Mortgages Explained: Is FHA or USDA Rural Housing the Better Loan?

by Mortgage Nerd on April 14, 2011 · 13 comments

In this article I will be comparing two of the most popular loan programs for first time home buyers, FHA and USDA Rural Housing. I don’t think that one program is inherently better than the other but they do offer unique advantages, depending on your situation. Because of this, it is imperative that you understand what these advantages are.

Which program will provide a lower interest rate?
Advantage: Neither

Both programs are considered by lenders to be government programs and the interest rates should be the same. Be very wary of lenders that tell you otherwise.

Which program will provide a lower mortgage payment? Advantage: USDA

The biggest advantage that USDA has over FHA is that it doesn’t charge an annual mortgage insurance premium. As of 4/18/11, FHA charges an annual mortgage insurance premium of 1.15%. On a $200,000 loan that comes out to $191.67 per month!

Which program will have fewer closing costs?
Advantage: FHA

FHA does charge an upfront mortgage insurance premium of 1% which gets rolled into the loan but this is minimal compared to USDA’s 3.5% upfront funding fee. On a loan amount of $200,000, USDA will have closing costs that are $5,000 higher than FHA, because of their 3.5% upfront funding fee. You don’t have to pay for it out of pocket because it gets financed as part of your home purchase.

Besides the USDA funding fee of 3.5%, every other closing cost (e.g. origination fees, appraisal, underwriting, processing fees) shouldn’t be any different than those of the FHA loan, assuming you get a quote from the same lender.

Which loan program is easier to qualify for?
Advantage: FHA

With regards to credit scores, FHA does not have a minimum credit score requirement like USDA, which is 620. However, I should say that most lenders doing FHA loans will want a credit score of at least 620 although there are some that will go down to 580.

Also, in my experience FHA is more lenient with debt to income ratios. I have seen some lenders approve FHA loans up to a debt to income ratio of 55%. This can be beneficial for those borrowers whose DTI ratios are high because they have some income that they can’t use on a loan application (e.g. part-time, self employed income without a 2 year history). USDA is pretty strict about limiting borrowers to a DTI of 41%. I have seen them go as high as 45% but they will require some compensating factors such as excellent credit scores or 6 months worth of mortgage payments in the bank.

Which program will result in more equity after 5 years?
Advantage: USDA Rural Housing

To make this comparison we have to make a couple of assumptions…

First Assumption:  Let’s assume that you put 3.5% down with both programs. On a purchase price of $200,000, your FHA loan amount will be $194,930 ($193,000 + 1% upfront mortgage insurance). On the USDA loan your loan amount will be $200,000 because your entire 3.5% goes towards their 3.5% funding fee.

Second Assumption: Let’s assume that you make the same mortgage payment. On the FHA loan at 5.0%  your mortgage payment will be $1,232. On the USDA loan your mortgage payment would be $1,073. This means that on the USDA loan, you get to apply an extra $158.36 to the principal each month.

After 5 years: With the FHA loan your principal balance will be $179,001 after 5 years. With the USDA loan paying that extra $158.36 towards the principal each month will result in a principal balance of $172,888.02 after 5 years. If you sell your home at that time, you will have made $6,113 more dollars with the USDA loan.

Please note: 5 years is a good time to compare because that is the minimum # of years that FHA requires you to pay the mortgage insurance premiums.

Conclusion

If you do the principal balance comparison after a 2 year time frame you will get the same principal balance with both loan programs. You could say that if you plan on owning the home for less than 2 years that the FHA loan has the advantage. However, if you are only planning on being in the home for 2 years, you may want to rethink home ownership.

In my experience as a loan officer, if a borrower qualifies for both FHA and USDA, the USDA loan almost always makes the most sense for that borrower’s situation, for the simple fact that it offers a lower monthly payment and an opportunity to build more equity over the long term. There are those times when a borrower wants an adjustable rate mortgage, or a 15 year loan term and in those cases FHA or Conventional is the only option as USDA only offers a 30 year mortgage. There are also times when a borrower is buying a home as a short term investment (less than 2 years), and in that case a USDA almost never makes sense.

There are other advantages for both of these loan programs that I didn’t discuss in this article (e.g. FHA loans are assumable) and so you will want to discuss each of these loan programs in depth with your loan officer.

13 comments on “Mortgages Explained: Is FHA or USDA Rural Housing the Better Loan?

  1. Pingback: Cache Valley Mortgage: The USDA Rural Housing Mortgage | Cache Valley Mortgage

  2. Andrew on said:

    My wife and I are looking to be first time buyers in a one road town and have alot of questions about which is better USDA or FHA, this was very informative for us.

    • John Neil on said:

      Thanks for the feedback Andrew! Again I think it all comes down to how long you are going to have that mortgage for. If it is longer than 2 years, USDA should always win in my book, especially if the interest rates are the same, which they should be! If not, find a different lender.

  3. My wife and I sold our house that we were in for nearly 3 years. It was through USDA. My broker/ lender has told me that I get back pro-rated PMI. According to what I see, USDA charges a flat fee of 3.5%, nothing refundable. Did it use to be different? He swears that he personally has seen pmi refunds on USDA. Maybe he is confused between FHA and USDA past loans. Regradless. The amount was fee/ or pmi was $3500 upfront. By his calculations, I should get back around $2200. Is this right?

    • Mortgage Nerd on said:

      The USDA fee was recently raised from 2% to 3.5%. However, as of October 1st it is going back down to 2% but they will also start charging an annual mortgage insurance premium of .3%. I have never seen anybody get a refund for the USDA upfront fee when they sell or refinance. I think your mortgage broker may be thinking of FHA where you would get a refund of the upfront mortgage insurance. Hope it worked out!

  4. Are the interest rates fixed for both of these?

  5. So you can no longer role your closing costs into your mortgage payments with the USDA loan? This has to be out-of-pocket or a gift?

    • Mortgage Nerd on said:

      To my knowledge you could never roll in closing costs with the USDA loan on a purchase transaction. The closing costs must come from out of pocket.

  6. Lindsay on said:

    Thank you for all the helpful information. We are currently approved for both the USDA and the FHA loan. The problem we are having is that seller’s (and my real estate agent) seem to have a negative feeling about using the USDA loan. She is very reluctant to use it for presenting offers and I can’t quite figure out why. The information we have received from her indicates that since we are not putting money down with the USDA loan, that if there are other offers to be considered, they will be chosen over ours. So, basically, the information we are “hearing” is that if we want to even consider using our USDA rural housing loan, we need to buy a house that has been on the market for a long time, and that has no competetition. Can you help clarify this for me? thank you!!!

    • Mortgage Nerd on said:

      Hmmm…It’s possible that your Realtor has had a bad experience with the USDA loan in the past. Also, it is possible that their may be a stigma associated with 100% financing programs in that it’s more likely the financing will fall through at the last minute. The Rural Housing loan does have to go through two approval processes, one being the lender’s underwriter, and the other being USDA itself. However, in my experience the USDA loan is just as reliable as the FHA loan and any stigmas are unfounded.

  7. Pingback: Rural Housing Financing in Cache Valley, Utah

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