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Is an FHA loan or a conventional loan with PMI a better option?

Among the many decisions you'll have to make on your journey to homeownership will be the choice of how much to pay upfront, also known as the down payment.
12/9/2016 11:38:38 AM

Among the many decisions you'll have to make on your journey to homeownership will be the choice of how much to pay upfront, also known as the down payment.

The traditional amount to put toward your down payment is 20% of the home's value. But, as many prospective homebuyers know, this isn't always feasible. Many lenders will accept lower down payments, while requiring the buyer to also purchase Private Mortgage Insurance.

Another way to put less than 20% down is to look into other loan products, like an FHA loan. These are government-sponsored products that allow down payments of as low as 3.5%.

For the buyer who wants to put less than 20% of the price of the home down, both PMI and an FHA loan are good options. But for some, one might be more beneficial than the other. Before making this decision, it's important to know which is the more financially responsible choice.

History of FHA loans and PMI

The Federal Housing Administration was first created in 1934. At that time, the housing industry was struggling immensely, according to the U.S. Department of Housing and Urban Development. The FHA helped many Americans become homeowners, and largely improved the market as a whole. 

Years later, in the late 2000s, another housing downturn came in the form of the Great Recession.

"Between 2007 and 2009, FHA loan originations increased 355%."

During this time, many homebuyers didn't qualify for PMI, so people who wanted to buy a home with less than a 20% down payment needed to find another option. This caused FHA loan popularity to soar. Between 2007 and 2009, FHA loan originations increased 355%, according to WalletHub. In 2009, a record 1.8 million FHA loans were issued, compared to the 402,000 just two years prior.

Meanwhile, conventional loans with PMI plummeted. In 2007, 1.5 million conventional loans with PMI were originated. By 2010, that number dropped to 260,000.

In the years that followed, FHA loans began to increase in price. Additionally, as the housing market continued to recover, PMI became affordable again. This gave rise to conventional loans with PMI once more.

In 2015, FHA loans were still more popular than those with PMI attached. However, FHA loans are trending downward overall, while PMI is gradually growing more popular. And while they both have their merits, it's important for homeowners to understand why one might be a better option than the other.

When does PMI make sense?

If you can pay 22% of the home's value quickly or plan on staying in the home for a long time.

WalletHub pointed out that the economic value of an FHA loan depends on several factors, including how long you plan to live in the home and what your credit score is. FHA options include mortgage insurance, but it's wrapped up in the price of the loan as a whole. PMI, on the other hand, is a completely separate product from the loan itself. PMI can be taken off after a few years, once the loan amount reaches 78% of the home's value. In the case of an FHA loan, however, the mortgage insurance will be included for the entire life of the loan.

If you have good credit.

There is no set amount that a lender can charge for PMI, but it's usually between 0.5% and 1% of the cost of the loan per year. One factor that contributes to how much it will cost is your credit score.

"The cost of PMI dropped 47% for people who had a credit score of 760 or more."

Generally speaking, the higher your score, the lower your PMI will be. WalletHub noted that between 2014 and 2016, the cost of PMI dropped 47% for people who had a credit score of 760 or more. But for people who had a credit score of 660 or lower, the cost increased 28%. For people with a good credit score, choosing PMI over an FHA loan could save them as much as $8,000.

When does an FHA loan make sense?

If you plan on refinancing soon.

PMI makes sense if you plan on staying in the home long enough to pay down 22% of the home's value, at which point you can get rid of the insurance and just pay off the loan. Likewise, if you don't plan on staying in the home for long, an FHA loan might be the way to go, since it's generally a bit less expensive right off the bat.

Additionally, Zillow pointed out that FHA loans are typically easier and cheaper to refinance than conventional mortgages through a process called "streamline refinance."

They also are assumable loans, which means they can be transferred to another party. This means that when it's time to sell a home, the buyer can take on the responsibility of the loan at the same time that he or she purchases the house. Since FHA loans typically have lower interest rates, this might end up be a good selling point.

If you have low credit.

If your credit score is 660 or lower, opting for an FHA loan instead of a conventional loan with PMI can save you as much as $11,000.

If you recently experienced a credit problem.

FHA loans also have looser restrictions for time elapsed between certain problems you might have encountered, like a bankruptcy or foreclosure. If you are pursuing a conventional loan, you'd have to wait four years after a bankruptcy or seven years after a foreclosure to qualify. But if you're looking for an FHA loan, you can qualify just two or three years, respectively, after the event.

Academy Mortgage is one of the top independent purchase lenders in the country as ranked in the 2015 CoreLogic Marketrac Report. Visit www.academymortgage.com to find a loan, get a rate, or calculate your payment today.