Buying your first home can be as overwhelming as it is exciting.
There are so many different things to check out, fill out and research that choosing your mortgage provider often gets left until the last minute.
Use this quick guide to figure out what kind of loan works best for you.
FHA vs Conventional Loans: The Basics
The biggest difference between conventional and FHA loans is the backing of the federal government. An FHA loan is effectively a traditional mortgage insured by the Federal Housing Authority (FHA).
The FHA is a unit of the U.S. government that helps lower- and middle-class Americans purchase a home. They do not issue loans themselves. Instead, they certify private lenders to offer loans under the terms they specify.
These loans are backed against default by the U.S. government. This lets lenders offer loans to people they otherwise would consider too likely to default.
FHA loans have lower creditworthiness, down payment and income requirements than do conventional loans. We’ll go more into detail on these points below.
The most obvious difference between an FHA loan and a traditional mortgage is the lower down payment required. Most conventional lenders prefer a buyer to have a 20% down payment. FHA loans require only 3.5%.
It is possible to get a conventional loan with a lower down payment but there is a hard cap at 5%. You will also have to add private mortgage insurance (PMI) to your monthly payment.
The down payment requirements are the main reason FHA loans are so popular. They significantly lower the entry requirements for home ownership and make it much easier to save up a down payment.
FHA loans have less stringent requirements about where your down payment comes from. Traditional lenders often require that at least part of your down payment come from savings. The entire amount of your FHA down payment can be a gift or other windfall.
FHA loans have much more lenient credit requirements than do conventional mortgages. People with a credit score as low as 500 can still qualify for an FHA loan.
The whole point of the FHA program is to allow people otherwise unable to secure financing to purchase a house. Traditional loans usually require at least a 620 credit score.
There are other credit-related benefits to an FHA loan over a conventional one. You may qualify for an FHA loan as little as two years after filing for chapter 7 bankruptcy.
Combined, these lenient credit requirements give people a chance to rebuild their lives after a financial breakdown.
Mortgage insurance reimburses your lender for a part of your mortgage amount if you default on your loan. All FHA loans and any conventional loan with a down payment below 20% require mortgage insurance.
For FHA mortgages there are two insurance payments. When you originate your loan you make a lump sum payment equal to about 1.75% of the loan value. Then you must pay a monthly insurance premium of about .45% to 1.05%.
You can sometimes roll your initial insurance payment into your monthly premium. The downside, of course, is that you pay more each month.
It is much more difficult to remove FHA insurance. The insurance effectively is the loan program. If you put at least 10% down on your loan it will naturally be removed after 11 years.
The only way to get rid of insurance payments on an FHA loan early is to refinance. You would need to increase your equity in the home to at least 20%. This can happen because of appreciating home values or additional payments on your mortgage.
Conventional loans require PMI whenever your down payment is lower than 20%. This is comparable to the monthly FHA loan insurance at about .5 to 1% of the value of the loan.
PMI can be eliminated as soon as your equity in the loan equals at least 20%. If your home appreciates in value during your first year or so of ownership you can often refinance out of PMI.
The interest rate of your mortgage has a huge impact on how much money you will pay over time. FHA loans have a slight advantage over traditional mortgages in interest rates.
This especially applies to people who would only marginally qualify for a traditional loan. In this case, their interest rate would be on the high end of the market rate. Under the FHA program, they could save as much as a percentage point in interest.
If your credit score is below the 620 required by most conventional lenders you will have a higher interest rate on your FHA loan. It is important to remember though that most interest rate gains will be offset by the initial mortgage insurance payment and monthly rate.
FHA or Conventional
The choice between an FHA or conventional loan really comes down to your financial situation.
Conventional mortgages work best for people with good to great credit and the ability to make a large down payment. If you can do this you’ll save money on fees and mortgage insurance.
Even if you can’t make 20% down payment PMI will often be cheaper and easier to refinance out of than FHA insurance. If you’re purchasing a second home or an investment property you will have to use a conventional loan.
If you don’t meet one or more of the above criteria then an FHA loan can be a great way to realize your dream of homeownership. You can stop paying rent and begin putting your monthly housing money into equity on a home.
Take the First Step
If you aren’t sure if you qualify for a conventional mortgage an FHA loan can be to your advantage. Get your financials in order, do what you can to build your credit score and then contact a high-quality lender. When choosing FHA vs conventional loans you need to know exactly what works best for you.
To learn more about different mortgage options and begin your journey to homeownership contact us today.