Should I Refinance Using FHA or Conventional?

So, you’re asking yourself, “Should I refinance using FHA or conventional mortgages?” You’ve probably already guessed the answer: it depends. 

Not to worry. By the time you’ve finished this article, you’ll have a very good idea of which better meets your needs.

Your conclusion should depend on your circumstances. So, let’s run through different scenarios that typically make one choice better than the other.

Key Takeaways:

• 20% Equity Advantage: With 20% or more equity, a conventional loan is usually best, allowing you to drop mortgage insurance.
• FHA Streamline Refi: If you have an FHA loan and less than 20% equity, an FHA streamline refi offers a quick, lower-cost refinance option.
• Conventional Loan Holders: Stick with a conventional loan if you’re close to 20% equity to eliminate PMI sooner.
• Limited Options for Low Home Value or Credit: FHA streamline refis may be your best bet if your home value or credit score has dropped.
• Run the Numbers: Always compare the costs and savings before refinancing.

You’ve built up plenty of equity

What is equity?

Equity is simple. It’s the amount by which your home’s value exceeds your mortgage balance. Typically, home prices rise, increasing your home’s value, and, of course, your monthly payments reduce your mortgage balance. So, over time, your equity grows. 

Lenders look at equity as a percentage of a home’s value. So, suppose your home’s worth $300,000 today and your mortgage balance is $240,000. Your equity is $60,000 ($300,000 – $240,000 = $60,000).

Sixty thousand dollars is 20% of your home’s $300,000 current value ($60,000 ÷ $300,000 = 0.2, which is 20%). 

Twenty percent is a bit of a magic number for lenders, and having at least 20% equity is important when answering the question, “Should I refinance using FHA or conventional mortgages?”

With ≧20% equity, should I refinance using FHA or conventional mortgages?

You’ll almost certainly be better off opting for a conventional mortgage when you refinance if your equity has reached 20% or more of your home’s value. 

This allows you to escape the mortgage insurance premium (MIP) on an FHA loan or private mortgage insurance (PMI) on a conventional one. 

If your down payment was 10% or higher when you got an FHA loan, you must pay MIP for 11 years, regardless of your equity’s worth. But if your down payment was less than 10% (and most people’s are), you have to keep paying them for the entire length of your mortgage.

However, a conventional loan lets you stop making PMI payments when your equity grows to 20% of your home’s value. And, if you refinance to a conventional loan leaving 20% equity in place, you’ll never make them again.

This is huge. Even for a modest home, monthly mortgage insurance premiums can reach three figures, and for more costly properties, they can run to several hundred dollars — every single month.

Twenty percent may be a magic figure, but it’s one worth bearing in mind, even if you haven’t quite reached it yet. If you’re close and your equity is rising quickly or if it’s already up at 17%, 18%, or 19%, you might prefer to opt for a conventional loan even though you’ll have to pay PMI for a while. 

The alternative is to continue paying MIPs on your FHA loan and then face new refinancing closing costs when you get to 20% equity and switch to a conventional mortgage. Run the figures using our refinance calculator to see if swapping to a conventional loan makes financial sense.

Some caveats

We’re only comparing FHA and conventional loans here. You don’t pay mortgage insurance on a VA loan (after your initial funding fee), so there’s no equity advantage to refinancing one to a different mortgage.

Meanwhile, USDA loans have reduced-rate mortgage insurance. So, you need to check whether refinancing is worthwhile.

Finally, there’s no guarantee that home prices will continue to increase at their current rate — or at all. Yes, they have so far always risen over a long enough time, and we haven’t spotted any signs that they’re likely to fall anytime soon. 

However, periods when prices fall do happen occasionally, and that would slow or even reverse your equity-building process. So be aware of the risk, even if you think it’s probably slight.

You have an FHA loan and may be eligible for a streamline refi

On Sep. 7, 2024, we ran an article under the headline, “Mortgage Rates Just Dropped. Time To Fight Rampant Inflation With a Refinance?”

Its point was that mortgage rates had fallen so far in the previous six months that plenty of people who bought their homes after September 2022 could now financially benefit from refinancing. Check current rates to see if that still applies by the time you read this.

In other words, a refi could get them a lower mortgage rate and monthly payment than their existing one. This strategy could work for all types of mortgages, but it could be especially valuable for those eligible for an FHA streamline refi. 

An FHA streamline refi allows someone with an existing FHA loan to refinance with much less paperwork, hassle, delay, and expense. Often, the lender even skips the in-depth credit check, income verification, and appraisal.

But this isn’t an FHA cash-out refinance; the most you can add to your mortgage balance is $500.

There are some rules to this refi. Your existing loan can’t be more than 210 days old. You must be current on your mortgage and have a timely payment history, and you must gain a tangible benefit, typically a minimum 0.5% (50-basis-point) reduction in your mortgage rate.

Don’t forget to factor in the mortgage insurance benefits of a conventional loan if your equity level is approaching 20%. But, if yours is way lower, you might be able to begin to save money soon.

You currently have a conventional loan

Chances are, you’ll want to stick with a conventional mortgage if you already have one. Being able to stop paying private mortgage insurance premiums when you have 20% equity is a powerful reason not to trade yours in for an FHA loan. 

In other words, the answer to your “Should I refinance using FHA or conventional mortgages?” question is a bit of a no-brainer. 

However, there may be rare circumstances in which a switch would be smart. If you think you might be in such a situation, run the numbers.

The great thing about refinancing is that it’s all about saving or extracting money. The things that indicate the desirability of your choice always begin with dollar signs, though you should always view them in the context of your wider needs.

Your home’s value has dropped

According to CoreLogic, “Negative equity [when your mortgage balance is higher than your home’s value] peaked at 26% of mortgaged residential properties in the fourth quarter of 2009.” But it’s plummeted since then.

In the country as a whole, equity climbed 8% in the 12 months ending in the second quarter of 2024, adding $1.3 trillion to homeowners’ wealth. 

During that same quarter, in Louisiana, the worst-performing state for this, only 5.6% of homes still had negative equity. 

But, what if you’re one of the unlucky ones? Unfortunately, your refinancing options are severely limited. 

Indeed, your only way forward may be a streamline refinance, assuming you already have an FHA loan. Still, that could cut your rate and monthly savings, provided you’re eligible. 

Your credit score has dropped

A low credit score won’t necessarily stop you from refinancing. You’d probably need a sub-500 one to be shut out completely.

However, many lenders won’t touch people with low or subprime scores. So, it could take some work to track one down that will.

Those who will approve your application will likely demand eye-wateringly high mortgage rates and closing costs. Be ready to explain what caused your credit drop and what your financial problems were in the past.

The exception might be an FHA streamline refinance. Some lenders don’t do credit checks for those applicants. 

Should I refinance using FHA or conventional mortgages? Conclusions

If your finances are strong and your equity is close to or over 20%, a conventional loan is probably your better choice. You can either avoid mortgage insurance costs now or soon will be able to.

But, if your equity is nowhere near 20%, you might prefer to stick with your FHA loan. That’s especially attractive if you want an FHA streamline refi. But this might also apply if you need a cash-out refi.

The most important thing is to think this through, take professional advice from a lender, and run the numbers using different models. Of course, you can always get quotes from multiple lenders, so you can choose your best type of mortgage (and best overall deal) based on real-life scenarios.