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Homeowners with FHA loans have a golden opportunity to save money on their mortgages this year by refinancing—if they meet a few financial conditions.
FHA loans are private mortgages backed by the Federal Housing Administration, a government agency. That makes them less risky for lenders, and relatively easier to qualify for. So many first-time homebuyers end up with an FHA loan. Last year, 83% of FHA-backed mortgages went to people purchasing their first home, according to the agency.
But they have their downsides, including an ongoing insurance requirement that must be paid every month for the life of the loan. With mortgage refinance rates at a record low right now, experts say there are several scenarios when it might make financial sense to trade in your FHA loan for a conventional loan.
Here’s the difference between FHA and conventional loans, and four potential reasons to make a switch.
FHA vs. Conventional Loans
Conventional loans are the most popular types of home loans, and represent any mortgage that isn’t backed by a government agency like the FHA.
Compared to an FHA loan, conventional loans can be cheaper in the long run, but they may be harder to qualify for. Conventional lenders will allow a low down payment, but they generally want borrowers with good credit scores well over 600.
With a conventional loan, if your down payment is less than 20%, you’ll have to pay private mortgage insurance (PMI). PMI increases your monthly mortgage payment cost but drops off once you’ve built up 20% equity in your home. FHA loans, on the other hand, require mortgage insurance payments every month for the life of the loan, no matter how much equity you’ve built.
Should You Refinance Your FHA Mortgage to a Conventional Loan?
There are four standout benefits of refinancing from an FHA loan to a conventional loan, according to experts. But first, make sure you understand your situation.
“In order to consider what the value is in refinancing, you really need to know what the house is worth and what the outstanding balance is on the mortgage,” says David M. Dworkin, President, and CEO of the National Housing Conference. In addition, you should know your current mortgage rate and credit score.
You Can Get a Lower Interest Rate
Mortgage interest rates are rising in 2021, but they’re still near record lows. If refinancing into a conventional loan can lower your rate, you could save thousands of dollars in interest and potentially lower your monthly payment.
“If you’re paying more than 5% in interest on an FHA loan, you’re almost certainly going to save money refinancing,” says Dworkin. The average 30-year-mortgage rate was just above 3% in April.
“Usually the rule of thumb is that in order for a refinance to make sense, you want to be able to save 1% in interest,” says Charles Davis, President & CEO at Davis Mortgage Ltd in Albuquerque.
Pay attention to the new loan’s APR when refinancing. It includes the interest, as well as all the other costs you’ll pay for the loan.
It’s important to understand what kind of interest rate you’re getting with the new loan. Although a variable rate could start lower, it might pose a serious risk in the future. Dworkin recommends refinancing to a fixed-rate loan, so you can lock in today’s low rates.
Your Credit Score Has Improved
When looking into refinancing to a conventional loan, pay close attention to your credit score. It’s critical in determining the value of the refinance.
“Credit scores are very important when determining both the interest rate and the monthly cost of private mortgage insurance on conventional mortgages,” says Julienne Joseph, Associate Director of Government Housing Programs at Mortgage Brokers Association. “The higher the credit score, the better the interest rate and the private mortgage insurance monthly payment.”
If your credit score has improved since you applied for your FHA loan, you might be able to get more favorable terms with a new conventional mortgage. Due to high demand this year, most private lenders will need to see excellent credit scores above 700 to give you the best refinance rates.
You’ve Built Equity in Your Home
When you get an FHA loan, you must pay insurance premiums over the loan’s entire life. These are called Mortgage Insurance Premiums (MIP). One big reason for homeowners to consider refinancing to conventional is to get rid of this mortgage insurance. If you have at least 20% equity in your home, conventional loans don’t require mortgage insurance.
You Can Shorten Your Term
When you refinance, you could choose a shorter loan term than your original loan, letting you pay off your mortgage months or years faster. You could reduce your monthly payment or pay off the mortgage faster.
That’s the tactic recommended by financial expert and NextAdvisor contributor Suze Orman. For example, you may be able to trade a 30-year mortgage for a 15-year mortgage, which typically have even lower rates.
“A lot of times people can refinance to shorter terms and keep their payments similar to what they’re paying now, except more of the payment is going toward the actual principal,” continues Davis.
The Cons of Refinancing
If you’re considering refinancing to a conventional loan, be aware of closing costs.
“The pitfall is closing costs. It’s important to talk to the bank or the loan officer about loan estimates—what types of closing costs are involved in the transaction—to get an idea of how much you’re going to pay to get that refinance,” says Davis.
The process isn’t cheap. Expect to pay thousands of dollars during a refinance. You may be able to roll the closing costs into your new mortgage, but doing so increases what you’ll owe.
“If the payment isn’t coming down where you can recoup your closing costs within a 3 to 5 year period, I would suggest to just stay put with the FHA loan that you have,” continues Davis.
If you’re planning to sell your home soon, you may also think twice about refinancing. The equity you spend during the process means you’ll own less of the house when selling.
“Prior to refinancing, borrowers should determine how long they intend to stay in the property. If they haven’t been in the home that long (e.g., 3 years or less) and haven’t established much equity, refinancing the home and rolling in closing costs for the transaction may complicate selling the home in the short term,” says Joseph.
What Do I Need to Convert My FHA To a Conventional Loan?
You will generally need to present a complete picture of your finances to the lender for a refinance. You may need to gather tax returns, W-2’s and 1099s, asset statements, and credit reports. In many cases, you’ll also pay for a home appraisal to satisfy the lender.
“It would be helpful for borrowers to have the closing documents from their existing mortgage handy to help compare terms with the proposed new mortgage costs and payment,” says Joseph.
To make sure you get the best refinancing option that’s available to you, speak with a few different banks and lenders before settling. The right choice may not be the first that comes up.
“It’s important to do comparison shopping in the same way you would if you were buying a car or anything else,” says Dworkin.
Take an honest look at your financial situation and what you expect the next few years will look like. Depending on what your goals are, sticking with the FHA loan could be the better bet.