When you’re buying a house, the mortgage options can be overwhelmingly confusing. It seems so simple: Go to the bank or apply online, get a pre-approval, shop for a home, and finally close. What you’ll find when you begin the process, however, is that there is a shocking number of home loan options, programs, and plans available. Some of them can be ruled out because they don’t apply to your financial situation or circumstances, but for many home buyers, the two most obvious options are FHA loans and conventional loans. On the surface, these loan programs look very similar, but the details make a big difference in who qualifies and how much money you can save or will spend. Understanding the differences can help you choose the right loan to finance your home.
A conventional mortgage loan is what most people think of when they consider taking out a mortgage to buy a home. Housing is expensive, and while the lender will hold the house and property as collateral in case a borrower defaults, there is no guarantee that the lender won’t still lose money in the event a borrower defaults. There’s a lot of money on the line. As a result, lenders prefer to approve borrowers with excellent credit histories, solid down payments, and a positive debt-to-income ratio, because statistically the likelihood of those borrowers defaulting is lower than it is for borrowers who don’t meet that standard. As a rule, most conventional loans require a credit score of 620 or higher to qualify. The standard 20 percent recommended down payment on a house isn’t actually a requirement for a conventional loan. If, however, borrowers don’t have a 20 percent down payment, they’ll be required to pay a premium for private mortgage insurance that will cover the difference if they default, making the total monthly mortgage payment prohibitively expensive for many borrowers. Interest rates tend to be a bit higher for a conventional home loan than they are on other loans because of the slightly higher risk to the lender.
The credit and down payment standards protected the lenders and allowed them to continue safely issuing loans. The problem is, those standards were denying homeownership to would-be homeowners. Many people who live paycheck to paycheck do so because rent and insurance are so expensive, and as they continue to put money toward rent each month, they can’t afford to save enough for a significant down payment. They might fall behind by a month or two on a payment and then be unable to overcome the hit to their credit score. Other borrowers may have gone through a rough time and damaged their credit significantly, and even though they’ve improved their credit since, make enough money to easily cover a mortgage payment, and have some money saved, they can’t qualify for a traditional loan because of their credit history. The FHA loan program was designed to help these borrowers. In the battle of conventional loan vs. FHA, the best choice for each borrower can be determined by just a few numbers.
1. FHA loans, which are backed by the Federal Housing Administration, tend to have qualification requirements that are easier to meet, making homeownership a possibility for more people.
Understanding the FHA loan definition requires a little background information. FHA loans were developed by the Federal Housing Administration when the FHA realized that some of the requirements for obtaining a conventional mortgage were prohibitive for many would-be homeowners who were designated by lenders as high-risk. These borrowers might have a checkered credit history, or a very limited one, or they might be in a position where their rent costs such a substantial percent of their income that they aren’t able to save enough for a conventional down payment. Traditionally, lenders have viewed those borrowers as too risky, because without a sizable down payment, the borrowers had nothing to lose if they defaulted on the loan. The FHA, recognizing that many of those borrowers were fully capable of making their monthly payment each month (and in fact were anxious for the opportunity to do so), developed the FHA loan program. Through this program, the FHA guarantees the loans that lenders offer through the program, which includes lower down payments, lower credit score requirements, and several other easements that make borrowing easier for hopeful home buyers but reduces the risk for the lenders by covering their losses should a borrower default. This program helps people who might not qualify for a traditional loan out of the renting cycle and into a home faster than they would otherwise be able to, helping add stability to the housing market, adding to the economy, and helping people who want to work hard and experience the pride of homeownership to achieve their dream.
2. The credit score minimum requirement for an FHA loan is much lower than that of a conventional loan.
The industry standard credit score requirement for a conventional loan is 620 or higher. The FHA loan program can offer loans to borrowers with scores as low as 500—but there’s a catch. The lower the credit score, the higher the down payment has to be, so a borrower with a credit score between 500 and 579 would need to have a 10 percent down payment to qualify. Once the credit score hits 580, FHA borrowers can qualify to offer a down payment as low as 3.5 percent. These parameters are the minimums, however—lenders are allowed, within these guidelines, to set their own standard. Some FHA loan lenders will only grant mortgages to borrowers with a credit score of 580 or above. Larger lenders and national banks are more likely to take a risk on borrowers with a lower score.
3. How much of a down payment is needed is another main difference between an FHA loan and a conventional loan.
Many borrowers assume that the 20 percent down payment is the gold standard of home buying—and in a way, it is: Borrowers who can put down 20 percent of the purchase price are viewed as safer risks for the lender to take because that 20 percent is free and clear should the lender need to foreclose. However, 20 percent is not actually required for a conventional loan down payment. In fact, with good credit scores, traditional loan borrowers with excellent credit scores can make a down payment of significantly less than 20 percent. To cover the difference, borrowers who are permitted to put down less than 20 percent are required to pay for private mortgage insurance (PMI), which is a policy that will cover the lender’s losses up to 20 percent of the home value should the borrower default. When the borrower reaches 20 percent equity in their home, they can apply to have the PMI policy canceled. PMI premiums are paid as part of the monthly mortgage payment, so until the borrower reaches 20 percent and cancels the PMI, the monthly payments may be significantly higher than they expected.
FHA borrowers are certainly welcome to put down 20 percent if they can; it buys immediate equity, and for borrowers who have the cash saved it’s a great option. But the size of the down payment is, for many otherwise-qualified borrowers, the single greatest obstacle to homeownership. Old credit debt, high rent, and student loan payments, not to mention the out-of-pocket costs for medical treatment, make it difficult for many buyers (those just starting out and those who are older as well) to scrape up enough savings to even approach the 20 percent down payment necessary in a hot market. While FHA down payment requirements are tied to the borrower’s credit scores, even the required 10 percent down payment for borrowers with scores lower than 580 is only half of the standard 20 percent down payment, saving borrowers thousands of dollars up front and much more for borrowers who qualify for the 3.5 percent down payment.
4. Mortgage insurance, debt-to-income ratio, and interest rates are just a few other considerations when choosing between an FHA loan and a conventional loan.
Mortgage insurance requirements have changed over the last few years. The purpose of all forms of mortgage insurance is to protect the lender so that if the borrower defaults on the loan, the lender doesn’t lose money. In a conventional loan, private mortgage insurance (PMI) is required only if the borrower makes a down payment of less than 20 percent. The premium for the mortgage insurance is paid either annually or, more commonly, as an addition to each monthly mortgage payment. When the borrower’s equity in the house reaches 22 percent, the PMI is automatically canceled, and their monthly payment will decrease.
FHA loans require a different kind of mortgage insurance. Borrowers who have had previous FHA loans may recall that they, too, had PMI that they could cancel when they reached 20 percent equity, but that rule has changed. All FHA borrowers must now carry a mortgage insurance premium, or MIP. If the borrower initially makes a down payment of 10 percent or more, the MIP can be canceled after 11 years. For borrowers who make a down payment of less than 10 percent, the MIP will continue for the life of the loan. MIP is paid in two parts: the first is an up-front mortgage premium, which can be rolled into the closing costs and paid with part of the loan, and is approximately 1.75 percent of the loan amount. Then borrowers will pay between 0.45 and 1.05 percent of the loan amount each month as part of their monthly mortgage payment. While this doesn’t seem like a huge amount, remember that it’s for the life of the loan (likely 30 years), so it adds up. The only way to cancel MIP on a loan prior to 11 years (if the down payment was 10 percent or more) or ever (if the down payment was less than 10 percent) is to refinance the FHA loan into a conventional mortgage.
Debt-to-income ratio (DTI) is a calculation that lenders use to determine if a borrower will be able to make monthly mortgage payments and still be able to afford basics like food, utilities, and the expenses of everyday life. The DTI calculation is not insignificant: While borrowers may initially be confident that they’ll be able to pinch pennies and make ends meet, lenders know that when there’s a choice between feeding a family and making a mortgage payment, dinner usually wins (and should), so the lender wants to make sure that the borrower will have enough money to make it through the month with all obligations met. To do this, the lender uses a calculation that begins with the borrower’s pretax income. They total the amount of money that a borrower will spend on all debt, including the mortgage, credit cards, student loans, auto loans, any other loans, and child support, then calculate what percentage of the borrower’s pretax income will be spent on debt. In a conventional loan, lenders prefer that the DTI ratio be no higher than 45 percent of income. Borrowers applying for an FHA loan can have a DTI ratio of up to 57 percent, because the FHA’s backing of the loan reduces the risk to the bank. It’s important for borrowers to remember that the DTI ratio does not include other expenses, such as food, clothing, utilities, entertainment, school fees, or anything other than debt, so while the lender may be willing to offer a loan that will result in a DTI ratio of 57 percent, it’s still a good idea to make the calculations and determine whether that’s a livable amount of monthly expense.
How do interest rates compare? Interest rates are based on a lot of factors and can feel hard to pin down. Interest rates are affected for all borrowers by the economy, the prime rate set by the Federal Reserve, and other factors in the market. Generally, both conventional and FHA lenders use those numbers as a starting point and base their calculations on income, credit score, DTI ratio, the base amount of the loan, the down payment, and the loan-to-value ratio (or how much money is taken in a loan compared to the value of the property). Remember, for lenders, mortgages are about risk: The lenders want to make money in interest and not lose money through defaults, so they’ll put the numbers together, decide on the risk or potential reward each borrower may be, and set the interest rate for that individual borrower. In general, FHA loans are less risky for the lender because of the federal guarantee, so even though an FHA borrower may be a greater overall risk than a conventional borrower, the FHA guarantee often commands a lower interest rate overall.
5. Whether an FHA loan or a conventional loan is right for you depends on two main factors in your financial profile: your down payment and credit score.
There are other distinctions between FHA and conventional loans. If, for example, you’re hoping to finance a second home, you’ll have to apply for a conventional loan: FHA loans can only be used for a primary residence and can’t be used for flipping houses or purchasing rental properties. Also, the total amount of the loan you need will guide your choice. FHA’s total loan limits are lower than those for conventional loans, so if the home you’re planning to buy requires you to take out a loan for more than $420,860 (or $970,800 in certain high-priced areas), a conventional loan will be your only option, as FHA will not grant loans higher than those limits. The limit for conventional loans is $647,200, which offers more room for larger or more expensive homes. Any loan above that amount is considered a jumbo loan and is processed differently, in which case neither an FHA nor a conventional loan will work for you. Taking a good look at the market prices of homes in the area you’d like to buy in will help you determine which options will be available.
The two greatest determiners of what kind of loan will be most beneficial to you are the down payment you’re able to make and your credit score. These two numbers guide everything else: Your credit score determines what kind of down payment you’ll need to make, and the combination of credit score and down payment affect the interest rates available to you, the need for PMI on a conventional loan or MIP on an FHA loan, and the total amount you’ll pay for the home over time.
If your credit score is lower than 620, an FHA loan may well be your only option, and even with a score higher than 620 an FHA loan can be a great choice if you’re looking at a smaller down payment. If, however, your credit score is very high, you’ll probably find that a conventional loan is less expensive each month. But there are many variables, so the first thing to do when you start comparing mortgage options is to sit down and assess your financial picture: What is your credit score? What is your DTI? How much do you have available for a down payment? Making these calculations will make it more straightforward when you meet with a mortgage broker or loan officer to ask about the products they offer and help them guide you to the best program for your needs.