FHA Vs Conventional Loans

When looking to buy a home, one of the first steps is to come to your mortgage lender and get pre-qualified to see what you can afford. The lender will fill out your application, run your credit, and take some documents showing proof of your income and assets. Once that information is received, the lender will be able to go over with you which loan option is best for you. Often times this means getting a Conventional loan or a government guaranteed FHA loan. Although there are other loan programs, these are the two most common. In some cases, the client will only qualify for one or the other. In other cases, the client can qualify for both and the lender can help you understand the benefits and downfalls of each loan program.

FHA

In general, the FHA government guaranteed loan can be a great loan for people who have a lower credit score, less money for a down payment, or a smaller income with more revolving debts. Starting with the credit report, for clients that have a credit score of 580-680, a lot of times the FHA program will seem to make more sense. If you are an individual with a credit score between 580-599 and are in no hurry to buy a home immediately, I would recommend waiting until your credit score gets above a 600 for a better interest rate. In addition, if you have things such as foreclosures, bankruptcies, delinquents, etc… on your credit report, FHA tends to be more lenient compared to Conventional. When it comes to the down payment on the house, FHA minimum requirement is only 3.5% down of the purchase price, keeping your closing costs lower and more affordable. Clients that make less monthly income are able to qualify for slightly more because their housing ratio (housing mortgage payment/total monthly income) can be up to 47%. As for people with more revolving monthly debts such as credit card payments, car payments, student loan payments, etc…, your total Debt-to-Income Ratio ((mortgage payment + total monthly expenses)/(Total monthly income)) can be up to 50% and sometimes as high as 55%.

While FHA loan programs can be great, one major downfall of this program is called the Mortgage Insurance Premium (MIP). MIP is part of your monthly mortgage payment and depending on the size of your loan, can typically range from $50 a month to $200 a month, sometimes more. While conventional loans do still have this mortgage insurance, it cancels once 20% of principal has been applied to the loan. However, in FHA loans, MIP never cancels and is part of the mortgage payment for the life of the loan. In addition to the monthly MIP, the FHA loan has a one-time upfront MIP fee of 1.75% of the purchase price to add into your loan amount. Simply put, if you require a loan of $100,000 to purchase your mortgage, your upfront MIP fee is $1,750. So now, instead of receiving a loan of $100,000, your loan amount with the upfront MIP will be $101,750. Oftentimes, when a person increases their credit score and can qualify for a conventional loan, the borrower will do so by refinancing their FHA loan and turn it into a Conventional loan. FHA loans are great programs and can make a lot more sense and can even be cheaper to choose them over Conventional loans based on your unique situation.

Conventional

Many times, clients understand the standard Conventional loan program to be the better loan program for most cases if they qualify. A reason for that is because people with high credit scores tend to get conventional loans. Although many lenders will accept lower scores to go Conventional, you will have to pay a much higher interest rate. Clients should consider receiving a conventional loan when they have a credit score of at least 680 or above. Of course, the higher the better. As I discussed above, FHA loans are required to pay Mortgage Insurance Premium (MIP), which is built into their monthly mortgage. While this is true with conventional loans, once 20% of the value of the house is paid off in principal, the MIP automatically cancels saving you $50-$200+ each monthly mortgage payment. If you have a good amount of money saved up and you decide to put 20% for the down payment that means that your loan will never pay the Mortgage Insurance. In addition, while FHA loans require an Upfront MIP fee, conventional loans never have that, saving you several thousand dollars in your loan amount.

Just like all things, there are downsides to all loan programs, including conventional, as minor as they may seem. Conventional loans require a minimum of 5% for a down payment of the purchase price, compared to FHA minimum of 3.5%. However, don’t let that be a determining factor as there is a conventional loan program called HomeReady that only requires a 3% down payment in which you may be able to qualify for. The second main downfall of conventional loans are related to the housing ratio (monthly mortgage payment/monthly income) and total Debt-to-Income ratio ((monthly mortgage payment + all monthly revolving debts)/(monthly income). The Housing ratio is at 45%, unlike FHA which is 47%. The total Debt-to-Income (DTI) ratio is also only 45%, compared to FHA’s 50-55%. To persons who have little to no other revolving debts such as car payments, student loans, or credit card payments, this would hardly affect them. If those persons are also seeking a home that makes there housing ratio very small, it wouldn’t affect them much either. On the other hand, when you have a car payment and student loans of $300 or more each month, that can dramatically affect your ability of being able to qualify for a conventional loan.

All and all, both the FHA and Conventional loan programs are very good and common loans. Based on your unique situation, a specific loan program can fit your needs and give you the better deal. And if these programs aren’t a good fit for you, we will help find the one perfect for you and your financial situation.