Many borrowers concern themselves with the interest rate on a loan. They consider it the more important factor without looking at the big picture. The good news is FHA interest rates tend to be lower than conventional interest rates. But what does it mean for you? Let’s look at the details.
The Total Monthly Payment
If you focus on interest rates alone, you’ll not get the full grasp of your payment. FHA loans consist of the following:
- Mortgage insurance
The key component above is mortgage insurance. Every FHA borrower pays mortgage insurance. It doesn’t matter how much you owe. You can’t cancel mortgage insurance on an FHA loan. You’ll pay 0.85% of your average annual balance.
Conventional loans may look the same at first glance. You’ll pay:
- Private Mortgage Insurance (in some cases)
Conventional loan requires Private Mortgage Insurance only for borrowers with less than 20% down. If you put less than 20% down, you can cancel PMI. Once your loan balance is less than 80% of the home’s value, the lender cancels the insurance. This is often the cheaper option for borrowers keeping the home for the long-term.
Comparing FHA Interest Rates to Conventional
Interest rates are variable, no matter which program you use. FHA interest rates do tend to be slightly lower than conventional rates. This is due to the guarantee the FHA provides lenders. Because the lender knows they will get back a portion of the money if you default, they can lower the interest rate. There is no one guaranteeing a conventional loan, though. If you default on that loan, the bank loses.
Does this mean conventional rates are always higher than FHA rates? Not really, it depends on the situation. Interest rates vary based on many factors including:
- Credit score
- Debt ratio
- Credit history
- Loan-to-value ratio
Basically, the lender looks at the big picture. How risky are you? Did you ever default on a housing payment before? How much money did you put down on the home? These factors help a lender determine the interest rate.Our lenders can answer your questions about FHA loans here.
Interest Rates Vary by Lender
Just like any other loan program, you can go from Lender A to Lender B with the same file and get 2 different interest rate quotes. Each lender has a different threshold for risk. They know what they can handle with their current portfolio. If you present too high of a risk, they will either decline your application or charge a higher interest rate.
Remember, interest rates are how lenders make money. Today, they are very restricted on what they can charge borrowers upfront. They used to be able to charge more points, which helped them make a profit. With the tighter restrictions, they have to make a profit somewhere. That somewhere usually ends up to be the interest rate.
What Can You Afford?
It really comes down to what you can afford. If you don’t have more than 3.5% to put down on the home, FHA is a good choice. If you have at least 5%, you may want to look at the conventional loan. There are some differences though. Just because you put 5% down doesn’t automatically qualify you for the conventional loan. You must show you have:
- A credit score over 680
- A clean credit history
- No more than a 95% LTV
- A housing ratio no higher than 28%
- A total debt ratio no higher than 36%
Keep in mind, you’ll pay PMI on the conventional loan. This too is based on your credit score and LTV. You can expect to pay between 1 and 2% of your loan amount per year. On a $200,000 loan, this could amount to as much as $167 – $333 per month. This is in addition to your regular mortgage payment.
Of course, you’ll pay mortgage insurance on an FHA loan too. The insurance is usually less, though. On a $200,000 loan, you’d pay $142.
Each insurance premium decreases as you pay your balance down. One time per year, the lender calculates your average outstanding principal balance. They use this figure to determine the amount of your insurance for the next year. They then divide that amount up into 12 equal payments. This is how you pay your PMI or FHA MI.
Comparing both payments side-by-side can help you determine which is right. But, you should also think of your long-term plans. If you can afford at least 5% down and you know you will stay in the home for the long-term, a conventional loan might be better. The conventional loan’s PMI cancels eventually. FHA insurance doesn’t cancel. The only way out of it is to refinance into a conventional loan.
The bottom line is that FHA interest rates may or may not be higher than conventional rates. It depends on your situation. What you present to the lender and which lender you use matters. If you take the first lender that offers you a loan, you may pay a higher than necessary rate. Instead, shop around. See what loan options you have. Consider your plans and where you see yourself in 10 to 20 years. If this is a short-term purchase, an FHA loan can help you save money upfront. You might even score a lower interest rate. If it’s a long-term investment, though, you may want to consider your other options.
Either way, you get a solid mortgage with the chance to buy a home you want. Make sure you do your research before deciding what to do!