What Is the Difference Between FHA and Conventional Loans?
When shopping for a mortgage, one question is almost unavoidable: Should I apply for a Federal Housing Administration (FHA) or a conventional loan? The correct answer depends on a couple of things and varies by borrower. Let’s see if we can help you decide which is best for you.
FHA loans usually make sense for people with less of a down payment and lower credit scores. There are more fees involved, but greater flexibility in the underwriting guidelines and rates are typically lower than with conventional loans. Conventional loans are the popular choice for people with stronger credit scores and a larger down payment. The guidelines are tighter, but the monthly payments could be significantly lower because of several mitigating factors.
Here is why.
FHA loans, which were created in 1934 to increase home ownership during the Great Depression, offer more flexibility because they are insured by the government agency. FHA doesn’t lend the money, but it does guarantee the loan if you default. The loan is actually made by a private lending institution with FHA setting the underwriting parameters. A down payment of only 3.5% of the sales price is needed for these loans and the money can come as a “gift” from an outside source such as parents, close friends, employer or a charitable organization.
Conventional loans are made by private lenders then are bought by government-sponsored companies Fannie Mae and Freddie Mac. You need at least a 680-credit score and a 5% down payment in most of the time to make it worth considering. In most circumstances, lenders require you to have 5% of your funds before a gift can be used.
FHA loans are a bit pricier because of the required mortgage insurance. They require an upfront Mortgage Insurance Premium (MIP) calculated at 1.75% of the loan amount that is added to the loan, then a monthly premium based on 0.85% of the loan amount. One can argue that’s the cost of having a limited down payment and less-than-stellar credit. But if you are financing with a minimum down payment, you are required to keep this MIP payment for the life of the loan unless you refinance down the road.
One of the most attractive features of a conventional loan is Private Mortgage Insurance (PMI) rates that are scaled to the size of your down payment. You can eliminate PMI altogether if you can make a down payment of 20% or more of the sale price. There are also preset benchmarks that allow PMI to be canceled on conventional loans. If you are purchasing a home that you expect to live in for many years, this point should be heavily considered when determining which type of loan to apply for.
A major part of the underwriting process is a borrower’s debt-to-income ratios (the percentage of monthly income that is spent on housing, student loans, auto loans, credit card payments, other credit debt and child support). Lenders have some flexibility on these ratios when there are strong compensating factors such as plenty of reserves left in the bank after the transaction or very high credit scores. Generally speaking though, FHA’s guidelines are more forgiving on this than conventional rules. Therefore, if your total payments will require a huge part of your income, an FHA loan may be your best option.
Getting the borrower(s) approved is only half the formula for a successful transaction. The house you are purchasing must also be approved. This is done via an appraisal report that the lender will order on your behalf. While both FHA and conventional guidelines have strict standards for the property, FHA’s appraisal process is considered tougher than conventional. By theory, this is an advantage to you as the buyer. However, if you are intending to purchase a home “as is” that needs some TLC, you may find it more difficult to get the financing done via FHA.
Keep in mind both FHA and conventional loans have a maximum loan size that varies per county. Conventional loan maximums can be higher than FHA, but it’s important to research limits for your area or speak to your mortgage consultant for details.
If you have had financial issues recently, FHA may be your only choice as the wait times for a new loan are more forgiving. In general, 3 years must pass following a foreclosure or short sale while the wait after a Chapter 7 bankruptcy is 2 years. Conventional loans require 4 years waiting period for both situations in most circumstances.
In short, it’s important to understand the characteristics of both FHA and conventional loans. If you have credit scores below 680 and lack a good-sized down payment, FHA is likely the best way to go. On the other hand, there are advantages to going conventional if you can do so. Discussing your options with your mortgage professional before starting the house hunt will help you make the best decision and allow the process run more smoothly.