When you explore mortgage options, you will likely hear about Federal Housing Administration and conventional loans. Let’s see, FHA loans are for first-time home buyers and conventional mortgages are for more established buyers – is that right?
In fact, the differences between FHA loans and conventional mortgages have declined in recent years. Since 1934, FHAn guaranteed loans have been a great option for first-time homebuyers because they come with low down payments and relaxed credit requirements.
But conventional loans – which aren’t insured by a government agency like the FHA, the Department of Veterans Affairs, or the US Department of Agriculture – have become more competitive in recent times.
Both types of loans have their advantages. Here are the factors to consider when deciding between an FHA mortgage and a conventional mortgage.
What type of property are you buying? You can use a conventional loan to buy a vacation home or investment property, as well as a primary residence.
The same cannot be said of FHA loans.
An FHA loan must be for a property that is occupied by at least one owner, as a primary residence, within 60 days of closing. Investment properties and homes that are returned (sold within 90 days of a previous sale) are not eligible for FHA loans.
The FHA ratings are also more stringent. Not only is the property assessed for its value, but it is carefully monitored for safety, soundness of construction, and compliance with local code restrictions.
Where you plan to buy your home can play a role in which type of loan is best for you. FHA guidelines and conventional loans give borrowers a lot of leeway in expensive areas, but in some cases you might need a jumbo loan, which is higher than FHA or conventional limits.
FHA loans are subject to county-level limits based on a percentage of a county’s median house price. In some high-cost areas, the limit in 2017 can be as high as $ 636,150 – and in Alaska, Guam, Hawaii, and the Virgin Islands, the limits can be much higher than that.
For loans guaranteed by Fannie Mae and Freddie Mac, the government-sponsored companies that help fund the conventional mortgage industry, single-family home loan limits are $ 424,100 in most countries. Again, higher loan limits are available in the more expensive counties.
You can find your county’s loan limits for FHA (listed on the link as “FHA forward”) and conventional mortgages (“Fannie / Freddie”) on the Website of the Ministry of Housing and Urbanism.
” MORE: Best Lenders For FHA Loans
This is where conventional loans have really improved. FHA loans were once the leader in low down payments, requiring only 3.5% down payment. But now Fannie Mae and Freddie Mac both have 97% loan products; that means a 3% down payment option – even lower than FHA – for qualified buyers.
From time to time, you may find lenders offering down payment options that are even lower than conventional loans. Quicken Loans, for example, offered a 1% loan.
Another example where the FHA and conventional standards converged: how bad credit is accounted for. Over the past few years, there have been many changes in policies regarding credit issues and the way they are handled for FHA and conventional loans, with new standards implemented – then expiring.
However, as it is now, for a buyer to qualify for an FHA or conventional loan, it typically takes two years from discharge from bankruptcy and three years from foreclosure or short sale. .
There will certainly be some hurdles to overcome to prove to a lender that you have restored your creditworthiness:
- You will need to document that the circumstances leading up to the financial setback were beyond your control
- You may need to take a credit education course
- Your loan will likely have to go through a manual loan approval process, which means approval and closing will likely take longer.
With a down payment of less than 20%, FHA and conventional loans require borrowers to pay mortgage insurance premiums. This insurance helps defray the costs of the lender in the event of a loan default.
There are differences between the two insurance programs.
With an FHA loan, if you put less than 10% down payment, you’ll pay 1.75% of the loan amount up front and make monthly mortgage insurance payments for the life of the loan. With a down payment of 10% or more (that is, a loan-to-value ratio of 90% or more), the premiums will end after 11 years.
Conventional loans with less than 20% down payment Private mortgage insurance. It can be billed as an upfront expense payable at closing, or built into your monthly payment – or both. It all depends on the insurer used by the lender.
“PMI rates vary based on two factors: credit score and loan-to-value ratio,” says Joe Parsons, loan manager at PFS Funding in Dublin, California. He gives the following examples:
- A borrower with a score of 620 with a loan-to-value ratio of 97% will pay 2.37%
- The same loan for a borrower with a score of 760 will cost 0.69%
- A borrower with a score of 620 and a loan-to-value ratio of 90% will pay 1.10%
- The same loan for a borrower with a score of 760 will cost 0.31%
The PMI can usually be canceled once your loan is paid off (and / or your property’s value appreciates) to 78% of your home’s value.
|Cost of the initial premium||1.75%||Depending on the insurer, there may or may not be an initial premium. You can also opt for a single premium payment instead of monthly payments.|
|Cost of monthly premium||The cost varies. Based on the length of the loan, the amount and the down payment. For purchase loans, the premium ranges from 0.45% to 1.05%, according to the FHA.||The cost varies. Based on credit score and loan-to-value ratio. For purchase loans, fees can range from 0.55% to 2.25%, according to Genworth and the Urban Institute.|
|Duration||With down payments of less than 10%, you’ll pay mortgage insurance for the life of the loan. With a loan-to-value ratio equal to or greater than 90%, you will pay premiums for 11 years.||It can usually be canceled once your loan balance reaches 78% of your home’s value.|
Credit score standards
Here is the main distinction between the two types of loans: FHA loans are easier to obtain. When it comes to a credit score, the FHA sets the bar low: a FICO of 500 or higher. Lenders can set “overlays” in addition to this credit score requirement, raising the minimum much higher.
But to qualify for the lowest 3.5% FHA down payment, you’ll need a credit score of 580 or higher, says Brian Sullivan, HUD public affairs specialist. With a credit score between 500 and 579, you will need to deposit 10% on an FHA loan, he adds.
The average FICO score for FHA purchase loans closed in 2016 was 686, according to mortgage industry software provider Ellie Mae.
Conventional loans generally require a FICO credit score of 620 or better, Parsons says.
“A borrower with this score who can document their income and assets will, in all likelihood, receive loan approval,” he says. “They will pay a higher price for this loan because of Fannie Mae and Freddie Mac’s ‘risk-based pricing’, but they are unlikely to be turned down because of their credit rating.”
Risk-based pricing involves compensating the lender for taking the additional risk on a borrower with a lower credit score (the average FICO score for a conventional loan was 753 in 2016, according to Ellie Mae). In other words, the lower your credit score, the higher your mortgage interest rate.
HUD’s Sullivan says your debt-to-income ratio – including the new mortgage, credit cards, student loans, or any other monthly obligation – must be 50% or less for an FHA loan. Ellie Mae reports that the average debt ratio of borrowers with FHA purchase loans in 2016 was 42%.
Conventional loans typically require a debt-to-income ratio of no more than 45%, Parsons says. In 2016, borrowers with conventional purchase loans had an average debt ratio of 34%, according to Ellie Mae.
Another distinction for FHA loans: generally lower mortgage interest rates. However, the difference between the two became more pronounced last year. The 30-year fixed rate for FHA purchase loans closed in 2016 averaged 3.95%, compared to a conventional same-term mortgage rate of 4.06%, according to Ellie Mae.
With respect to mortgage refinancing, the advantage goes to the “streamlined” refinancing of the FHA. With no credit check, no income check, and probably no home appraisal, it’s about as easy a refi as it gets. But there are five conditions for one FHA streamline refinancing.
So, which mortgage to choose?
Your decision may first be based on your credit score. If it is well below 620, an FHA loan may be your only choice. Above 620 and you’ll want to run the numbers on both to see what works best for you.
However, if you serve in the military or are a veteran, a VA guaranteed loan may be the way to go. VA loans generally do not require a deposit. And if you live in the suburbs or in a rural area, a USDA loan could also be a smart option.
FHA loans vs conventional loans
|Property type||Financing for a main residence only||Financing of a main residence, a secondary residence or an investment property|
|Advance payment||Down payments as low as 3.5%||Some programs offer down payments as low as 3% or even less|
|Mortgage insurance||Mortgage loan insurance premiums required: 1.75% initial and monthly premiums which vary depending on the length of your loan, the amount of the loan and the down payment, from 0.45% to 1.05%||With a down payment of less than 20%, private mortgage insurance is generally required. Monthly fees vary by credit score, loan-to-value ratio and insurer, and range from 0.55% to 2.25%.|
|Credit score||Usually a credit score of 500 or higher is required, although this depends on the lender. Average FICO score in 2016: 686.||Usually a credit score of 620 or higher is required, although this depends on the lender. Average FICO score in 2016: 753, according to Ellie Mae.|
|Rate of endettement||2016 average debt ratio: 42%||2016 average debt ratio: 34%|
|Interest rate||FHA loan interest rates tend to be slightly lower than conventional loans||Interest rates for conventional loans tend to be slightly higher than for FHA loans|