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FHA vs. Conventional Loans in Plain English

April 20th, 2018 7:23 AM by Jackie A. Graves, President

Make sure you understand how these two types of mortgages differ.

Potential homebuyers with credit problems, low income or not much saved for a down payment may have trouble finding a home loan. For those borrowers, an FHA-insured loan might be a good solution. Here's what you should know if you're weighing whether a conventional or FHA mortgage is the best way to go.

What Is an FHA Loan?

The FHA insurance program provides a means for many prospective homeowners to achieve the dream of owning a home who might not have otherwise been able to do so.

An FHA loan is a mortgage issued by a federally approved bank or financial institution that, unlike a conventional mortgage, is insured by the Federal Housing Administration. This mortgage insurance provides the security that qualified lenders need in order to take on a riskier loan.

But that security comes with a cost for the buyer: With FHA loans, the buyer must pay a 1.75 percent upfront mortgage insurance premium at closing, regardless of the down payment. Then, the buyer must make monthly mortgage insurance payments for the life of the FHA loan if the down payment is less than 10 percent. It can be canceled after 11 years if the down payment is 10 percent or more.

According to the agency's website, the FHA has insured more than 47.5 million properties since the program was created in 1934, making it the largest mortgage insurer in the world.

Comparing FHA With Conventional Mortgages

There are several key differences between FHA and conventional loans. Each has its advantages and drawbacks. Here's a quick comparison:

Conventional mortgages

FHA loans

Minimum FICO credit score

Typically no lower than 620

Typically as low as 580

Minimum down payment

As low as 3 percent, but 5 to 20 percent is typical

As low as 3.5 percent

Mortgage insurance

Monthly payments are required if you have a down payment of less than 20 percent, but generally, the insurance can be canceled when your loan-to-value ratio reaches 80 percent.

Upfront and monthly payments, sometimes for the duration of the mortgage term, are required.


FICO score

Your FICO credit score, which is the most widely used score among lenders, generally needs to be at least 580 to qualify for an FHA loan. If your score is between 500 and 579, you need to come up with a down payment of at least 10 percent. Conventional loans generally require that you have a FICO credit score of at least 620 to qualify, and a higher credit score is needed to qualify for the best interest rates.

Down payment

You can get an FHA loan with a down payment as low as 3.5 percent. Though some conventional mortgages have a down payment requirement as low as 3 percent, most typically require a down payment of 5 to 20 percent, according to the Consumer Financial Protection Bureau.

Mortgage insurance

No mortgage insurance is required on a conventional loan with a down payment of at least 20 percent. Though if your down payment is less than 20 percent, you will be required to pay for private mortgage insurance, or PMI. Once your loan-to-value ratio (the amount left on the mortgage divided by the property's appraised value) reaches 20 percent, the PMI requirement will go away and so will the need to pay this monthly cost. This is not done automatically: You will need to request that your lender remove the PMI payment.

By contrast, FHA loans require an upfront mortgage insurance premium and monthly mortgage insurance payments.

Debt-to-income ratio

You can usually qualify for an FHA loan with a less favorable debt-to-income ratio, known as a DTI. Your DTI is calculated by taking the amount you pay each month toward debt and dividing it by your monthly gross income. Your debts may include car, rent, mortgage, student loan payments, installment debt and child support payments, and monthly minimum payments on credit cards. The lower your DTI, of course, the better.

Purchase restrictions

Conventional loans can be used to purchase a vacation home, investment property or primary residence. FHA loans are limited to owner-occupied properties, which can include multi-unit properties as long you live in at least one of the units.

Hurdles

Conventional mortgages generally present fewer hurdles in terms of processing and inspections. For example, the FHA has minimum property standards, and if the property doesn't meet them, the seller or the buyer may need to pay for repairs before it can qualify for a mortgage. This might include ensuring that any peeling paint in the property is addressed. Who pays for the repairs might be a topic of negotiation between the buyer and seller.

"While FHA loans can be advantageous for some home purchases, some sellers don't want to deal with the red tape involved with FHA buyers," says Christopher Clepp, a financial advisor with the Chicago office of Strategic Financial Group. In a competitive bidding situation where sellers have many offers to choose from, this can put a buyer at a disadvantage.

Loan limits

It's a common misconception that FHA loans are only for lower-income borrowers with credit challenges. However, one aspect of the FHA program that might dissuade a higher-income borrower is its loan limits, which are, in many cases, lower than those of conventional mortgages.

For 2018, you can take out an FHA home loan in a low-cost area for less than $300,000. In a pricey area, the FHA loan limit is nearly $700,000, according to the U.S. Department of Housing and Urban Development. Limits vary depending on your location. There are special exceptions for both FHA and conventional loan limits for Alaska, Hawaii, Guam and the U.S. Virgin Islands, which have a single-unit limit of more than $1 million.

For example, in a low-cost area, the loan limits are:

FHA

Conventional

1 unit

$294,515

$453,100

2 unit

$377,075

$580,150

3 unit

$455,800

$701,250

4 unit

$566,425

$871,450


In a high-cost real estate market such as San Francisco or the District of Columbia, the limits are:

FHA

Conventional

1 unit

$679,650

$679,650

2 unit

$870,225

$870,225

3 unit

$1,051,875

$1,051,875

4 unit

$1,307,175

$1,307,175

Sources: HUD and Fannie Mae

Choosing the Right Type of Loan for You

Consider these factors when deciding between an FHA loan or a conventional mortgage:

Your FICO score and credit history

"An FHA loan is a great option for those with poor credit," says Casey Fleming, mortgage advisor with C2 Financial Corp. and author of "The Loan Guide: How to Get the Best Possible Mortgage."

Indeed, for those with a particularly low credit score, an FHA loan might be your only option. You may also decide to put off buying a house and work on building your credit instead.

The down payment you can afford

If you don't have the cash for a large down payment, an FHA home loan might be your best option. FHA loans require a down payment of at least 3.5 percent. Some lenders offer conventional loans with down payments as low as 3 percent, but most require a down payment of 5 to 20 percent.

How long you plan to own the home

On an FHA loan, the monthly mortgage insurance premiums will stay in place for at least 11 years. A conventional loan typically has no upfront premium and allows the borrower to request that the lender cancel the monthly premium when the loan-to-value ratio hits 80 percent.

If you are only planning to put down less than 20 percent and expect to stay in the home for a short period of time, the FHA monthly mortgage insurance premium may not matter much. However, if you plan to own the home for at least 11 years, you will pay the monthly premium for the full 11 years, even if your loan-to-value ratio improves. In the future, you may be able to refinance to a conventional mortgage with no mortgage insurance requirement, if your financial situation qualifies.

The APR and overall cost

When determining what the best loan is for you, factor in any upfront closing costs, required mortgage insurance and other fees that can come with the mortgage. These types of costs can turn a mortgage with a lower interest rate into an unattractive option.

The APR, or annual percentage rate, is the annual cost of procuring your loan and includes not only the quoted interest rate but also any other fees that you will be paying over the life of the loan. Comparing loan APRs is a good way to evaluate their overall costs.

Fleming cautions, "FHA loans can be a more expensive option after factoring in the mortgage insurance due at closing and the monthly mortgage insurance premiums, even if the stated interest rate is lower than a conventional alternative." 

Consider Hiring a Mortgage Broker

While you can certainly assess mortgage options on your own, it may make sense to hire a knowledgeable professional, like a mortgage broker.

Ask friends, family members and colleagues to refer someone who is reliable and who will put your needs first. As you evaluate brokers, it's also a good idea to check out their experience, professional affiliations and, of course, if they've had any major complaints against them. Make sure the broker knows about all types of loan programs spanning conventional, FHA and the VA programs if you are a veteran or active-duty military service member. Often, the broker's fees may be paid by the lender or the borrower.

And make sure you're prepared when you meet with the broker. Dan Green, long-time mortgage professional and founder of the mortgage education site Growella, suggests, "Before applying for a mortgage, consider your loan traits [like your credit and how much of a down payment you expect to make] and what you're trying to accomplish. Then, ask your mortgage professional, 'Where am I going to get the best combination of rate and price?'"

To view the original article click here             Apply to Buy a Home             Apply to Refinance

Posted by Jackie A. Graves, President on April 20th, 2018 7:23 AM

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