There’s no one-size-fits all when it comes to real estate mortgages. For some borrowers a Federal Housing Administration-insured loan will win hands down; for others a conventional loan will trump all others in the race.That said, there are material differences between conventional and FHA-backed loans — and it doesn’t just come down to money.
A conventional loan is a mortgage not backed by any government agency such as the Federal Housing Administration or the Department of Veterans’ Affairs. Conventional loans fall into one of types categories: conforming and non-conforming. Conforming loans meet the strict lending guidelines laid down by Fannie Mae and Freddie Mac. The vast majority of mortgage lenders sell the loans they underwrite to either Fannie or Freddie, and they can only do this if the loan meets the lending criteria laid down by these agencies.
A non-conforming loan does not meet Fannie and Freddie standards. Usually, these loans are jumbo mortgages that fall above the lending thresholds set by Fannie and Freddie, or are loans made to borrowers with non-conforming credit histories or debt loads. Non-conforming loans are riskier than conforming loans and carry a much higher interest rate.
What is an FHA Loan?
An FHA loan is a mortgage insured by the Federal Housing Administration. Many borrowers believe that the FHA actually issues the loan. This is a misconception. The FHA simply guarantees the loan and pays the lender’s losses if the borrower defaults or the bank has to foreclose. The guarantee greatly reduces the lender’s risk. As a result, the lender can offer mortgages to borrowers who may not qualify for a conventional loan, such as those with a poor credit score or a low down payment. The FHA famously insures mortgages with a little as 3.5 percent down.
When reviewing a loan application, lenders typically look at three areas: credit score, debt-to-income ratio and the size of your down payment.
. Credit Score: Conventional lenders require a credit score of at least 620 out of 800; however, many lenders will charge extra fees if your credit score is less than 700. Research carried out by the Fair Isaac Corporation indicates that 760+ scores qualify for the best rates. The FHA, by contrast, accepts borrowers with a credit score of just 500, and usually accepts borrowers with defaults and forecloses on their credit record. However, if your credit score falls below 580, you will have to make a down payment of at least 10 percent.
. Debt-to-income ratio: Your debt-to-income ratio is the amount of debt you have to pay each month (credit cards bills, child maintenance payments, car loans, personal loans etc, as well as mortgage principal and interest, property tax, homeowners’ association dues and homeowners’ insurance) expressed as a percentage of your gross monthly income. So, if you earn $4,000 per month and make debt repayments of $1,600, your debt-to-income ratio is 40 percent. Conventional lenders typically have a debt-to-income ceiling of 45 percent. The FHA debt-to-income ratio is slightly lower at 43 percent, so those with a high debt load may find it harder to qualify.
. Down payment: Historically, conventional lenders have required a down payment of at least 20 percent, whereas the FHA insures mortgages with a minimum 3.5 percent down. However, lenders have become increasingly flexible over recent years and it is now possible to secure a conventional loan with a little as 10 or even 5 percent down. In 2014, Fannie and Freddie both announced plans to deliver loans with a 3 percent down payment to a small minority of buyers with stellar credit, full documentation and housing counseling under their belt. It’s too early to predict how borrowers will react to these super-low down deals, but it’s clear that Fannie and Freddie are tossing their hat into the ring in the bid to win low-down home buyers.
Can Relatives Finance the Down Payment?
Saving up for a down payment is one of the hardest parts of buying a home. The FHA recognizes this and lets borrowers receive gift money to finance the down payment. The gift can come from family members, friends, your employer, a charitable organization or anywhere else, as long as the payment is a gift and not a repayable loan. If you have a viable gift source, you may be able to get an FHA mortgage with literally none of your own money down.
Conventional loans have no hard-and-fast rules. Some conventional lenders accept a borrower with a gifted down payment; others don’t. In general, conventional lenders wish to see that a borrower has a good track record of earning and saving, and may require that you finance your own money down.
What About Mortgage Insurance?
Much the same way that an auto insurer pays out after a collision, mortgage insurance pays the lender’s losses if a borrower defaults on his loan. Lenders who know they won’t lose out financially are more willing to offer loans to riskier borrowers, such as those with poor credit or a low down payment.
FHA Mortgage Insurance
FHA loans require mortgage insurance. All borrows must pay it, regardless of their credit score or the amount they put down. Borrowers who put down more than 10 percent pay mortgage insurance for 11 years. Everyone else pays mortgage insurance for the entire lifetime of the loan.
FHA mortgage insurance is split into two payments — a one-time closing payment equal to 1.75% of the loan amount, and a monthly premium. Monthly premium costs vary depending on the length of your loan, how much you borrow and the size of your down payment, but most borrowers pay between 0.45 and 0.85 of their loan amount. The more you put down, the less mortgage insurance you pay.
Conventional Loans – Private Mortgage Insurance
Conventional loans do not charge any upfront premium. However, borrowers who put down less than 20 percent will be charged a monthly premium, calculated on a sliding scale depending on the borrower’s credit score, down payment and size of the loan. Most conventional borrowers pay between one-half and two-thirds of a percent of their loan value.
Cost Differences are Substantial
The major difference between conventional mortgage insurance and that required by the FHA is the conventional lenders automatically cancel the policy when you pay down your loan to 78 percent LTV. LTV or loan-to-value ratio is the amount you have left on your loan expressed as a percentage of the original purchase price. So, if you purchase a house for $300,000 with 10 percent down, your LTV is 90 percent. As soon as you pay the loan down to $235,000, your LTV drops to 78 percent and you no longer pay mortgage insurance. Most borrowers hit this mark ten years after taking out the loan.
There’s no automatic cancelation of FHA mortgage insurance. Most borrowers pay this money for the lifetime of the loan, no matter how much equity they build in the property. Most people regard life-long mortgage insurance as the major drawback of an FHA loan. Research carried out by personal finance website Wallet Hub fund that FHA mortgage insurance premiums have nearly doubled since 2008. An FHA buyer who purchases a median-priced home today pays just over $17,000 in premiums during the first five years of the loan, up from $9,210 in 2008 — and astaggering $2,251 to $12,026 more than the mortgage insurance borrowers pay with a conventional loan Much of the difference is due to the FHA’s upfront 1.75 percent premium that is financed into the loan.
Remember, mortgage insurance is money that you pay, of which the lender is the sole beneficiary. You never get that money back, no matter how timely you are with your mortgage payments. While insurance is unavoidable for low down payment borrowers, it can add tens of thousands of dollars to the cost of your mortgage.
So What is the Verdict? Which is the Better Loan?
Conventional mortgages require higher down payments and borrowers need a good credit score to qualify for the lowest rates. However, borrowers typically pay less mortgage insurance than they would with an FHA mortgage, which allows them to build equity in the home faster as they can direct the monthly payment into the mortgage rather than insurance. If you have good credit and at least a 5 percent down payment, a conventional loan is the right product for you.
FHA lenders are more likely to accept borrowers with less-than-stellar credit and require a lower down payment as standard. The flipside is mortgage insurance, with relatively high rates, that the majority of borrowers pay for the life of the loan. This can raise the cost of an FHA loan by tens of thousands of dollars. That said, if you find the perfect home, at the perfect price, and require an FHA mortgage to make that happen, then clearly an FHA loan is the right product for you.
The advice, as always, is to shop around. Before you make any decision, talk to a mortgage company about both options – FHA and conventional loans. Your broker or loan officer can give you a detailed comparison of both types of loan, including upfront fees, mortgage insurance and monthly payment estimates, so you can compare the cost.
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