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FHA Loan or Conventional Mortgage?

FHA loan products have become increasingly popular in recent years, both for home purchases and for refinancing an existing mortgage. But conventional mortgages- those backed by Fannie Mae or Freddie Mac - also have their appeal, especially when it comes to the lower cost and limited duration of mortgage insurance.

FHA lenders provide loans with down payments as small as 3.5 percent. That's an especially attractive feature now, considering that conventional mortgages typically require a down payment of 10 to 20 percent or more.

Sellers are allowed to contribute as much as 6 percent of the loan amount toward closing costs on FHA loan transactions, which saves the borrower out-of-pocket money. Essentially, this allows you to trade a slightly higher purchase price in return for having the borrower cover your closing costs, so you don't have to pay those up-front.

Plus, FHA loans are assumable, meaning you can simply transfer the loan to a qualified buyer when you sell the home, rather than having them incur the cost of obtaining a new mortgage. That means you can lock in today's low rates for a 30-year loan and have that to offer as an incentive a few years down the road if rates have risen and you're looking to sell.

Negatives of FHA loans

One downside of FHA loans is that borrowers must pay rather hefty mortgage insurance premiums. To begin with, all FHA borrowers must pay an upfront mortgage insurance fee of 1.75 percent of the loan amount, although that can be rolled into the mortgage itself (Exception: Borrowers doing a "streamlined refinance" of an existing FHA loan pay only 0.01 percent).

In addition, FHA borrowers must pay annual mortgage insurance premiums that are higher than those on conventional mortgages. For example, most borrowers with 30-year FHA loans will pay annual insurance premiums of 1.30-1.35 percent, compared to about 0.5-0.8 percent on conventional loans, though the difference is partially offset by lower rates on FHA mortgages.

You also have to carry mortgage insurance on FHA loans longer than you do on conventional loans. Effective June 3, 2013, all FHA borrowers who make less than a 10 percent down payment must carry mortgage insurance for the life of the loan, rather than being able to cancel it eventually. Those making larger down payments can cancel after 11 years, but that's still longer than on conventional mortgages, where you can typically cancel private mortgage insurance after 7-8 years.

For many borrowers, the higher costs of an FHA mortgage are well worth it. That's because coming up with the down payment is typically the biggest obstacle to home ownership for borrowers with decent credit and sufficient income to handle the monthly payments. Furthermore, you can always refinance into a different loan once you build up some home equity.

Positives of conventional mortgages

As mentioned above, the big advantage of a conventional mortgage vs. an FHA loan is that the fees are much lower, particularly since the FHA has raised its fees several times in recent years to cover losses sustained during the downturn.

Conventional mortgages also offer much better arrangements on mortgage insurance than do FHA loans, also mentioned above. Private mortgage insurance (PMI) on conventional loans with less than 20 percent down typically ranges from 0.5-0.9 percent of the loan amount each year.

Conventional loans also allow you to cancel PMI once your mortgage balance falls to a certain level. Regardless of how much of a down payment you make, you can always request to have PMI cancelled when your loan balance reaches 80 percent of your home's current value - which can happen fairly quickly when home values are rising.

In addition, for most borrowers PMI must be cancelled when the loan balance falls to 78 percent of the home's original value at the time the mortgage was obtained, even if the home has fallen in value since. The borrower must be current on his or her payments and the loan must reach 78 percent through normal amortization - that is, without additional mortgage payments.

Finally, while most conventional mortgages require a down payment of at least 10 percent these days, there are some lenders who will approve as little as 5 percent down for borrowers with good credit and financial profiles.

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