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First-time homebuyers have been told for years that FHA mortgages were their best financing option, the loan they were most likely to get, mainly because of relaxed credit standards and ultra-low down payments. But homebuyers are increasingly shying away from FHA mortgages, according to a new study from the National Association of Realtors (NAR).
“More first-time buyers are going with conventional rather than FHA-insured loans,” says NAR Research Economist Gay Cororaton. In 2020, 57 percent of first-time buyers obtained conventional financing, up from 52 percent in the prior year. Meanwhile, the fraction of first-time buyers obtaining FHA-insured financing slightly fell to 29 percent.
Why are homebuyers turning away from FHA financing? Here’s what you need to know.
New competition for low down payment mortgages
The primary barrier to homeownership for first-time homebuyers is saving money for the down payment and closing costs, according to Fannie Mae.
FHA loans, which are made through private lenders and backed by the federal program, require less money upfront. FHA borrowers can finance with just 3.5 percent down while conventional loans generally require 5 percent, and often much more than that. For a $200,000 loan, the difference is $7,000 upfront for FHA financing versus $10,000 for conventional mortgages.
But to be more competitive, conventional loans with just 3 percent down are now available through Fannie Mae and Freddie Mac. Buyers who finance with 97 percent conventional loans need just $6,000 for the down payment with a $200,000 mortgage. For many borrowers such smaller upfront financing costs are crucial to getting on the property ladder when money is tight and resources are limited.
A big factor is the cost of insurance for FHA loans and conventional loans requiring private mortgage insurance (PMI).
Insurance costs for FHA loans versus conventional
Both the FHA and the 3 percent down conventional financing programs available through Fannie Mae and Freddie Mac require mortgage insurance. Lender losses will be covered by the insurance if something goes wrong with the mortgage. With insurance in place lenders do not need 20 percent down, the upfront percentage they require to avoid private mortgage insurance.
So the question is, which program is cheaper? Cororaton outlines an example where the expense of FHA coverage on a 30-year $300,000 mortgage is more than $15,000 greater than the insurance required over 30 years for a conventional 3.5 percent program with PMI.
There’s some caveats to this analysis, however. First, mortgage insurance may or may not last the entire loan term.
With the FHA program, if you buy with less than 10 percent down, mortgage insurance is required for the life of the loan. With 10 percent or more down, FHA mortgage insurance can be canceled after 11 years. Since most FHA borrowers finance with 3.5 percent down, insurance coverage will be required for the length of such loans.
The rules for conventional financing are different. PMI goes away when you reach 80 percent equity in the home. Even if you don’t ask your servicer to cancel PMI, your servicer still must automatically terminate PMI on the date when your principal balance is scheduled to reach 78 percent of the original value of your home.
However, most borrowers will not keep their mortgages for 30 years. According to NAR’s 2020 Profile of Home Buyers and Sellers, the typical home was owned for 10 years before being sold. In almost all cases, once a home is sold, the mortgage is paid off at closing.
Mortgages may not even last that long. Freddie Mac says that, at the end of 2020, the typical mortgage refinance came just 3.2 years after the current loan was originated. This figure moves up and down — when interest rates fall, refinancing activity increases and borrowers trade-in loans more quickly. When rates rise, borrowers hold onto their loans.
Since it’s difficult to estimate how long the insurance must be paid, borrowers may tend to focus on the upfront costs of mortgage financing, including mortgage insurance. Borrowers who use PMI will pay substantially more in the first years of the loan term than those who finance with FHA mortgages. Alternatively, the longer the loan is outstanding, the higher the cost for FHA coverage.
The bottom line
Is it cheaper to get an FHA loan or a conventional mortgage with PMI? The answer is complicated.
It may well be that one loan option has a higher or lower mortgage insurance cost than another, and that will depend on how long you own the home or keep the loan.
And that’s not the whole story when it comes to real estate financing. Interest rates, application fees, points (loan discount fees) and other loan charges are also factors.
Lenders will provide an official Loan Estimate (LE) form for any mortgage you consider. This form was developed by the government to provide a ready ability to compare loan options.
On page one you will find the interest rate. Also, there is a chart that shows the monthly cost for the first seven years of the loan for mortgage interest, mortgage principal, mortgage insurance and escrow costs. A second column shows the same monthly costs for years eight through 30.
On page three you can find the annual percentage rate (APR) for the proposed loan as well as the total amount you will pay for principal, interest, mortgage insurance and loan costs. Subtract the principal paid off that’s shown on the page and you can get a clear idea of potential mortgage expenses.
Above all, shop multiple lenders. Ask questions, take notes and make comparisons. Prepare in advance by checking credit reports for errors and out-of-date items. Because of the COVID-19 pandemic, credit reports are available for free once a week from Equifax, Experian and TransUnion until April 20, 2022, at AnnualCreditReport.com. You want to clean up any issues because credit reports are the basis for credit scores, and good credit scores can help you get a lower mortgage rate.
When you are comparing offers, consider how long you plan to stay in the home. That could be the deciding factor in choosing which loan type best fits your needs.