FHA vs. conventional loans in plain language

Potential buyers with poor credit, low income, or little savings for a down payment may find it difficult to find a home loan. For these borrowers, an FHA insured loan might be a good option. Here’s what you need to know if you’re wondering if a conventional or FHA mortgage is the best solution.

What is an FHA loan?

The FHA insurance program offers many potential homeowners a way to make the dream of owning a home come true that they might not otherwise have been able to.

An FHA loan is a mortgage issued by a bank or federally approved financial institution that, unlike a conventional mortgage, is insured by the Federal Housing Administration. This mortgage insurance provides the security qualified lenders need to take out a riskier loan.

But that security comes at a cost to the buyer: With FHA loans, the buyer must pay an initial mortgage insurance premium of 1.75% at closing, regardless of the down payment. Then the buyer should do monthly mortgage insurance payments for the life of the FHA loan if the down payment is less than 10%. It can be canceled after 11 years if the deposit is 10% or more.

According to the agency’s website, the FHA has insured more than 47.5 million properties since the program’s inception in 1934, making it the largest mortgage insurer in the world.

Comparison of the FHA with conventional mortgages

There are several key differences between FHA and conventional loans. Each has its advantages and disadvantages. Here’s a quick comparison:

Conventional mortgages FHA loans

Minimum FICO credit score

Usually not less than 620

Usually as low as 580

Minimum deposit

As low as 3%, but 5% to 20% is typical As low as 3.5%

Mortgage insurance

Monthly payments are required if your down payment is less than 20%, but generally insurance can be canceled when your loan-to-value ratio reaches 80%.

Upfront and monthly payments, sometimes for the duration of the mortgage term, are required.

Your FICO credit score, which is the most used score by lenders, generally must be at least 580 to qualify for an FHA loan. If your score is between 500 and 579, you must bring a deposit of at least 10%. Conventional loans generally require that you have a FICO credit score of at least 620 to qualify, and a higher credit score is required to qualify for the best interest rates.

You can get an FHA loan with a down payment as low as 3.5%. While some conventional mortgages have a down payment requirement as low as 3%, most typically require a 5-20% down payment, depending on the Consumer Financial Protection Bureau.

No mortgage insurance is required on a conventional loan with a down payment of at least 20%. If your down payment is less than 20%, you will need to pay for private mortgage insurance, or PMI. Once your loan-to-value ratio (the amount left on the mortgage divided by the appraised value of the property) reaches 80%, the PMI requirement will go away, as will the need to pay that monthly cost. This does not happen automatically: you will have to ask your lender to remove the PMI payment.

In contrast, FHA loans require an initial mortgage insurance premium and monthly mortgage insurance payments.

You can usually qualify for an FHA loan with a less favorable debt-to-income ratio, known as DTI. Your DTI is calculated by taking the amount you pay each month for debt and dividing it by your monthly gross income. Your debts can include a car, rent, mortgage, student loan payments, installment debt, and child support payments, as well as minimum monthly payments on credit cards. The lower your DTI, of course, the better.

Conventional loans can be used to purchase a vacation home, investment property, or primary residence. FHA loans are limited to owner-occupied properties, which can include multi-unit properties as long as you live in at least one of the units.

Conventional mortgages generally present fewer barriers in terms of processing and inspections. For example, the FHA has minimum property standards, and if the property does not meet them, the seller or buyer may have to pay for repairs before they can qualify for a mortgage. This can include making sure that any chipping paint in the property is dealt with. Who pays for repairs can be a matter of negotiation between buyer and seller.

“While FHA loans can be beneficial for some home purchases, some sellers don’t want to deal with the bureaucracy associated with FHA buyers,” says Christopher Clepp, financial advisor in the Chicago office of Strategic Financial Group. In a competitive bidding situation where sellers have many offers to choose from, this can put the buyer at a disadvantage.

It is a common misconception that FHA loans are only for low income borrowers with credit problems. However, one aspect of the FHA program that might deter a higher income borrower is its loan limits, which are, in many cases, lower than those of conventional mortgages.

For 2021, you can take out an FHA home loan in a low-cost area for less than $ 360,000. In an expensive area, the FHA loan limit is around $ 822,000, according to the US Department of Housing and Urban Development. The limits vary depending on your location. There are special exceptions for the FHA and Conventional loan limits for Alaska, Hawaii, Guam, and the US Virgin Islands, which have a per unit limit of over $ 1 million.

For example, in a low-cost zone, the loan limits are:

FHA Conventional

1 unit

$ 356,362

$ 548,250

2 unit

$ 456,275

$ 702,000

3 unit

$ 551,500

$ 848,500

4 units

$ 685,400

$ 1,054,500

In a high cost real estate market like San Francisco or the District of Columbia, the limits are:

FHA Conventional

1 unit

$ 822,375

$ 822,375

2 unit

$ 1,053,000

$ 1,053,000

3 unit

$ 1,272,750

$ 1,272,750

4 units

$ 1,581,750

$ 1,581,750

Choosing the right type of loan for you

Consider these factors when deciding between an FHA loan or a conventional mortgage:

Your FICO score and credit history

“An FHA loan is a great option for those with poor credit,” says Casey Fleming, mortgage advisor at C2 Financial Corp. and author of “The Loan Guide: How to Get the Best Possible Mortgage. “

Indeed, for those with a particularly low credit rating, an FHA loan might be your only option. You may also decide to postpone buying a home and work on build your credit instead of.

The down payment you can afford

If you don’t have the money for a big down payment, an FHA home loan might be your best option. FHA loans require a down payment of at least 3.5%. Some lenders offer conventional loans with down payments as low as 3%, but most require a 5-20% down payment.

How long do you plan to own the house

On an FHA loan, monthly mortgage insurance premiums will stay in place for at least 11 years. A conventional loan usually has no initial premium and allows the borrower to ask the lender to waive the monthly premium when the loan-to-value ratio reaches 80%.

If you plan to deposit less than 20% and expect to stay in the house for a short time, the monthly FHA mortgage insurance premium may not matter much. However, if you plan to own the home for at least 11 years, you will pay the monthly premium for the full 11 years, even if your loan-to-value ratio improves. In the future, you may be able to refinance a conventional mortgage without mortgage insurance requirements, if your financial situation permits.

When determining which loan is the best for you, consider the initial closing costs, mortgage insurance required, and other fees that may accompany the mortgage. These types of costs can turn a mortgage with a lower interest rate into an unattractive option.

The APR, or annual percentage rate, is the annual cost of obtaining your loan and includes not only the interest rate shown, but also any other fees that you will pay during the life of the loan. Comparing loan APRs is a good way to assess their overall costs.

Fleming cautions: “FHA loans may be a more expensive option after factoring in mortgage insurance due at closing and monthly mortgage insurance premiums, even if the interest rate quoted is lower than that of mortgage insurance. ‘a conventional alternative. ”

Consider using a mortgage broker

While you can certainly assess mortgage options on your own, it may be a good idea to hire a knowledgeable professional, such as a mortgage broker.

Ask friends, family and coworkers to recommend someone you trust and who will put your needs first. When you are evaluating brokers it is also a good idea to check their experience, professional affiliations, and of course, if they have had any significant complaints against them. Make sure the broker is familiar with all types of loan programs covering conventional, FHA, and VA programs whether you are a veteran or active duty military service member. Often the broker’s fees can be paid by the lender or the borrower.

And make sure you are prepared when you meet the broker. Dan Green, longtime mortgage professional and founder of mortgage education site Growella, suggests, “Before you apply for a mortgage, consider the characteristics of your loan (like your credit and how much down payment you have. you plan to do) and what you are trying to accomplish. Then ask your mortgage advisor, “Where am I going to get the best combination of rate and price?” “

About Joan Dow

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