Conventional Loan vs. FHA Loan

Home buyers making a down payment of less than 10% should evaluate both FHA and conventional loans. FHA loans are easier to acquire for those with low credit ratings and require as little as 3.5% down payment. The disadvantage is expensive mortgage insurance, which is paid upfront as well as in annual installments. Conventional loans are cheaper over all but require good credit. Mortgage insurance may also be required with conventional loans if the down payment is below 20% but pricing for this is usually better than FHA loans.

When comparing numbers for both options, include the mortgage insurance payments that will be required in each scenario.

Comparison chart

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Conventional Loan

FHA Loan

Limits Typically $417,000 ($625,000 in DC high-cost areas and $494,500 in Baltimore areas) Typically $417,000 ($625,000 in DC high-cost areas and $494,500 in Baltimore areas)
Required credit score Over 660 640 is typical in market place, although some lenders will accept 580 with larger downpayments.
Down payment 5 – 20% 3.5%
Interest rates Fixed or adjustable. Fixed or adjustable (generally slightly lower than conventional loans)
Term 15-30 years for fixed-rate, greater variety (e.g. 1 year) for adjustable. 15-30 years for fixed rate.
Cost Origination fees, down payments, mortgage insurance, points and appraisal fees Upfront mortgage insurance premium (1.75%), ongoing annual premiums (1.35% with minimum downpayment)

Contents: Conventional Loan vs FHA Loan

edit What is a conventional loan?

Conventional loans are not guaranteed by any government agency but generally comply with the guidelines set by Fannie Mae and Freddie Mac. After a lender, such as a bank or credit union, loans money to a borrower for buying a home, they usually sell the loan to either Fannie Mae or Freddie Mac. So the lender must ensure that the borrower meets Fannie and Freddie guidelines for loans.

Conventional loans are of two types: conforming and non-conforming. Conforming loans are for amounts less than $417,000 (or higher in some areas that have a high cost of living). Non-conforming loans, also called jumbo loans, usually have a higher interest rate.

edit What is an FHA loan?

FHA loans are guaranteed by the Federal Housing Administration, a government agency. This guarantee makes it less risky for the lender to issue the loan, which allows lenders to lower their qualification criteria. This sometimes makes FHA loans the only way that two types of borrowers can buy a home:

  1. borrowers with poor credit rating (often less than 600),
  2. borrowers who do not have funds for a high down payment

In exchange for this government (FHA) guarantee, the borrower must purchase mortgage insurance. This increases the long-term cost of the loan for the borrower.

edit Eligibility

edit Eligibility for conventional loans

Most conventional loans require a credit score of at least 620; and scores under 700 may lead to either extra fees or a higher interest rate. Conventional loans usually require a down payment of between 5 and 20 percent, and typically have a ceiling of 45% for the debt-to-income ratio. Other criteria for conventional mortgages may include a steady job history, full documentation of income and assets, and price stability in the neighborhood where the home is located.

edit FHA loan eligibility criteria

FHA loans require a minimum down payment of 3.5%. The minimum credit score required is 500; however, only borrowers with a credit score of 580 or higher qualify for the lowest (3.5%) down payment option. Others are required to put 10% down.

edit Mortgage Insurance

FHA loans require mortgage insurance, which must be paid both upfront and annually. Most 15 or 30 year FHA loans require the borrower to pay 1.5% of the loan amount at closing, along with a 0.5% annual renewal premium for the length of the loan. Half of the upfront mortgage insurance premium is refundable when the home is sold. And monthly premiums are not required if the down payment is more than 22% of the value of the home. However, for most FHA borrowers such high down payment is not feasible.

Conventional loans do not require any upfront mortgage insurance payment. However, ongoing mortgage insurance is required for conventional loans where the borrower has made a down payment of less than 20%.

edit Mortgage insurance pricing

For borrowers trying to choose between a conventional and FHA loan, the mortgage insurance premium is a significant factor. Pricing for insurance is risk-based for conventional loans. This means the premium is lower for higher down payment and higher credit scores. This is not the case with FHA loans — all borrowers are required to pay 1.5% of the loan amount upfront. This cost is typically bundled into the loan.

edit Closing costs

FHA loans allow borrowers to use money that is a gift from a relative, nonprofit organization or government agency to pay 100% of the downpayment at closing. Conventional loans, on the other hand, place some limits on this.

edit Assumable

FHA loans are assumable, i.e. the loan can be transferred to the new owner when the house is sold. The new owner can take over the FHA loan without the additional cost of obtaining a new loan, which is a big advantage and can make it easier to sell a home. Of course, the new owner must meet the eligibility criteria for an FHA loan for it to be transferred.

edit Pre-payment penalties

Prepayment penalties are not allowed in FHA loans, whereas there can be fees for paying the money back early with a conventional loan. Some states disallow prepayment penalties and loan terms vary by lender so it is a good idea to check before making a decision. Avoid any loans that have a prepayment penalty.

edit Acceptance

Some condominium complexes and non-owner investment properties do not allow FHA financing so a conventional mortgage may be the only option when buying such real estate; there are no such restrictions with conventional mortgages.

edit In summary: Pros and cons

Conventional mortgages are easier to process and allow home equity to build faster, as they require higher down payments. However, you need a good credit score to qualify for a good interest rate, and some lenders require up to 20% as a down payment.

Lenders for FHA loans are more willing to look at the overall credit picture, rather than just the credit score alone. They require a much lower down payment, and have no minimum credit score requirement. They are a good choice for those with less-than-perfect credit scores, borrowers with moderate debt-to-income ratios, and those who do not have much money for down payments.

edit Popularity

After the 2008 financial crises, FHA loans have risen to a larger percentage of over all mortgage issuance.

 Gross mortgage issuance (including refinancing) in America, by type. Source: Bloomberg
Gross mortgage issuance (including refinancing) in America, by type. Source: Bloomberg

edit References

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