If you plan to buy a home with a small down payment, you can choose between conventional (non-government) and government home loans. FHA mortgages require a minimum of 3.5 percent down, Fannie Mae and Freddie Mac community mortgages are 97 percent home loans for first-time buyers, and other conventional options require five percent down.
But how do their interest rates compare? Are FHA interest rates lower than those of non-government loans?
FHA Loans Are Funded by Private Lenders
First, you need to understand that the Federal Housing Administration (FHA) does not lend money to home buyers. It insures mortgages, protecting lenders if borrowers default on home loans. Without this protection, mortgages with such low down payments and flexible underwriting would become very expensive or unavailable.
Because FHA mortgages are underwritten and funded by private mortgage lenders, their pricing and interest rates are not dictated by the government, but are set by the lenders themselves. FHA mortgage rates are subject to the same factors that drive mortgage rates as conventional home loans.
Conventional Mortgage Rates Depend on Your Credit Rating
The next thing you need to know is that interest rates for conventional mortgages depend on your credit scores, the amount of your down payment, property type and other factors. Both Fannie Mae and Freddie Mac, the government-sponsored enterprises that back the majority of non-government home loans in the US, impose surcharges on riskier mortgages. These extra fees are called loan level pricing adjustments and can add thousands to the cost of a home loan. FHA home loans don't have risk-based pricing.
Mortgage Insurance Makes a Big Difference
Finally, you need to understand that while FHA interest rates might be lower, their annual percentage rates (APRs) are considerably higher. That's because in addition to interest, FHA loans come with two kinds of mortgage insurance – an upfront premium of 1.75 percent, which can be added to the loan, and an annual premium that's .85 percent for most borrowers. This insurance is included in the loan's APR but not the advertised or stated rate.
Conventional mortgages with less than 20 percent down payments also have mortgage insurance requirements. This insurance comes from private insurers, and your rate depends on your credit rating and other factors. There are no upfront premiums, just the annual insurance. In addition, you can ask your lender to drop this coverage once your mortgage has been paid down to 80 percent of the original home value (the appraised value or purchase prices at the time your loan closed). The coverage is canceled automatically when the balance reaches 78 percent of the original property value. FHA insurance, on the other hand, is required for the entire time you have the mortgage regardless of your loan balance.
APR Is More Important than Interest Rate
FHA loans are not more expensive -- or cheaper – for everyone. In general, conventional mortgages are less expensive for applicants with excellent credit, putting down more money, or eligible for special 97 percent loans available to first-time buyers with low-to-moderate incomes. FHA loan interest rates can be lower (or the only option) for those with lower credit scores and smaller down payments.
Finding the Cheapest Loans – Fast!
You could spend a couple of hours with a spreadsheet, an FHA insurance table and Fannie Mae's LLPA matrix, analyzing your credit, down payment, income and other factors. Or you could input your credit rating, home price, property location and down payment into LendingTree's LoanExplorer and get a list of offers in seconds. Click the "sort" link and arrange your results by APR. Clicking the "details" link for any offer gets you a list of loan costs and shows you the estimated monthly payment, including the mortgage insurance. The program displays only mortgage offers tailored to your profile, and you can easily see which program is cheapest for you.