An FHA loan is an attractive mortgage option that can offer several benefits, especially for first-time buyers. Because these loans are insured by the Federal Housing Administration (FHA) – an agency within the U.S. Department of Housing and Urban Development (HUD) – lenders can offer more favorable terms, including lower down payments and lower credit score and income requirements.
However, FHA loans do have some drawbacks and some of the program’s provisions can be a burden on a homeowner’s budget. That’s why it’s not uncommon for FHA borrowers to refinance into a conventional mortgage when if and when they’re able to.
If you’re a current FHA borrower, how do you know if it’s worth making the switch? The answer depends on many factors, but here are a few considerations.
Your qualifying criteria has improved
As mentioned, requirements for FHA loans aren’t as strict as those imposed by conventional mortgage programs. Currently, the minimum credit score needed to qualify for an FHA loan with a 3.5% down payment is 580. It’s possible to get an FHA loan with a score below that cutoff – as low as 500 – but you’ll need to bump up your down payment to 10%.
Borrowers with credit challenges like collections or other blemishes that could disqualify them for a conventional loan may still be eligible for FHA loans, and the debt-to-income allowance is also less restrictive.
With a conventional mortgage, you can purchase a home with as little as 3% down, but a minimum credit score of 620 or higher is typically required for this type of financing.
If you purchased a home using an FHA loan due to credit or income issues, but your financial position has since improved, you might be able to get more favorable terms by switching to a conventional mortgage.
You don’t want to pay mortgage insurance forever
One of the main advantages of refinancing to a conventional loan is the ability to eliminate FHA mortgage insurance premiums (MIP). With an FHA loan, borrowers must pay an upfront MIP fee (currently about 1.75% of the loan principal) as well as an annual MIP premium (typically 0.85% of the loan principal), which remains in effect throughout the life of the loan.
While conventional loans do require private mortgage insurance (PMI) on loans with less than 20% down, borrowers are able to cancel PMI once their balance reaches 80% of the home’s original value.
If you refinance to a conventional mortgage and still have to pay PMI, there is always the possibility that your premium will cost more than it did with an FHA loan. However, you may be able to lower your monthly payment enough to compensate, and the tradeoff is that you’ll eventually be able to cancel PMI altogether.
You’ve built equity in your home
With interest rates on the rise, FHA borrowers who purchased last year when rates were at historic lows may not even consider refinancing. However, Wayne Lacy, branch manager with Cherry Creek Mortgage, says borrowers need to consider “long-term affordability.”
For example, let’s say you purchased a home this time last year for $150,000 at 3.25% using an FHA loan. Refinancing to a conventional product today at a 90%-95% loan-to-value with a 4% interest rate would give you approximately the same monthly payment, or maybe a bit higher because of the rate differential. However, looking at this from a long-term perspective, refinancing still makes sense because PMI will eventually drop off. This would allow you to lock in a 4% interest rate (still low from a historical standpoint) on a conventional product and be better set up for long-term success.
“And if you’ve been in the home even longer, you may have already reached 80% loan-to-value because of the amount of appreciation we’ve experienced over the past few years,” said Lacy. “Between March 2020 and May 2021, we had approximately 17% appreciation in our market, which is huge.”
With that in mind, let’s go back to that $150,000 FHA loan at 3.25%. If you refinance to a conventional product with 80% loan-to-value at 4% interest, it would drop your payment by approximately $105 a month. That’s 10% of your mortgage payment.
It’s important to keep in mind that refinancing does come with costs. Costs are an important consideration because Lacy says the average person stays in a mortgage for only 5.5 years before selling or refinancing.
“If you don’t plan on staying in the home long enough to recoup your closing costs then refinancing probably isn’t the best move,” he said.
Whether or not a refinance is right for you depends on your individual financial profile and your long-term goals. Lacy says regardless of the final decision, it’s at least worth a phone call to your lender.
“Our office doesn’t charge anything to submit an application to see if a refi will work,” he said. “We can run the numbers and talk through the options, but at the end of the day, we’ll never suggest a move that doesn’t make financial sense for our borrowers.”
For a list of professional lenders, visit the Greater Lansing Association of REALTORS® website at www.lansing-realestate.com.