periods shorter than 11 years, the conventional cost was lower, and beyond 11 years, the FHA cost was lower. In all other niches, the conventional cost was lower.

In sum, the generalization that a borrower who qualifies for a conventional should take it rather than an FHA holds up pretty well. I found one exception in both the less-than-$217,500 and the $417,001-$729,750 loan size groups, but it applies only to borrowers who expect to have their mortgage a long time.

The disadvantage of not qualifying for a conventional loan is most costly to borrowers in the intermediate loan size group, $217,500-$417,000.

Thanks to Jack Pritchard for helpful comments.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

***

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