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Updated on Friday, February 1, 2019
Whether you’re buying a new home or thinking of refinancing your current mortgage, it always pays to explore your options so you can get the best deal. Two of the most common loans are conventional loans and FHA loans. In 2018, 61% of all borrowers chose a conventional loan, while 17% took out an FHA loan, according to the National Association of Realtors 2018 Profile of Home Buyers and Sellers.
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A conventional loan, or conforming loan, is a mortgage that is not backed by a government agency, but does conform to standards set by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). It typically has a fixed rate and term, the most common being 30-year fixed. Conventional loans are the most popular home mortgage product.
FHA loans are backed by the Federal Housing Administration, so lenders have more flexibility to offer loans to borrowers, using less stringent qualifications.
Except for borrowers seeking a specialized home loan program, like veterans, the majority of borrowers will end up with one of these two mortgage types. The question is, which one is best for you?
Read on to explore the benefits, drawbacks and qualifications of each type of home loan. This information can help you figure out which loan is best suited to your needs.
The dirt on FHA loans
FHA loans can provide individuals who might not otherwise qualify a pathway to homeownership, said Tendayi Kapfidze, chief economist at LendingTree, which owns MagnifyMoney.
Pros of FHA loans
The most obvious pro is that FHA loans have lower credit score and down payment requirements than conventional loans. Interest rates are also favorable, usually slightly lower than conventional loans, because of the government backing, Kapfidze said.
Cons of FHA loans
The biggest con is that FHA borrowers have to pay a substantial mortgage insurance premium (MIP), which is what allows the government to back the loans, Kapfidze said. You’ll have to pay 1.75% of the total mortgage price up front, and then you’ll have a monthly MIP, the amount of which depends on your LTV, or loan-to-value ratio, for the life of the loan. If you put down more than 10% on the home, you may have the opportunity to stop paying MIP after 11 years.
FHA applications also tend to be a bit more tedious than other loan programs, and homes must meet safety standards set by the Department of Housing and Urban Development (HUD) in order to be approved for the loan. In addition, FHA loans are typically only for borrowers who will occupy the property they are purchasing, so they can’t be used for investment properties or second homes.
Which borrowers can benefit the most?
For borrowers with less-than-stellar credit, or who don’t have the ability to save a lot toward a down payment, an FHA loan can be a great option, said Andrew S. Weinberg, principal of Silver Fin Capital Group LLC, a mortgage brokerage in Great Neck, N.Y.
“Let’s say you want to buy a house, but you have a 580 credit score, or you don’t have much cash in post-closing reserves. FHA will allow that,” Weinberg said.
How do I qualify?
FHA lenders consider a number of factors, including income, credit history, debt-to-income (DTI) ratio, down payment and cash reserves. You’ll have to submit proof of employment, tax returns and other documentation, and have at least a 3.5% down payment.
The dirt on conventional loans
Conventional loans are typically fixed-rate loans for buyers who have strong credit and income, and meet other minimum qualifications.
Pros of conventional loans
For borrowers who are able to make a 20% down payment, there is no mortgage insurance. Those who put down less than that will pay private mortgage insurance (PMI), but only until they achieve 20% equity in the home.
Another pro is that conventional mortgages can be used for second homes or investment properties.
Cons of conventional loans
Because the government doesn’t back conventional loans, credit score requirements are typically higher, usually a minimum of 620, although this can vary by lender.
Which borrowers can benefit the most?
If you have a strong credit history and meet other requirements, conventional loans are usually cheaper, Kapfidze said, especially if you can afford 20% down and don’t have to pay PMI. Even if you have to pay PMI, you won’t have to pay an upfront premium, and you can stop paying PMI once you’ve achieved 20% equity.
How do I qualify?
Besides having a clean credit report, you’ll need to have sufficient income to make the mortgage payments. Lenders also want to see that you have cash reserves in case you lose your income, and that your DTI is less than 45%. Exceptions are sometimes made up to 50%, as long as you have a top-notch credit score to compensate.
FHA loans vs. conventional loans
While both loans are typically fixed-rate mortgages with similar interest rates, the key differences lie in their general requirements for approval and process.
FHA loans have more restrictions regarding the nature of the property you’re buying, as well as that pesky MIP, which offsets their lower interest rates.
Conventional loans may require PMI payments if you’re putting down less than 20%. You can also purchase a home for any purpose, and the appraisal process will likely be less intense than it is for an FHA loan.
So which one is better?
“I wouldn’t say one loan type is better or worse; it’s more about what fits your financial situation,” Kapfidze said.
Take a closer look at how some of the key factors compare:
|Conventional loans vs. FHA loans|
|Minimum credit requirements||620||As low as 500|
|Down payment requirements||As little as 3%||As little as 3.5%|
|PMI/MIP requirements||If your down payment is less than 20%, you’ll pay PMI. You can request it to be removed once you have an 80% LTV ratio, or automatically at 78%.||An upfront mortgage fee of 1.75% of the loan amount, plus monthly MIP payments for the life of the loan. One exception: if you put down more than 10% initially, you may be able to end MIP payments after 11 years.|
|Waiting period requirements after bankruptcy/foreclosure||For Chapter 7 or Chapter 11 bankruptcy, the waiting period is four years from the discharge or dismissal date, or two years if you can prove extenuating circumstances.|
For Chapter 13 bankruptcy, the waiting period is two years from the discharge date, or four years from the dismissal date.
For foreclosures, a seven-year waiting period is required from the completion date of the foreclosure action, or three years if you can prove extenuating circumstances.
|For Chapter 7, a waiting period of less than two years, but not less than 12 months, may be acceptable if you can prove extenuating circumstances and that you’ve managed your finances well. |
For Chapter 13 bankruptcy, you’ll need to wait one year into the bankruptcy payout. You’ll also need to prove you’ve made one year of on-time payments toward the bankruptcy and get written permission from the bankruptcy court.
For foreclosures, the waiting period is generally three years. Extenuating circumstances and reestablishing strong credit since the foreclosure may waive the waiting period.
|DTI requirements||43% is the rule of thumb for many lenders, but Fannie Mae and Freddie Mac will back loans up to 50%.||31/43, which means 31% of income is the max for front-end (or home-related) DTI, and 43% is the max for back-end (total) DTI. FHA allows wiggle room on a case-by-case basis depending on your credit score, cash reserves and other compensating factors.|
|Rates||In December 2018, the average interest rate on a 30-year fixed-rate loan was 4.64%||Usually lower than conventional mortgage rates.|
FHA vs. conventional loan refinancing
Refinances made up 18% of all FHA loans and 31% of all conventional loans in November 2018, according to Ellie Mae.
If you’re thinking of refinancing your existing mortgage, here’s what you need to know about your options.
If you currently have an FHA loan, you might consider an FHA Streamline refinance. This allows you to take your existing FHA-insured mortgage and refinance to a new FHA loan with limited credit documentation. To qualify, you must be current on your existing FHA loan. There must also be a benefit to you, meaning the refinance will lower your monthly payment or reduce your interest rate.
If you want to refinance your current mortgage — whether it’s FHA, conventional or non-conventional — into a conventional loan, the qualifications are pretty much the same as what you’d need to qualify for a conventional mortgage for a home purchase. The main difference is that for a conventional refinance, you typically also need to have at least 20% equity, or an LTV of 80% or less, but lender preferences vary.
If you have ample equity, you might also consider what’s called a cash-out refinance, in which you borrow a lump sum of cash on top of the mortgage amount. Most lenders allow for a cash-out refinance up to 80% of the value of the property, but underwriting criteria may be stricter.
Ultimately, if you’re thinking of refinancing, you want to be sure there is a clear benefit, whether it is lowering your monthly payment, reducing the amount of interest you’ll pay in the long run or both.
Going from an FHA to a conventional loan (especially without PMI) will usually be beneficial, but it depends on whether you can qualify and at what interest rate. For FHA borrowers who don’t qualify for a regular FHA loan refinance, a Streamline FHA refinance could be the next best thing. And for those who already have a conventional loan, lowering the interest rate would be the main motivation to refinance to a new loan.
Shopping for an FHA or conventional loan
When you’re ready to move forward, Weinberg advised getting a recommendation for a couple of licensed mortgage loan originators or brokers who can guide you and answer your questions.
“Don’t speak to 10, or you will have information overload and will find it hard to keep track and to compare,” he said.
Brokers work with scores of lenders and can do the work of shopping for your loan and finding the right lender and program to fit your financial situation.
Finding the right loan
Having options might seem overwhelming at first, but they make it more likely you’ll find a loan that fits your financial profile and lifestyle, Kapfidze said.
“It’s like buying a car. Not everyone wants or needs a truck, and not everyone wants a sports car, but most people find a car that suits their needs and within their budget,” he said.
If you’re still not sure whether an FHA or conventional mortgage is right for you, start by examining where your credit stands and work with a professional who can help you.
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