What's the Difference Between a Conventional Loan with Fannie Mae and an FHA Loan?

If you are looking for a home loan, you will soon hear about conventional loans with Fannie Mae and government backed loans from FHA. What is the difference?

An FHA loan is a government backed loan that requires a 3.5% down payment. Government backed means the government will reimburse the lender if you default on the loan. Because of this guarantee, lenders are more willing to provide credit to borrowers with past credit problems and lower credit scores and down payments. While these borrowers are a higher risk, the risk to the lender is reduced because of government backing.

A conventional loan that conforms to Fannie Mae guidelines is an open market type of loan. This means the loan is not backed by the government. Rather, investors on the open market purchase investments that contain these conventional loan notes. As free market investors naturally want to have lower risk investments, conventional loans are designed to be lower in risk. They generally are for people with higher credit and higher down payments.

One of the surprising differences between FHA loans and conventional Fannie Mae loans is that FHA loans often may have a lower monthly payment. How can a loan for a person with a worse credit profile have a lower payment? Again, the fact that the loan is backed by the US government makes all the difference. With the government guarantee, the rate for an FHA loan can be as much as .5% below market rates, but .25% or so is more common.

Also, Fannie Mae loans offer a 3% down program that has slightly higher mortgage insurance costs than FHA loans. So, believe it or not, you can end up with a lower payment with an FHA loan.

FHA Mortgage Insurance Explained

FHA mortgage insurance operates differently than conventional loan mortgage insurance. In both cases, you have to pay mortgage insurance because you are putting down less than 20% on the loan in most cases. If you put down 20%, you do not have mortgage insurance. Mortgage insurance protects the lender against financial loss and makes it less risky for them to offer credit to a lower down payment buyer.

FHA mortgage insurance on loans issued after June 2013 is permanent, unless you put down at least 10%. In that case, the insurance can be cancelled after 11 years. With a conventional loan, you can cancel mortgage insurance when you reach 20% equity.

So, in that sense, mortgage insurance is more of a long-term cost with an FHA loan. That said, conventional mortgage insurance payments stay steady until you reach 20% equity and can cancel. FHA mortgage insurance is based upon the balance of the loan. It is recalculated every 12 months. As you pay down your FHA loan, the insurance cost goes down.

This actually is a big benefit in the long run with the FHA loan. Towards the end of the loan term, you would have a lower payment than if you had gotten a 3% Fannie Mae loan. You can even reduce your FHA mortgage insurance even more by making more principal payments each year. With some planning, you may spend less on your FHA loan than on other conventional loans.

If You Want to Make a Big Principal Reduction in the Near Term

If you want to pay off a big chunk of your loan balance in the first three years to five years, you may want to get a conventional Fannie Mae loan. The reason is that conventional loans allow you to cancel your mortgage insurance as loan as the loan balance is under 78% of the loan value, and mortgage insurance is paid for at least two years.

If you are going to pay down your mortgage and think there will be a big increase in your equity in the first five years of the loan, you may be able to cancel your mortgage insurance before it drops off from year eight to 10.

Even though you may end up paying for FHA mortgage insurance for the length of the loan, the actual costs of FHA loans, plus the lower rate, can lead to lower costs over conventional loans. FHA loans once were much more expensive than conventional, but FHA mortgage insurance reductions in recent years have made the loan a solid competitor and a good option for someone with a lower credit score and down payment.

FHA is also good if you plan to own the home for six to 10 years, and you do not plan to make a major principal reduction in the first five years of the loan. Also, consider FHA if you are ok with refinancing to get rid of mortgage insurance after you reach 20% equity.

Consider a Fannie Mae conventional loan if you can put down 5%, and you plan to keep the home and mortgage for at least 10 to 20 years. Also, choose Fannie Mae if you can't stand the idea of paying for mortgage insurance for decades.