Choosing between a conventional and Federal Housing Authority-backed mortgage is not an academic question. My calculations show that the wrong choice can cost as much as $33,000 over 15 years on a $200,000 loan, and as much as $66,000 on a $400,000 loan.
Don’t jump to the conclusion that the better choice is the mortgage with the lower interest rate. FHAs carry a lower interest rate but largely because of their high insurance premiums, they usually (but not always) cost the borrower more.
Do you qualify for both?
You have a choice between FHA and conventional mortgages only if you qualify for both. Then you can select the one that will cost you the least over the period you hold it, provided you correctly identify which one that is. Borrowers who cannot qualify for a conventional loan have no choice, they must use an FHA, which means that step 1 is to determine whether or not you qualify for both. If you can only put 3.5 percent down, for example, you can only qualify for an FHA, and the same is true if you can only put 5 percent down and your credit score is less than 660.
Because qualification requirements can vary with the purpose of the loan and type of property, there are a number of other situations where borrowers can only qualify for an FHA. If the borrower is looking to purchase a four-family house, for example, qualification may be possible only with an FHA because the down payment requirement is much smaller than it is on a conventional loan.
While FHA qualification requirements are generally less restrictive than conventional requirements, there is one important exception. Loans used to purchase a property for investment purposes, as opposed to occupancy, are not allowed by FHA under any circumstances.
Lenders today have two price lists for FHA loans and three lists for conventional loans. On FHAs, they distinguish:
FHA standard loans, which are for amounts up to $271,050, and
FHA jumbo loans, which are for amounts up to $625,500, the maximums varying by county.
On conventional loans, they distinguish:
Conforming standard loans, which are for amounts up to $417,000 and eligible for purchase by Fannie Mae and Freddie Mac.
Conforming jumbo loans, which are for amounts up to $625,500, the maximums varying by county, and eligible for purchase by Fannie Mae and Freddie Mac.
Non-conforming jumbo loans, which are for amounts that exceed the conforming jumbo county limits and cannot be purchased by Fannie Mae and Freddie Mac.
These pricing structures require that FHA/conventional cost comparisons be done separately for different loan amounts. The amounts I use are $200,000 which captures the pricing of conforming standard versus FHA standard; $400,000 which captures the pricing of conforming standard versus FHA jumbo; and $600,000 which captures the pricing of conforming jumbo versus FHA jumbo.
Measuring cost to the borrower
The cost of a mortgage to a borrower should be measured over the period the borrower has the mortgage. It is always possible that one mortgage might have lower costs over one period while the other would have lower costs over a longer or shorter period. Since mortgage life is not known in advance, I measure cost over three periods: 5, 10 and 15 years.
My cost measure includes lender charges and mortgage insurance charges, but not charges of other third parties, such as title insurers, which are not related to mortgage type. Total cost is defined as the sum of monthly payments of principal, interest and mortgage insurance, points and other lender fees paid upfront, and lost interest on upfront and monthly costs at 2 percent, less reduction in the loan balance over the period.
For each of the three loan amounts I compared the costs at 4 loan-to-value ratios (80 percent, 85 percent, 90 percent and 95 percent), three credit score (640, 740 and 800), and 3 periods (5, 10 and 15 years), or 36 comparisons altogether.
On both the $200,000 loan and the $400,000 loan, the cost of the FHA was significantly higher than that of the conventional in all 36 comparisons. This conclusion would hold for loan amounts up to $417,000. Prospective borrowers can safely assume that for loans up to $417,000, they are better off with the conventional than with the FHA.
On the $600, 000 loan, however, the results are mixed. At a credit score of 640, a borrower cannot qualify for a $600,000 conventional loan. At 740 and 800, the cost of a conventional loan is smaller with loan-to-value ratios of 90 or less, but at a ratio of 95, the cost of the conventional is larger. This mixed result would hold for any loan amount greater than $417,000.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.