FHA vs. Conventional: Choosing the Right Loan for You
- posted 1.26.2012
- Susan Malcolm
- Home Loans
What loan is right for me? My neighbor refinanced with an FHA loan, should I get that type of loan too? If you are first time home buyer or looking to refinance, you are probably asking yourself these kinds of questions. Different situations require different types of loans. In this blog, we will take a look at FHA and Conventional loans. Using examples, this blog will give you a better understanding of these two loans, their benefits and their drawbacks.
Joe the Gnome Collector: FHA Is the Way
Joe has a low credit score due to his obsession with garden gnomes. He maxed out many credit cards buying garden gnomes, and traveling to see different gnomes throughout the world. Joe now needs a house (and garden) to put all his gnomes. His parents offered to help him with the down payment, but he is still not sure how he will be approved for a loan. An FHA loan may be the perfect for Joe. Let’s check out why.
An FHA loan offers easier credit qualifying guidelines than a Conventional Loan. This is due to the fact that the Federal Housing Administration(FHA) insures this type of loan. The FHA does not lend the money, they guarantee the loan. Therefore the lender doesn’t take a financial risk by extending credit to a borrower-like Joe. Due to the fact that the government is backing the loan, a lender is able to offer a competitive interest rate. A low interest rate can really help save the borrower a lot of money. Maybe Joe can buy some more gnomes with the money he saves!
The requirements necessary for obtaining an FHA loan are relatively simple. Joe does not need to be worried about having the perfect credit score to get an FHA loan. Currently, FHA guidelines state you only need a 500 credit score to qualify for an FHA loan, where a conventional loan will require at least 640. However, this number may vary from lender to lender.
Another advantage to an FHA loan is that only a 3.5% down payment is required for approval. This number is lot smaller than other loan types which will ask for anywhere from 5-20% of the loan. In addition, the down payment does not necessarily have to come from the borrower’s pocket. The money is allowed to come from a family member, employer or charitable organization as a gift. In Joe’s case, his parents can “gift” Joe the down payment.
A big downside to the FHA loan is the Mortgage Insurance Premium. It is required, regardless of how much money you put down, for the first 5 years of the loan. It is collected at loan closing in addition to an annual premium collected in monthly installments. The borrower ends up paying about 1% of the loan amount at closing, and then .25% annually for the duration of the loan term.
Kate: Conventional Is the New Pink
Kate has a very high credit score. She wants to buy a home and has saved enough to make a down payment of 20%. Kate has decided to settle in Beverly Hills, her dream home is a bit pricey so she will need a large loan. A Conventional loan is likely the right choice for Kate.
There are two types of Conventional loans: conforming and non-conforming. Conforming loans have terms and conditions that comply with guidelines dictated by Fannie Mae and Freddie Mac. These two companies purchase mortgage loans from lenders then package them into securities and sell them to investors. Fannie Mae and Freddie Mac guidelines establish the maximum loan amount, borrower income, credit standards and the down payment necessary to get a home loan.
Loans that are above the maximum loan amount set forth by Fannie Mae and Freddie Mac guidelines are called non-conforming loans, and are also known as Jumbo loans. These loans are distributed on a smaller scale and therefore have higher interest rates than regular conforming loans.
Conventional loans give the borrower more flexibility when it comes to loan amounts while an FHA loan caps out at $271,000 in most areas. Since Kate’s dream home is in Beverly Hills, her loan amount will most likely be above the FHA loan cap, so a Conventional loan is her only choice.
Conventional loans often do not come with the amount of provisions that FHA loans do. Conventional loans do not require mortgage insurance if the loan to value is less than 80%-in other words, if the borrower can make a down payment of 20%. Because Kate has saved enough to put 20% down, a Conventional loan will be a better option because she will not have to pay for mortgage insurance. In addition, if the property you are buying is more of a fixer-upper, the Conventional loan is the only option. The appraisal requirements to get an FHA loan are extremely severe, making it nearly impossible to buy a fixer-upper with an FHA loan. Lastly, if you have a credit score over 720, a Conventional loan will be more beneficial to you. You will end up receiving a better rate on a Conventional than an FHA loan. Kate wants to get the best interest rate possible. She will likely get a better rate with a Conventional loan because her credit score is above 720.
In closing, an FHA loan is easier to obtain, but no matter what you have to pay mortgage insurance. A Conventional loan requires a higher credit score and more money down, but does not have as many provisions.