Should I go Conventional or FHA?

[Marshall F. Graham]

Should I Go Conventional or FHA?

By: Marshall F. Graham
Aulds Horne and White
www.auldshorneandwhite.com
marshall.graham@auldshornewhite.com
(318) 869-4444

01/07/2010

2009 represented a changing time within the real estate industry, as our understanding of what signified an ideal client for conventional loans changed dramatically. Credit scores that were at one time praised are now considered to be meager at best. 2009 brought about a change within our political arenas in regards to whether home ownership was a privilege or a basic fundamental right, as it was deemed to be over the last 10 years. Federal Housing Administration (FHA) loans by definition were designed to help those individuals achieve home ownership, whom for whatever reason could not go conventional. FHA in its creation was never meant to compete with its brethren Fannie Mae, but existed independently to aide middle to low income families in their pursuit of “the American dream”. The underlying changes of regulation within Fannie Mae has shaken the industry down to its basic core of understanding, leaving most clients asking, “should I go conventional or should I go FHA”?

One of the biggest changes that 2009 brought was the introduction of Risk Based Pricing. Traditionally, as long as a client met the minimum requirements across the board, they would receive “the” conventional rate of the day in relation to the desired term they seek. Conventional interest rates are now more challenging to compute, since they are based not only on where a client’s credit score falls within a complex tiered matrix, but as well as a client’s Loan To Value (LTV), or in other words, how much money they are borrowing in regards to the appraised value of the property. It is important to note that Risk Based Pricing only affects mortgages with terms greater than 15years. Also, the credit score used to calculate the rate is the lower median score of the two borrowers. FHA, however, has not “yet” introduced Risk Based Pricing in their system. Therefore, FHA absorbs many clients, who traditionally would be considered conventional loan candidates, since the clients often can receive a ½% better rate by going FHA and avoiding Risk Based Pricing all together.

FHA’s volume has increased significantly due to the increase of conventional loan minimum credit score requirements. Much of the change to the minimum conventional credit score requirements was due to the Principle Mortgage Insurance (PMI) companies eliminating coverage for credit scores sub 680. By default, since PMI is required on all conventional mortgages where a client puts less than 20% down, borrowers with credit scores of <680 must either go FHA or put at least 20% down. With 680 now being the “minimum” credit score allowed, they represent the highest adjustments to conventional interest rates. FHA in turn, raised its minimum credit scores from 580 to 620. A borrower can no longer purchase a property if his or her credit score is 620 or lower. PERIOD So, all borrowers purchasing a property and putting less than 20% down that have credit scores between 620 and 680 now by default go FHA.

One of the hardest hit sectors within our industry by the foreclosure crisis is the PMI companies. They in turn have increased their rates. Since a 5% down payment is the minimum down payment required on a conventional loan, 5% down payment loans will experience the highest annual PMI rate of .0084 times the loan amount. The rate is reduced significantly to .0049 if the client is able to put an additional 5% down. FHA, however, still offers a fixed rate of .55% with a client putting only 3.5% down. For instance:

Conventional - $200,000 Purchase Price (Credit > 700)
5% DP = $190,000 LN Amt (.0084) = $1,596 Annual PMI
10% DP = $180,000 LN Amt (.0049) = $882 Annual PMI
15% DP = $170,000 LN Amt (.0038) = $646 Annual PMI
Conventional - $200,000 Purchase Price (Credit 680-699)
5% DP = $190,000 LN Amt (.0108) = $2,052 Annual PMI
10% $180,000 LN Amt (.0061) = $1098 Annual PMI
15% $170,000 LN Amt (.0044) = $748 Annual PMI
FHA - $200,000 Purchase Price (with Funding Fee)
3.5% DP = $196377 LN Amt (.0055) = $1,080 Annual PMI
5% DP = $193,325 LN Amt (.0050) = $966 Annual PMI

The higher PMI charges for conventional loans solidify why most clients with credit scores between 680 and 699 end up choosing an FHA route. With these PMI rates, clients find that the total payment for a FHA loan with a 3.5% payment is lower than a conventional loan with a 5% payment. Therefore, many clients that would normally put 5% and go conventional have elected to save the 1.5% down payment difference, and go FHA. FHA requires a borrower to have PMI on a mortgage no matter the down payment for a minimum of 5 years. Why? The Federal Housing Administration says that if you plan on putting 20% or more down, and don’t want to have to pay PMI, then go conventional. Remember, they are “not” designed to be a competitor of conventional loans.

FHA mortgages require a 1.75% Funding Fee be added to the loan to help “fund” the reserve for future FHA mortgages. This 1.75% fee is not considered to be an Out of Pocket Expense, since it is designed to be rolled into the loan amount. A typical FHA loan would look like the following:

$200,000 Purchase Price
3.5% DP = $193,000 LN Amt (.0175) = $3,377 + $193,000
Total Loan Amt = $196,377

Special Circumstances:
1. Projected length of homeownership - How long one projects to retain the property can play a role in whether to go conventional or FHA. FHA, as we know, has the upfront fee, while conventional does not. If a client does not foresee owning the property for long (<2 years) then he or she should avoid as many upfront fees as possible, and therefore go conventional with the higher rate.
2. Owner Occupancy – In regards to conventional loans, every party that is on the mortgage note must reside within the home. If one or more parties does not plan on residing within the property, then the second home or investment property rules go into play. FHA, however, does allow for a Non Occupant Co-Borrower to be on the note. A Non Occupant Co-Borrower could be considered in the same relation to a co-signer. FHA does not offer housing for investment style mortgages. At a minimum, the borrower themselves must plan to reside within the property.
3. Size of mortgage needed – Since FHA mortgages are designed for moderate to low income borrowers, they have placed a loan size limit of no more than $271,050. Conventional provides more of a leeway by allowing a borrower to finance up to $417,000 before moving into the Jumbo Loan category. If a borrower plans to purchase a property that is larger than $281,000 then they must either place more than the minimum 3.5% down payment for FHA, or utilize a conventional loan.
4. Condition of the property – FHA contains more stringent regulation in regards to what is deemed a “livable” property. Since FHA loans by trade are more borrower protective, FHA desires to insure that mortgage pursuers are not taken advantage of. FHA mortgages and properties needing tender loving care do not go in the same sentence. If a borrower decides to make an offer on a property that observably needs a lot of work, then it is imperative that they go a conventional route, or be willing to have all of the building requirements met prior to closing the loan.


We can deduct the following:
1. A sole borrower with a credit score <620 cannot at this time purchase a home.
2. If two borrowers are in play, and one has a score of <620, then that borrower, including his or her income and assets, cannot be included.
3. If one borrower has a 750 credit score, and one has a 665 score, then conventionally, the interest rate would be based off of the 665. The same borrowers would qualify fully with FHA.
4. If a borrower plans to sell a property in the near future (<2yrs) they should try to go conventional, if possible, to avoid the upfront FHA Funding Fee.
5. A borrower with a credit score <680 must either put 20% down or go FHA.
6. A borrower with a credit score between 680 -700 should go FHA due to the increased conventional PMI and interest rate, or be willing to place a down payment of 15% or more.
7. A borrower placing 5% down with a credit score between 700 and 720 in many cases would benefit using FHA.
8. A borrower placing 10% down with a credit score of 700+ should go conventional.
9. A borrower placing 5% or more down with a credit score of 720+ should go conventional.
10. A borrower pursuing a term of 15 or less years should go conventional.
11. Investment properties and Second Homes must go conventional.

By: Marshall F. Graham
Aulds Horne and White
www.auldshorneandwhite.com
marshall.graham@auldshornewhite.com
(318) 869-4444