FHA vs Conventional Loan Types
Let’s take a look at both mortgage types to help you decide what’s right for you.
FHA or a Conventional Loan: Which is Better?
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 the Gnome Collector: FHA Loan Benefits
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. FHA does not lend the money, rather they guarantee the loan. 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 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.
Another 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 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 Upfront Mortgage Insurance Premium (UFMIP). This is collected at loan closing but may also be financed into the loan amount. In addition, FHA loans also require payment of monthly mortgage insurance premium (MIP). 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. With FHA, the borrower ends up paying more over the life of loan.
Kate: A Conventional Loan Is the Easy Choice
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.
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
There are two types of these 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 the following facets:
- 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 an official mortgage application, along with paying applicable fees, have a credit report run that examines your creditor history and provides a credit score, and 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 lower cost areas, $726,525 in 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.
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, this type of loan will be more beneficial to you. You may 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 more flexible to obtain, but no matter what 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. You can use our mortgage payment calculator to estimate how much your payments might be.