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First-time homebuyers shifting from FHA mortgages to conventional loans

By Anthony SanFilippo
March 2021

FHA mortgages have been the standard practice for first-time homebuyers for decades.

Federally backed loans are easier to get because of relaxed credit requirements, and they are often paired with lower down payments. Couple that with lower-than-average mortgage rates, and they have easily been viewed as the best financing option for first-time homebuyers.

However, because of a new study from the National Association of REALTORS ® (NAR), first-time home buyers are trending away from these FHA loans and are choosing instead to get their mortgage through a more conventional loan.

IN 2020, the percentage of first-time homebuyers using conventional financing rose five percentage points to 57%. At the same time, the percentage of first-time homebuyers using FHA-insured loans slipped slightly to 29%.

Why might this be the case?

Competition on lower down payments

It used to be that the best deal you could get on financing for home loans was through the FHA, where down payments on a home could be as low as 3.5%. For the longest times, the best that conventional loans could do was 5%, and many times were much higher than that.

FHA loans were saving first-time homebuyers thousands of dollars up front.

But conventional loans became more competitive, and are now available through Fannie Mae and Freddie Mac, with down payments as low as 3%.

With home prices skyrocketing year-after-year and the first-time homebuyer getting squeezed more and more of out of the market, having to come up with less money for the down payment gives them a fighting chance to get into that first home.

Insurance costs

Both FHA loans and conventional loans require private mortgage insurance (PMI) that would cover mortgage lender losses in case of a default of some kind. As such, lenders do not need the 20% down payment that many people think they have to come up with to buy a home. Instead, that amount is what’s needed to avoid the need for PMI.

And while each loan and borrower situation is different, it is possible to save about $15,000 on PMI with a conventional loan over a 30-year fixed rate mortgage than it would be on the same term with a FHA loan.

Again, every situation is different. For instance, PMI does not have to last the life of the loan. If you have an FHA loan and you put down more than 10%, the PMI can be canceled after 11 years. But, since most FHA loan borrowers opt for the 3.5% down payment, then they need to have PMI for the life of the loan.

However, with a conventional loan, the PMI disappears when you reach 80% equity in the home. That’s an automatic cancellation – even without the request of the borrower.

Additionally, most borrowers don’t keep their mortgages for 30 years. According to another NAR report – the 2020 Profile of Home Buyers and Sellers – the average time a home is owned before it is sold is 10 years. That means most mortgages are paid off in full at closing.

The re-financing game is also a factor. When interest rates fall, borrowers are more likely to trade in loans. When interest rates rise, they’ll hold onto what they have in place. According to Freddie Mac, the average refinance of a loan in 2020 was just 3.2 years after it was originated.

That makes it a conundrum for borrowers. Those who have PMI will pay more up front with conventional loans than with FHA mortgages, but the longer they have the loan, the more they will save in comparison to FHA mortgages. So, the borrower needs to decide how long they plan on staying in a home before deciding which would be more affordable.

The Verdict

There really isn’t one. In fact, it’s more of a gamble. One type of loan could end up saving you thousands compared to the other… or vice versa. Each situation is unique.

There are other complicating factors as well – like loan discount fees, application fees, interest rates and other charges that could impact the cost of one versus the other.

Lenders often provide buyers with a loan estimate to consider. It’s a government form that is designed to easily compare loan options.

The best bet is to shop around. Compare offers. Take notes. Consider how long you are likely to stay in a home, and then make the call based on your individual needs.

But the trend nationally seems to be that conventional loans are saving first-time homebuyers money in the long run compared to FHA mortgages.


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