Key Differences Between Conventional and FHA

Securing a mortgage can be overwhelming, especially if your credit is less than perfect or you don't have much money saved for a down payment. Don't let uncertainty keep you from buying a home, however. If you don't qualify for a conventional mortgage, you may be able to secure a Federal Housing Authority loan instead. You could stop paying rent and start building a little equity in your own home.

What Is an FHA Loan?

The Federal Housing Authority insures mortgage loans for people who want to purchase a primary residence. The qualifications for this type of mortgage are more open than a conventional one. FHA loans are intended to make buying a home easier for people with smaller incomes, lower credit scores, or minimal savings.

FHA loans are issued by regular banks, not by the government. The FHA merely provides a guarantee to the bank that the loan will be repaid. The government's backing makes banks willing to accept applications for these loans with standards that are easier to meet.

What Are the Differences Between a Conventional Mortgage and an FHA Loan?

There are several key differences between an FHA loan and a conventional loan. The most common and often most important is that an FHA loan is easier to secure.

1. Qualifications

For a conventional mortgage, you need reasonably good credit and a significant down payment. FHA loans, because they are insured by the government, allow for lower credit scores, higher debt-to-income ratio, lower income, and smaller down payments.

Conventional Mortgage Qualifications

Typically, for a conventional mortgage, you'll need a credit score of at least 620. The higher your credit score, the better interest rate you can expect to get on your loan. If you have 20% or more to put down on the property, you will not have to carry private mortgage insurance.

You can often secure a conventional mortgage with less than 20% to put down. Your other qualifications will need to be excellent, however, and you will probably pay a higher interest rate than you would with a larger down payment.

Banks expect you to have a low debt-to-income ratio of well under 50% and enough income to comfortably make your monthly payments. In most cases, banks prefer that your complete mortgage expense, which includes principal, interest, taxes, and mortgage insurance, not exceed 25% of your gross monthly income. This is not a fixed requirement but a common rule of thumb.

FHA Loan Qualifications

You can qualify for an FHA loan with a lower credit score. Usually, banks will expect a score of 580 or above, although some lenders will accept applications with a score as low as 500. This can be very helpful if you've got little or no credit history or had financial troubles in the past and your credit score hasn't fully recovered yet.

Interest rates vary on both types of mortgage, but FHA rates are comparable to conventional rates. With a good credit score, your FHA rate will be lower, just as it is on a conventional mortgage. Shop and compare rates for either loan type. If your credit score is very low, you will not be able to secure the best rates.

An FHA mortgage only requires 3.5% down and allows for a higher debt-to-income ratio, up to 50%. These looser requirements can be advantageous if you are in a lower-income bracket. It's hard to save a big down payment and have little to no debt if you're not making a lot of money.

Buying a home can be an excellent way to build equity and lock in your housing expenses for the future so you can start saving. With a fixed mortgage, your housing costs are a lot more predictable than rent.

2. Loan Insurers and Availability

FHA loans are insured by the federal government. Conventional loans are not, making them a higher risk for the bank. This is why the bar is so high on a conventional mortgage. Having a larger down payment and a higher credit score makes the loan less risky.

Not all lenders offer FHA loans. They are a little less straightforward than conventional loans, and they require more paperwork on the part of the bank and borrower.

3. Property Type

An FHA loan can only be used for your primary residence. If you are financing a second home, vacation home, or rental property, you will require a conventional mortgage.

4. Mortgage Insurance

FHA loans require mortgage insurance, which is broken into two parts. The first is a fixed upfront fee of 1.75% of the loan amount. This fee can be paid when the loan is initiated, or it can be rolled into the loan, increasing the total amount being borrowed.

The second portion of this insurance is based on your down payment percentage. It's calculated annually and included in your monthly mortgage payments. With a minimum down payment of 3.5%, for example, you would be charged an annual premium of .85% of the loan amount, which you would pay in 12 equal installments over the year.

On a conventional mortgage, it is typically a requirement to hold mortgage insurance if you borrow more than 80% of the homes value.

If you have less than 20% to put down, you will have to pay for this insurance until you have built 20% equity in the home. You will gain equity by paying the mortgage, improving the property, or realizing gains from rising market values. You may experience a combination of all three over time.

Which Loan Is Right for You?

Your individual circumstances will determine which type of mortgage loan is most advantageous for you. If you can qualify for a conventional mortgage loan, you may be able to get a lower interest rate and avoid paying for mortgage insurance.

If you opt for an FHA loan, you can purchase a home with less money out of pocket, build equity, and improve your credit score over time. With either option, you can have the stability and pride that comes with homeownership. Get in touch with us at FHA Insider to learn more.