FHA loans have many benefits, but there can come a time when it makes sense to refinance out of it. Many FHA borrowers need the FHA loan originally because they can’t qualify for a conventional loan. At some point during their homeownership, though, they become a better candidate for the conventional loan.
Below we describe how to know when you should refinance into a conventional loan as well as the benefits of doing so.
What’s Your Loan-to-Value Ratio?
Chances are that when you took out an FHA loan you only put down 3.5% on the home. Maybe that’s all that you could afford at the time. Now that some time has passed, you have paid down the principal and your home may have even appreciated. If you owe less than 80% of your home’s current value it could be a good time to refinance into a conventional loan.
Unlike FHA loans, you don’t pay mortgage insurance on FHA loans if you owe less than 80% of the home’s value. This could save you money every month, not to mention over the life of the loan. Even if you owe a little more than 80% of the home’s value, you can still refinance. When you have a conventional loan, you can cancel the PMI once you owe less than 80% on the home.
If interest rates are low right now and you have the credit to qualify, you may want to jump on the chance to get out of the FHA loan and paying the monthly mortgage insurance premiums.
What’s Your Credit Score?
Another reason you may have opted for FHA financing is your credit score. Conventional loans typically require a score of at least 680. If you didn’t have that score, your next best option was FHA financing, which requires a 580 credit score – that’s quite a difference.
If some time has passed since you took out the FHA loan and you have improved your credit, you may want to refinance into a conventional loan. Again, you should be careful with your LTV. If you still owe close to the 97.5% you borrowed, you may just want to stay put. If, however, you owe much less than that and are closer to the 80% mark, you can refinance and eventually eliminate mortgage insurance altogether.
The Best Time to Refinance
Ideally, the best time to refinance is when you owe less than 80% of your home’s value and have a ‘great’ credit score. If you don’t have the combination of the two factors, you won’t get the favorable terms you want on the conventional loans.
Paying closing costs again just to have another loan with mortgage insurance might not make sense unless you are close to being able to cancel it.
Things to Consider
Before you jump into the refinance, thinking that it’s a great deal, consider the following factors:
- How long will you be in the home? If you don’t think you’ll be in the home for more than 5 years, it doesn’t make sense to refinance. You’ll pay thousands of dollars in closing costs just to save a little money each month. The costs will likely outweigh the savings in the short time you’ll be in the home.
- How long did you pay on the FHA loan? Resetting your term is like starting back at square one. If you can’t qualify for a term that matches the amount of time you have left on your current mortgage, it may not make sense to refinance. Let’s say you have 22 years left on your loan but you refinance into a 30-year conventional loan. You just added 8 more years onto your loan. Unless the savings are significant, it may not make sense.
- What are the closing costs? Of course, you should make sure that it makes sense to pay the closing costs the lender charges. You shouldn’t overpay for a refinance as it won’t make the savings worth it. Figure out how long it would take you to pay off the closing costs based on the savings you earn each month. If it’s more than 3 years, the closing costs are too high.
Refinancing out of your FHA loan into a conventional loan can save you money if the situation is right. Make sure you look at all aspects of the loan including the total cost of the loan. Will you really save money in the end? Will you be in the home long enough to see the savings? If you will, refinancing out of an FHA loan into a conventional loan can be a great way to get ahead financially.