What Is An FHA Loan?
An FHA loan is a home loan backed by the Federal Housing Administration, a government agency created to help home buyers qualify for a mortgage. The FHA provides mortgage insurance on loans made by FHA-approved lenders, protecting them from the risk of borrower default.
What Is A Conventional Loan?
Conventional loans are the most common in the mortgage industry. They’re funded by private financial lenders and then sold to government-sponsored enterprises like Fannie Mae and Freddie Mac. This is the most common/popular type of residential mortgage loan in the United States.
Comparing FHA vs. Conventional loans
An FHA loan allows for lower credit scores and can be easier to qualify for than a conventional loan. However, conventional loans have their own upsides. Ultimately, the benefits of FHA vs Conventional loans comes down to the individual needs of the borrower.
Minimum Down Payment
FHA loans require a minimum down payment of 3.5% for borrowers. Many people think of FHA loans as a first time home buyer loan because of the loan but you do not have to be a first time homebuyer to qualify.
Some conventional mortgages allow a 3% minimum down payment, but it’s reserved for first time home buyers or someone who has not owned a home in the last 3 years. If you are not a first time home buyer (or have owned a home in the last 3 years), the minimum down payment is 5%.
Credit Scores
FHA loans are easier to qualify for, with a minimum credit score of 580 to be eligible to make a 3.5 percent down payment.
Conventional loans typically require a credit score of 620 or higher; a lower credit score often comes with a higher interest rate for a conventional loan.
Debt-to-Income Ratios
The debt-to-income ratio, or DTI, is the percentage of monthly pretax income spent to pay debts, including mortgage, student loans, auto loans, child support and minimum credit card payments. To qualify for an FHA loan, the borrower’s debt-to-income ratio must be 50% or less.
Conventional loans allow debt-to-income ratios up to 50% in some cases, too. Even though lenders allow debt-to-income ratios that high, approval is more likely for mortgage borrowers with a DTI of 45% or less.
Loan Limits
Both Conventional and FHA loans limit the amount you can borrow, and the maximum loan sizes vary by county. Regulators typically change the loan limits annually. The 2021 FHA loan limit is $356,362 in low-cost areas, and $822,375 in high cost markets. You can look up your FHA county loan limit with this link: https://entp.hud.gov/idapp/html/hicostlook.cfm
Conventional loans are subject to the conforming loan limit set by the Federal Housing Finance Agency. For 2021, that limit is $548,250. High cost counties have a high balance loan limit as much as $822,375. Once a loan exceeds a county’s loan limit, it is considered a Jumbo Loan. Underwriting standards differ between conventional and jumbo loans so it is important to be aware of your county limits and plan your home buying accordingly.
Property Standards
The property’s condition and intended use are important factors when comparing FHA vs. Conventional loans. FHA appraisals are more stringent than Conventional appraisals. Not only is the property’s value assessed, but it is also thoroughly vetted for safety, soundness of construction and adherence to local code restrictions.
With an FHA loan, the borrower must live in the house as their primary home. Investment properties and homes that are being flipped (sold within 90 days of a prior sale) aren’t eligible for FHA loans.
On the other hand, Conventional loans may be used to buy a primary residence, second home, as well as investment property.
Interest Rates
Mortgage rates will largely depend upon the factors discussed above, as well as a choice between an adjustable rate mortgage (ARM) or a fixed-rate one.
The decreased risk for the lender generally means lower interest rates for an FHA loan borrower.
While Conventional loans may have a slightly higher interest rate than FHA loans, they can still be less costly and have a lower monthly payment because of the differences in mortgage insurance between these two types of loans.
In general, the higher the down payment and the higher your credit score, the lower your interest rate will be. Property type and loan amount (conventional vs high balance vs jumbo) will also affect your interest rate.
Refinancing
Both Conventional and FHA loans can be refinanced. Whether interest rates have gone down, you have increased your equity position in your home, want to remove/decrease monthly mortgage insurance or pull money out of your home, both loans give you the option to refinance.
Overall, FHA loans are considered a stepping stone in terms of mortgage loan options. There is no question that they are a reliable option for many first-time home buyers, but they do harbor some hindrances.
While there is an FHA streamline refinance option available for borrowers who currently have an FHA loan, the ultimate goal is to refinance out of the FHA space in order to get rid of mortgage insurance and reap the benefits of overall cheaper payments as offered with Conventional loans.
One of the two major drawbacks to FHA financing is that it has a much higher monthly mortgage insurance cost when compared to Conventional loans.
In addition, FHA loans have an Upfront Mortgage Insurance Funding Fee which is an additional cost that is generally rolled into the loan amount at the time of the loan closing. FHA mortgage insurance can not be canceled if there was a down payment of less than 10 percent. In order to get rid of the monthly FHA premiums, the borrower must accumulate a sufficient equity position, and can then refinance into a Conventional mortgage.
With a Conventional loan, a borrower can request to have the mortgage insurance removed once they reach 80% loan-to-value (20% equity) position.
FHA vs. Conventional Loans: Summary
FHA Loans
Lower or imperfect credit scores allowed
More rigid property standards
Minimum down payment of 3.5%
Private Mortgage Insurance (PMI) is required
FHA loan feature an Upfront Mortgage Insurance Premium expense
Conventional Loans
Higher credit score needed
Minimum down payment of 3% – 5%
More liberal property standards
If you’re looking into a new property and have any questions about which loan is right for you, please give us a call at (760) 930-0569 and one of our loan officers will assist you.
