FHA or conventional: which loan is cheaper?

FHA loans are easier to qualify for and usually carry a lower rate. They are also insured for longer — sometimes for as long as you own the house. Which of those two facts decides your answer depends on a single number that almost nobody is told at the application stage.

The rule the whole decision turns on

FHA charges two premiums. An upfront one of 1.75% of the loan, normally financed into the balance, and an annual one collected monthly.

How long the annual premium lasts is fixed on the day the loan closes, by your loan-to-value at origination. HUD's Mortgagee Letter 2013-04 sets it out in two sentences:

• At 90% LTV or below, the annual premium is charged for the first 11 years of the term, or the end of the term, whichever comes first.
• Above 90%, it is charged for the term of the mortgage.

There is no third option and no escape clause. Paying the balance down does not end it. Reaching 78% does not end it, because that rule — automatic termination at 78% of the original value — belongs to the Homeowners Protection Act and applies to conventional private mortgage insurance only. It has never applied to FHA.

Where the cliff falls

The line is at exactly 90.00%, which means it sits between a 10% down payment and a 9% one.

Take a $400,000 house on a 30-year loan. At 10% down the LTV is 90.00%, the annual premium is 50 basis points, and it stops after 11 years — about $18,530 in total. At 9% down the LTV is 91.00%, the annual premium is still 50 basis points, and it runs for all 30 years — about $35,893.

One percentage point of down payment, $4,000 on that house, is worth $17,363 of mortgage insurance. Not because the rate changed. It does not change. Only the duration does.

Two details make this sharper than it looks. FHA measures the LTV on the base loan before the upfront premium is financed in, so rolling that premium into the balance cannot push you over the line. And borrowers with a decision credit score between 500 and 579 are capped at 10% down — which puts the lowest-scoring FHA borrowers on the better side of the cliff, while a 580 borrower putting 3.5% down lands on the worse one.

You can see the whole thing move on the FHA versus conventional calculator: enter a price and a down payment and it names the LTV, the premium, how long it runs, and what one more percentage point would be worth.

Why FHA can still win

None of that makes FHA the wrong choice. Over a short hold it frequently wins, because it usually prices below conventional and because conventional PMI at a high LTV is expensive in its own right.

On that same $400,000 house at 9% down — FHA at 6.25%, conventional at 6.60% — the FHA payment is about $2,280 of principal and interest against $2,325, and the insurance is $154 in the first month against $237 of PMI. Over ten years the FHA loan costs about $17,198 in insurance and the conventional one about $27,446. Counting the cash at closing, every payment, and the balance still owed, FHA comes out about $12,926 ahead over that decade.

The reversal comes later. The conventional PMI on that loan stops after roughly ten years, when the scheduled balance reaches 78% of the purchase price. The FHA premium does not stop at all. Every year after that is one where the FHA borrower pays insurance and the conventional borrower does not.

What to ask

1. What is my LTV, to two decimal places? Not "about 10% down" — the line is at 90.00% and 90.01% is the wrong side of it.
2. How long do I actually expect to keep this loan? Short holds favour FHA's lower rate. Long ones favour the insurance that ends.
3. What conventional rate am I actually offered? FHA's advantage is a rate gap, and if your credit is strong the gap narrows or disappears.
4. Can I reach 10% down? If you are at 9%, put both figures into the calculator and see what the last percentage point is worth over the life of the loan, not just over the years you expect to be there.
5. What would refinancing out cost? It is the only exit from a lifetime premium, and it is a bet on rates rather than a plan you control.

The honest summary: FHA is a good loan that is priced to be escaped. If you can clear 90% loan-to-value, its insurance behaves like everyone else's and the comparison is a close one decided by the rate. If you cannot, you are choosing a loan whose insurance has no end date, and that is worth knowing before you sign rather than in year twelve.

Sources: annual premium durations and the LTV definition from HUD Mortgagee Letter 2013-04; current annual premium rates from HUD Mortgagee Letter 2023-05, effective for case numbers endorsed on or after 20 March 2023; the 1.75% upfront premium from HUD Handbook 4000.1, Appendix 1.0. Conventional PMI termination at 78% of original value from CFPB on removing PMI, implementing the Homeowners Protection Act of 1998. Payment, premium and amortization figures computed with this site's own code, on a $400,000 purchase over 30 years at the rates named above.