If you were like many other first-time homebuyers, you took out an FHA loan. It helped you get a loan with a small down payment. It also had flexible guidelines. Now that you have owned your home for a while, though, you may be ready for a different loan. If you want to get rid of the mortgage insurance, the only way to do it is with a conventional mortgage. How do you know when the time is right?
What is Your LTV?
The best place to start is with your LTV. This stands for loan-to-value ratio. It’s the amount of loan you have outstanding compared to your home’s value. Because FHA loans only require 3.5% down at the onset of the loan, you may still owe quite a bit. Once you get closer to owing 80% or less, you could consider a conventional loan.
If you refinance into a conforming loan before you are at or below the 80% LTV, you’ll pay Private Mortgage Insurance. This is similar to the mortgage insurance you pay on the FHA loan because it’s a monthly premium. However, you can cancel PMI after you owe less than 80% of the home’s value. This is a major difference between FHA and conforming loans.
How is Your Credit?
The next thing you should consider is your credit. FHA loans have rather flexible credit guidelines. All you need is a score of 580 to meet the guidelines. Conventional loans, on the other hand, require a score of at least 680 in most cases. Each lender varies on their requirements, though.
As a general rule, the better your credit, the higher your chances of loan approval on a conforming loan. You may be able to secure a loan with a lower credit score, but with a higher interest rate. At that point, it might not be worth it for you to refinance.
How Long Will You Stay in the Home?
Another major factor is your plans for the future. Are you staying in the home for at least 5 years? What about 10 years? This answer will help you determine if you should refinance into a conventional loan. Refinancing your loan costs money. You have to pay for the closing costs. They could cost you as much as 5% of the loan amount. If you won’t stay in the home long enough to start realizing the savings after paying off the closing costs, it may not be worth it.
We urge you to calculate your break-even point. This is when you start realizing the benefits of the conventional loan and its savings. In order to calculate it take your total closing costs and divide it by the monthly savings of the new loan. For example, if you had closing costs of $5,000 and you’d save $200 with the new loan; you’d break even in 25 months. If you knew you would be moving in say 3 years, it may not be worth it to refinance.
Can You Get a Low Rate?
Getting a low rate on a conventional loan means you have great credit, a low debt ratio, and a low LTV. Any factor that isn’t perfect will raise your interest rate slightly. We encourage you to compare this rate to what you could get on an FHA loan. If you decide to stick with the FHA program, you have a simplified refinance option. It’s called the Streamline Refinance program. You can refinance with very little verification required. Here’s the difference:
- FHA Streamline loan – You only need to verify that you have an FHA loan and paid it on time for the last 12 months.
- Conventional loan – You must supply your income and asset documents. The lender must pull your credit. You must also pay for a new appraisal.
If you can’t secure the best rates available on conforming loans, it may make more sense to stick with the FHA program.
The Downside of the FHA Loan
If you stick with the FHA loan, you’ll continue paying mortgage insurance. This lasts for the life off the loan. You can’t cancel it for any reason. If you plan to stay in the home for as long as possible, you may want to get out of the loan. It doesn’t make sense to pay mortgage insurance once you owe less than 80% of the home’s value.
Of course, if you don’t qualify for a conventional loan, you don’t have a choice. The FHA loan provides you with the flexibility you need to qualify. Its tradeoff is the mortgage insurance. The FHA uses the funds to guarantee loans. This enables lenders to continue offering FHA loans to “risky” borrowers.
The Bottom Line
Refinancing into a conventional loan from an FHA loan depends on your circumstances. How soon you plan to move is a big factor. Your qualifying factors are also important. Unless you have improved your credit and kept a low debt ratio, it might not make sense. The best time to refinance is when you can save the most money. It makes paying the closing costs worth it in the end.
If you are unsure about your ability to secure a conforming loan, talk with a few lenders. Let them know your parameters so they can determine the likelihood of an approval. Worst-case scenario, you can secure a few preapprovals from different lenders. This gives you an idea of what you can borrow and what lenders will charge. Each lender will send you a Loan Estimate once you apply for the loan. This way you know what to expect and can make the right decision.
It’s not always better to refinance into a lower rate. Only those borrowers who will stay in the home for the long run truly benefit. If not, you can ride out the mortgage insurance on the FHA loan until you move.
Whichever choice you make, they are both great mortgage programs with many benefits for its borrowers.