Refinancing FHA Loans to Conventional Mortgage • LIHH

Whether you’re a first-time home buyer, a buyer with a low credit score or you don’t have funds for a hefty down payment, FHA loans provide a convenient path to owning your own home.

They come with more minimal credit score and history requirements, making it easier for borrowers to qualify. Along with that, they typically come with lower down payments.

However, there are certain benefits to refinancing your FHA loan to a conventional mortgage. Keep reading to learn more about the differences between FHA loans and conventional mortgages, the reasons you should (or shouldn’t) consider refinancing, and how to get the process started.

FHA Loans vs. Conventional Mortgages

FHA loans are loans insured by the Federal Housing Administration (FHA), an agency under the jurisdiction of the U.S. Department of Housing and Urban Development (HUD).

The FHA does not grant the loans itself — it instead guarantees lenders of FHA-approved loans that it will pay the loan’s balance in the event of a foreclosure. This allows lenders to be less strict in their approval requirements.

For more conventional mortgages, lenders do not have any guarantee that the loan will be paid, which is why conventional mortgages have stricter approval requirements.

However, this is still the most common form of financing in the U.S. In 2020, 69% of new home sales were financed through conventional mortgages, while only 18% were through FHA loans. This is likely because while FHA loans make it easier to purchase a home, they do have some drawbacks. Due to these drawbacks, many FHA borrowers refinance their loans later on.

Reasons To Consider Refinancing Your FHA Loan

If you currently have an FHA loan, you might be wondering if refinancing into a conventional mortgage is the right path for you. There is no hard “yes” or “no” to the question as there are a lot of factors that need to be considered, including:

You Can Eliminate Mortgage Insurance Premiums

This is the main advantage that motivates borrowers to consider refinancing into conventional mortgages. Borrowers of FHA loans are required to pay two forms of mortgage insurance. The first is an upfront payment for mortgage insurance premiums (MIP) during closing, typically around 1.75% of the principal amount of the loan.

The second is an annual MIP, which most lenders typically add to monthly mortgage payments. While the amount will vary depending on the terms and conditions of the loan, you can expect to pay around 0.80% or 0.85% for your annual MIP if your loan’s principal amount is under or equal to $625,500.

Most FHA loans will require you to make these payments the entire life of the loan, which can result in hundreds of dollars on top of your monthly mortgage payments.

For this reason, conventional loans can be cheaper in the long run, especially once you’ve built up equity. With a conventional mortgage, lenders will still require you to pay private mortgage insurance (PMI) if your down payment was less than 20%.

This will increase your monthly mortgage payments similar to MIP, but the difference is that you’ll be able to cancel PMI once your balance has reached 80% of the home’s original value.

There’s also the fact that while the PMI premium may be higher than the MIP with your current loan, you may be able to compensate by lowering your monthly mortgage payments, as well as eventually canceling PMI.

You Qualify for a Conventional Loan

As mentioned previously, FHA loans allow borrowers with a low credit score or a shaky credit history to qualify. Borrowers with a credit score as low as 500 can still qualify for an FHA loan, albeit with a 10% down payment requirement. Meanwhile, borrowers with a credit score of at least 580 will be able to qualify for a loan with a 3.5% down payment.

At the time you secured your FHA loan, you might have had income or credit issues that barred you from a conventional mortgage. However, if your financial situation has since improved enough to qualify for a conventional loan (i.e. a credit score of 620), it may be worth refinancing to get better terms.

You Built Significant Home Equity

If you secured your FHA loan during a time when interest rates were at historic lows, such as during the past two years, you might not see much merit in refinancing because you’ve already locked in a low interest rate.

However, refinancing into a conventional loan may help you in the long term because of the aforementioned MIP that comes with FHA loans. If you’ve been in your home for a while, you’ll have built up a decent amount of home equity. This will lessen the amount you’ll need to pay for a conventional mortgage and you can always cancel PMI later on.

You Want To Shorten Your Loan Term

Refinancing is a valid strategy for those that want to pay off their mortgage faster.

If your original FHA loan was a typical 30-year mortgage, you may be able to bring it down to a 15-year mortgage. This typically results in lower interest rates, which means you could still make similar monthly mortgage payments to what you’re currently paying, but more of it will be going to the actual principal.

When To Avoid Refinancing

The biggest downside to refinancing is that it will come with closing costs.

Closing costs can typically run you thousands of dollars. If you don’t plan on staying in the home long enough to recoup them, then it’ll be better for you to stick with the FHA loan you already have. Ideally, you should be able to recoup the closing costs within 3 to 5 years.

In addition, if you’re planning on selling the home soon, refinancing will mean you’ll have less equity on the home when selling. At the very least, you should consult with your lender about what refinancing will cost you and whether it’s truly worth it.

How To Get the Refinancing Process Started

If you’ve decided you want to refinance, here is what you can expect the general process to look like:

Check your credit score — You’ll first need to verify if your score is high enough to qualify.
Pay for a home appraisal — Your lender may require an appraisal. Even if not, however, it’s a good idea to check your home’s current value and how much equity you have built up before refinancing.
Speak with several banks and lenders — Don’t settle for the first lender you come across. You want to compare rates and services to find the best option for your situation.
Verify that you have enough cash — Once you’ve settled on a lender, you can inquire how much cash you’ll need for the down payment, closing costs, and other fees.
Gather the necessary documents — Your lender will tell you what documents you’ll need. This typically includes tax returns, bank statements, proof of income, credit reports, and so on.
Go to closing — You’ll sign documents and pay for the closing costs.

The Bottom Line

Keep in mind that refinancing your FHA loan to a conventional mortgage is an advantageous strategy only if you’ll save money. If you can’t meet the requirements or afford the closing costs for a conventional mortgage, it’s best to stick with the loan you have. In any situation, always consider the benefits and risks carefully.

Sources:

How To Refinance a FHA Loan to Conventional Mortgage