If you are a candidate for both a government-backed loan and a conventional loan, you might wonder which loans offer the better interest rates. Do FHA loans provide lower rates than Fannie Mae loans?
Generally speaking, yes, government-backed loans offer lower interest rates than conventional loans. This is likely due to the government guarantee that these loans provide. Lenders are able to accept lower interest rates because they know they will get a good portion of the money back should you default on the loan.
Is this the case all of the time, though? We take a look below.
What Determines Interest Rates?
Determining the interest rate on an FHA loan is different than what drives the interest rates on a conventional loan. FHA loans offer one interest rate – it doesn’t matter what your credit score is or how much money you put down on the loan. The FHA rates are not driven by either of these factors. This means a borrower with a 580 credit score and a borrower with a 700 credit score would get the same interest rate.
The interest rates on conventional loans, on the other hand, are driven by your credit scores and the loan’s LTV. With conventional loans, the higher your credit score gets the lower the interest rate gets. Lenders base your interest rate on your risk level. The higher your risk, the higher your interest rate and vice versa. Lenders charge the higher interest rate due to the higher risk of default. If you do default on the loan, the lender will at least have made the interest on the loan during the time that you made payments.
The Other Factors
Don’t forget, though, it’s not just the interest rates that matter. While the rate on your mortgage does determine how much gets added to your principal payment, there is also the mortgage insurance component. FHA loans require mortgage insurance no matter how much you put down on the home. Conventional loans, on the other hand, only require mortgage insurance if you put down less than 20%.
There is one key difference between the two types of mortgage insurance, though. FHA MIP stays on the loan for its entire term. You cannot cancel the insurance no matter how low your LTV gets. Conventional mortgage insurance, on the other hand, does get canceled after you owe less than 80% of the value of the home.
How do you Decide?
So if you are faced with an FHA loan with a lower interest rate or a conventional loan with a slightly higher rate, what do you choose?
Unfortunately, there is not one answer for everyone. It depends on how long you think you will keep the loan. This takes into consideration a few things. How long will you live in the home? How long will you keep the same mortgage? Even if you see yourself staying in the home for the long-term, will you keep the same loan?
Consider the many reasons you may refinance. What if interest rates drop? Will you want to refinance to get the lower rate? Will you need to tap into the home’s equity down the road? These are things you have to consider, but of course, may not be able to answer, as they require you to predict the future.
It’s important to look at the big picture. While lower interest rates are usually desirable, they are not the only factor in a loan payment. Look at the big picture, especially the total cost of the loan over its entire life. This way you will know which loan makes the financial sense for you.