Which Mortgage for You? FHA Loan or Conventional Mortgage?

FHA loan products have become increasingly popular within the past year or two, both for mortgage refinance purposes and as first loans to buy homes. But conventional mortgages also have their appeal, especially when it comes to finding the cheapest possible interest rate.

FHA lenders provide loans with down payments as small as 3 to 5 percent.  That's an especially attractive feature now, considering that conventional mortgages require a down payment of 15 to 20 percent or more. Sellers must also pay part of the closing costs on FHA loan transactions, which saves the borrower out-of-pocket money. Plus, FHA loans are assumable, so you can simply transfer the loan to a qualified buyer when the house sells, and he won't incur the cost of obtaining a new mortgage.

Negatives of FHA loans

One downside of FHA loans is that borrowers must pay a rather hefty mortgage insurance premium. A charge of 1.5 percent gets rolled into the total loan balance, plus there are recurring mortgage insurance charges. If you pay a large enough down payment with a conventional mortgage, on the other hand, it's possible to avoid any private mortgage insurance (PMI) payments. For the average buyer in today's market, the extra FHA loan fees are well worth the price. That's because they allow the borrower to put down less cash. A big down payment is usually the biggest hurdle to home ownership for anyone who has decent credit and sufficient income to handle the monthly payments.

Positives of conventional mortgages

There are two very strong arguments for using a conventional mortgage. First of all, they usually offer the lowest interest rates around for those who want to do a mortgage refinance or take out a new loan. Secondly, using a conventional mortgage instead of buying into a property with an FHA loan and only 3 to 5 percent equity means starting with more home equity; this is the best defense against a downturn in the housing market. Recently the market has chalked up declines of 19 percent, as reported by the Standard & Poor's Case-Shiller Home Price Index. By putting 20 percent down, a drop in value of 19 percent-the largest price decline in the history of the Index-still leaves a homeowner with 1 percent equity.

One percent may not seem like much but. If your mortgage is about to go underwater, it can be the difference between one inch of breathing room and death by drowning. With a 97 percent FHA loan, the same price deterioration translates into negative equity of 16 percent--or drowning 16 inches underwater.

Many of today's foreclosures happen because people bought homes with little or no equity. Now they're unable to do a mortgage refinance, and selling doesn't raise enough cash to pay off their principal.  While paying a big down payment is hard, at least it doesn't leave borrowers walking on thin ice in fear of losing their homes if prices dip.