FHA vs Conventional Loans
- Jun. 8, 2019
- Nicole Johnson
- Home Loans
FHA vs Conventional Loan Types: Which is Right for Me?
In general, an FHA loan allows for lower credit scores and can be easier to qualify for. On the other hand, conventional loans may not require mortgage insurance with a large enough down payment. So in the end, the benefit of one over the other comes down to the individual needs of the borrower.
Let's take a look at both mortgage types to help you decide what's right for you.
FHA or a Conventional Loan: What's the difference?
What type of loan is right for me? My neighbor refinanced with an FHA loan, should I get that type of loan, too?
If you are a 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 types of loans, their benefits and their drawbacks.
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 loan for Joe, here's why:
An FHA loan offers more flexible credit qualifying guidelines than other loan types. This is due to the fact that the Federal Housing Administration (FHA) insures this type of loan. The FHA does not lend the money, rather they guarantee the loan. Since the government is backing the loan, a lender is able to offer a competitive interest rate, which can save borrowers money.
The requirements necessary for obtaining an FHA loan are relatively simple. Joe does not need to be worried about having the perfect credit score due to late payments, foreclosures, bankruptcies, tax liens, or legal judgments, in order to get an FHA loan. Currently, FHA guidelines state you only need a 580 credit score to qualify for maximum financing on an FHA loan, where a conventional loan will require at least a 620 credit score. However, this number may vary from lender to lender.
FHA Loan Benefits at a Glance
One of, if not the biggest advantage to an FHA loan is that only a 3.5% down payment is required for home loan purchase. This number is a lot smaller than other conventional types which will ask for anywhere from 5-20% of the loan.
It should also be noted that combining the FHA loan with a down payment assistance program could potentially mean only needing to put 0.5% down.
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” him the down payment.
Further, if you prepay your mortgage before a certain amount of time, many lenders will charge a prepayment penalty, but with an FHA loan there is no penalty for prepayment.
What is a debt-to-income ratio?
A person’s debt-to-income (DTI) ratio is the percentage of their gross monthly income spent to cover debts such as a mortgage, student loans, car loans, credit cards, etc. Lenders take your DTI into consideration because it’s often a strong indicator of how likely you are to have a hard time paying your bills.
To qualify for an FHA loan, you cannot spend more than half of your gross income on debt; that is, a DTI of 50% or more. In some cases, a person may qualify with such a DTI. In general, however, lenders will want to see your debt-to-income ratio be no greater than 43%.
“What is mortgage insurance and do I pay it with an FHA loan?”
While there are many upsides to an FHA loan, a big downside to the FHA loan is the Upfront Mortgage Insurance Premium (UFMIP). This is collected at loan closing but may also be financed into the loan amount.
FHA loans also require payment of monthly mortgage insurance premium (MIP) to protect the lender in case of default. In most cases MIP stays on for the life of the loan unless you put 10% down, then it’s a minimum of 11 years.
You can also get rid of your monthly mortgage insurance if you refinance your FHA to a conventional loan.
With an FHA mortgage, you will pay the same insurance premium regardless of your credit score. Conventional loans ask you to pay mortgage insurance each month if you put down less than 20%, but this premium may be less than with an FHA loan if you have a credit score over 720.
With an FHA loan, the borrower ends up paying more over the life of loan.
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.
A conventional loan, or conventional mortgage, is not backed by any government body like the FHA, the US Department of Veteran’s Affairs (or VA), or the USDA Rural Housing Service.
Roughly two-thirds of US homeowners’ loans are conventional mortgages, while nearly three in four new home sales were secured by conventional loans in the first quarter of 2018, according to Investopedia.
Sometimes conventional loans are mistakenly referred to as conforming mortgages, which is a separate type of loan which meets the same criteria for funding from Fannie Mae and Freddie Mac, but although conforming loans are technically conventional loans, the reverse is not always true. For example, an $800,000 jumbo mortgage is a conventional mortgage, since it does not qualify as a conforming mortgage because it exceeds the maximum loan amount Fannie Mae and Freddie Mac guidelines will permit.
2 Types of Conventional Loans
Let’s outline these 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, (shorthand for the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, respectively). 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 certain criteria such as:
- The maximum loan amount
- Borrower income
- Credit standards
- 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 have higher interest rates than regular conforming loans.
What do I need to qualify for a conventional loan?
You will need to complete a mortgage loan application and, along with paying applicable fees, have a credit report run that examines your credit history and provides a credit score, and also provide supporting documentation.
Such documentation can include:
- Proof of income such as pay stubs, two years of federal tax returns, two years of W-2 statements, etc.
- Asset accounting of bank statements and investments to establish that you can pay the down payment and closing costs.
- Employment verification demonstrating you have a stable work history to encourage lenders to work with you.
- Miscellaneous documents including your driver’s license or state identification card and your Social Security number
Conventional loans give the borrower more flexibility when it comes to loan amounts while an FHA loan caps out at $314,827 for a single family unit in most lower cost areas and $726,525 in most high cost areas.
Conventional loans often do not come with the amount of provisions that FHA loans do. They also 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, this 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, a conventional loan or FHA 203k loans could be an option.
Lastly, if you have a credit score over 720, a conventional loan will be more beneficial to you since you may end up receiving a better rate on a conventional than an FHA loan.
Kate wants to get the best interest rate possible, so she will likely get a better rate with a conventional loan because her credit score is above 720.
In sum, an FHA loan is more flexible to obtain, but no matter how large your down payment, you will have to pay mortgage insurance. A Conventional loan requires a higher credit score and more money down, but does not have as many provisions.
Use our mortgage payment calculator to estimate how much your mortgage payments might be.
FHA Streamline Refinancing
An FHA loan can even be used to refinance your home, even if you have less than perfect credit. FHA Streamline Refinance Loans traditionally require less documentation than a traditional loan, and do not require an appraisal.
FHA Streamline Refinance Loan Types
- FHA Streamline 30 Year Fixed Rate Refinance Loan: Designed to either lower your payment on your current FHA loan by lowering your current interest rate, or to convert an FHA Adjustable Rate Mortgage into a fixed rate mortgage. The FHA Streamline refinance loans require less documentation than a traditional loan, and there is no appraisal required. Generally, this loan is easy to apply for and does not require qualifying debt ratios or income verification.
- FHA 203k Streamline 30 Year Fixed Rate Refinance Loan: The FHA 203k allows borrowers to pull out up to $35,000 in equity to pay for home improvements or renovations.
- FHA Streamline 5/1 Adjustable Rate Refinance Mortgage: The FHA 5/1 ARM establishes low initial interest rate for the first five years; after that, your interest rates will fluctuate depending on market interest rates. Adjustable Rate Mortgages typically have the lowest rates and may be useful if you plan on selling your home in the near future.
FHA Fixed Rate Mortgages
- FHA 30 Year Fixed Rate Loan: A fixed rate loan that generally requires a small down payment. This loan may be obtained by buyers with low credit scores.
- FHA 15 Year Fixed Rate Loan: Similar to the 30 Year Fixed Rate Loan, it offers the benefits of a stable monthly mortgage payment, except that the interest you pay over the life of the loan is significantly less because the loan is expected to be paid in half the time.
- FHA 203k 30 Year Fixed Rate Loan: The 203k loan program provides borrowers special financing to buy a fixer-upper with enough extra money to complete necessary renovations.