When you are buying your first home, financing can be overwhelming. One point of confusion is whether you should get an FHA loan or a conventional loan. Understanding the differences can help you make an educated choice as to which will work best for your budget and situation.
What is the Main Difference?
The main difference is that FHA loans are backed by the government, while conventional loans are not. This makes lenders a little more likely to take a risk on lenders. Note that this does not mean the FHA (Federal Housing Administration) is actually lending you money. It means that they are underwriting the loan, protecting your lender if you default. Because of this, the FHA has some fairly strict rules on what both lenders and borrowers are allowed to do.
What are the Benefits of an FHA Loan?
Here are some of the benefits of an FHA loan:
- Lower down payment. Many borrowers will demand a down payment of 20% or higher for a conventional loan. If the down payment is lower, then Private Mortgage Insurance (PMI) will be applied, obliging you to pay a premium every month. Lenders may also require very high credit scores for a lower down payment or other proof you can pay off the loan. For FHA loans, your minimum down payment is generally 3.5%, but you may have to pay as much as 10% if your credit card is lower.
- Lower credit score requirement. Very few lenders will grant a conventional loan to people with a credit score of less than 620, with many having higher limits, whilst you can get an FHA loan with a score as low as 500. Lenders also often adjust your interest rate to go along with your credit score. The higher the score the lower interest.
- More generous debt-to-income ratio. Conventional guidelines cap debt-to-income at about 43%. This limits the size of your loan and also may cause problems if you have credit card debt or, even worse, student loans. In contrast, FHA guidelines go up to 57%.
- FHA interest rates tend to be lower.
- FHA loans have a more flexible maximum amount before being called a “jumbo” loan. This can be as much as $726,525 in some expensive markets. For conventional mortgages, the limit is $484,350 nationwide. If your loan is classed as jumbo, it will require a higher down payment and credit score.
What are the Downsides of an FHA Loan?
FHA loans are not, however, universally the best option and have a few downsides:
- The lower down payment means a higher loan amount. If you can afford a 20 percent down payment, you are probably better off with a conventional mortgage. You will get it paid off faster and thus pay less interest.
- With an FHA loan, you have to pay an upfront premium of 1.75% of the loan amount to cover the insurance.
- FHA mortgages tend to take longer to process.
- FHA loans can only be used for your primary residence. In other words, you must intend to live in the home full-time. You cannot flip the house (sell within 90 days for a higher value). You can use an FHA loan to buy a multi-unit property (for example a house split into three apartments) as long as you live in one of the units yourself.
- The home must meet stricter appraisal standards, which makes it harder to use an FHA loan if you like the idea of buying a fixer-upper. The appraiser will expect the house to already be up to code. For DIY fanatics, this may make a conventional loan better. Appraisers may be so strict they will require peeling paint or other minor issues to be fixed.
- You will continue to pay extra for the FHA insurance until you refinance. The only way to make it go away is to refinance into a conventional loan. If you paid a down payment of ten percent or more you can cancel the mortgage insurance after eleven years. Meanwhile, if you have PMI on a conventional loan, you can ask your bank to stop those payments once you owe less than 80% of the amount, which can come up fairly quickly.
- If you have an excellent credit score, you will often be able to get lower interest rates with a conventional loan. A credit score of above 720 will also result in lower PMI payments, which can easily be lower than the FHA mortgage insurance.
- Remember that flexible maximum amount? In some cheap areas, the FHA limit may be considerably lower than the conventional loan limit, making a conventional loan a better choice.
- Some sellers prefer not to deal with FHA buyers because of the extra red tape.
So, which should you choose? Ultimately, it depends mostly on your credit score:
Score of less than 620: You are not going to be able to get a conventional loan and an FHA loan will be your only option.
Score of between 620 and 720: Generally an FHA loan will be cheaper.
Score of 720 or more: A conventional loan will generally be cheaper.
Other factors you might want to take into account include:
- The typical cost of housing in your area. In a high-cost area, FHA loans may be better because they may have a higher maximum. In a low-cost area, the lower maximum may end up making a conventional loan your best option.
- Whether or not you intend to live in the property full time.
- Whether the house you are looking at needs a lot of work. If it does, you may have to get a conventional loan.
- How high a down payment you can afford.
Choosing between the two types of loans is a decision you should make, ideally, before you start seriously looking for a home. FHA loans are intended to help people who may have issues affording a home, but they are not the perfect solution for everyone, or even for all first-time buyers.
If you are trying to decide between an FHA or conventional loan, then you may want to talk to a qualified mortgage broker. The Knowmortgage Spot Light will connect you with a friendly mortgage expert who can help you out.