FHA Loan vs. Conventional Loan

February 22, 2012 7 Comments »
FHA Loan vs. Conventional Loan

Our latest mortgage match-up pits FHA loans against conventional loans, both of which are popular options for homeowners these days.

In recent years, FHA loans have surged in popularity, largely because subprime lending (and Alt-A) was all but extinguished as a result of the ongoing mortgage crisis.

Some even claim FHA loans are the “new subprime,” mainly because of the low down payment and credit score requirements, despite originally being designed for low and moderate-income borrowers.

But you don’t have to be a subprime borrower to take advantage of an FHA loan.

FHA Loans Are a Great Low Down Payment Option

As noted, these government-backed home loans have become insanely popular. The main selling point of an FHA loan is the 3.5% minimum down payment requirement.

However, in order to qualify for the flagship low down payment option, you need a minimum credit score of 580.

And 580 is just the FHA’s guideline – individual banks and mortgage lenders still need to agree to offer such loans.  So there’s a very good chance you’ll need an even higher credit score. Of course, a 580 credit score is pretty dismal…

[How to get a mortgage with a low credit score.]

Along with that, an eligible donor can provide gift funds for 100% of the borrower’s closing costs and down payment.  And no reserves are required if it’s a 1-2 unit property.  In other words, you don’t need much if any cash to finance your home purchase.

FHA Loans Good for Those with Poor Credit

The other major selling point to an FHA loan is that the minimum credit score is 500. Again, this is subject to lenders actually offering programs for scores this low. And scores between 500 and 579 require a minimum down payment of 10%.

But FHA loans can be a good option for those with poor credit who are determined to get a mortgage.

Another benefit to going with an FHA loan is the higher loan limit, which is as high as $729,750. This can be a real lifesaver for those living in high-cost regions of the country (this limit has since dropped to $625,500 as of 2014).

Meanwhile, conventional conforming loans backed by Fannie Mae and Freddie Mac are capped at $625,500. Anything above that is considered a jumbo loan, and will come with a higher mortgage rate.

Speaking of rates, FHA loans tend to come with slightly lower interest rates, though one has to consider the entire payment (with mortgage insurance included) to determine what’s the better deal.

FHA Loans Subject to Mortgage Insurance

We’ve talked about some benefits of FHA loans, but there are drawbacks as well.

The major one is the mortgage insurance requirement. Those who opt for FHA loans are subject to both upfront and annual mortgage insurance premiums.

The upfront mortgage insurance requirement is unavoidable, and the annual premium can only be avoided if you have 22 percent or more home equity and a loan term of 15 years or less.

All other borrowers must pay the annual mortgage insurance premium for a minimum of five years, which will clearly increase the cost of the mortgage.

[Note that FHA insurance premiums are also slated to increase!]

Keep in mind that FHA loan offerings are also pretty basic. They offer both purchase money mortgages and refinance loans, but the choices are slim.

In other words, you’ll most likely be stuck with a 30-year or 15-year fixed, or a 5/1 adjustable-rate mortgage. So if you’re looking for something a little different, the FHA probably isn’t for you.

Update: Many FHA loans now require mortgage insurance for life, making them extremely unattractive and expensive!

Conventional Loans Offer Many More Options

That being said, let’s discuss conventional loans, an alternative to FHA loans which tend to offer a lot more variety.

With a conventional loan, which includes both conforming and non-conforming loans, you can get your hands on pretty much anything from a 1-month ARM to a 30-year fixed, and everything in between.

So if you want a 10-year fixed mortgage, or a 7-year ARM, a conventional loan will be the way to go.

Conventional mortgages also aren’t capped at a certain loan limit, assuming they are non-conforming. For those who need a true jumbo loan, a conventional mortgage will be the only way to obtain financing.

No Mortgage Insurance Requirement on Conventional Loans

Additionally, you won’t be subject to mortgage insurance premiums if you go with a conventional loan, assuming you put 20% down, or have at least 20% equity when refinancing.

Even if you’re unable to put 20% down, there are low down payment programs that don’t require mortgage insurance.

In fact, the Fannie Mae Homepath program only requires a three percent down payment and does not require mortgage insurance (
the DP requirement has since been increased to 5%).

However, there are select lender programs that offer 3% down with no MI, so in some cases you can put down even less than an FHA loan without being subject to that pesky mortgage insurance.

Generally, conventional mortgages require a down payment between five and 20 percent, so low down payment borrowers will still want to consider FHA loans first.

You Can Get Conventional Loans Anywhere

Another plus to conventional mortgages is that they’re available at pretty much every bank and lender in the nation.  That means you can use any bank you wish and/or shop your rate quite a bit more.  Not all lenders offer FHA products, so you might be limited in that respect.

Additionally, conventional loans can be used to finance just about any property, whereas some condo complexes (and some houses) aren’t approved for FHA financing.

The FHA has minimum property standards that must be met, so even if you’re a great borrower, the property itself could hold you back from obtaining financing.  In other words, you might have no choice but to go the conventional route.

The same goes for second homes and non-owner investment properties. If you don’t intend to occupy the property, you will have no choice but to go with a conventional loan.

Final Word

These days, both FHA loans and conventional loans could make sense depending on your unique loan scenario.

Both offer competitive mortgage rates and closing costs, so you’ll really have to do the math to determine which is best for your particular situation.

Even with mortgage insurance factored in, it may be cheaper to go with an FHA loan if you receive a lender credit or a lower mortgage rate as a result.

Conversely, a slightly higher mortgage rate on a conventional loan may make sense to avoid the costly mortgage insurance tied to FHA loans.

Your loan officer or mortgage broker will be able to tell if you qualify for both types of loans, and determine which will cost less both short and long-term.  Ask for a side-by-side cost analysis.

Lastly, be sure to consider the property as well, as both types of financing may not even be an option.

FHA Loan Advantages

  • Lower down payment requirements
  • Lower credit score requirements
  • Lower mortgage rates
  • May be easier to qualify for than a conventional loan
  • No prepayment penalty
  • No reserve requirement (for 1-2 unit properties)
  • Gift funds can cover 100% of closing costs and down payment
  • Streamlined FHA refinances are fast, cheap, and easy

FHA Loan Disadvantages

  • Subject to mortgage insurance (for full term of mortgage in many cases)
  • Mortgage insurance harder to cancel
  • Fewer loan options than conventional loans
  • Only available on owner-occupied properties
  • Many condominium complexes aren’t approved for FHA financing
  • Loan limit of $625,500 in high-cost areas, much lower in more affordable regions
  • Generally only allowed to have one FHA loan

Conventional Loan Advantages

  • No mortgage insurance requirement if 80% LTV or lower
  • Can be used on all property and occupancy types
  • Many more loan program options
  • Can hold numerous conventional loans
  • No maximum loan limit and conforming limit higher than the FHA floor
  • More lenders to choose from (nearly every bank offers conventional loans)

Conventional Loan Disadvantages

  • Higher down payment requirements
  • Higher credit score requirements
  • Higher mortgage rates
  • May be more difficult to qualify than FHA loan
  • Mortgage insurance still required for loans above 80% LTV
  • Reserves often required to qualify
  • Possible prepayment penalty

7 Comments

  1. Justin McClelland February 15, 2013 at 11:40 am -

    I appreciate you breaking down these differences in summary. It surely beats reading thru the dry content of hud.gov and other sites to get a quick snapshot of the two types.

  2. Leora June 30, 2013 at 8:06 am -

    Thanks for the side-by-side comparison. I’m going to have the bank show me both options to see which will cost me the least. I know the insurance costs went up, but if the interest rate is cheaper, it could be better to go with the FHA.

  3. Betty November 6, 2013 at 6:20 pm -

    I was told that my rate on an FHA loan would be about 0.25% cheaper than a conventional loan, but with mortgage insurance premiums factored in the costs eclipse the interest rate savings. Why is the FHA charging so much for insurance. What’s the point of offering a low rate if it doesn’t really cost less?!?!?

  4. Colin Robertson November 7, 2013 at 10:06 am -

    It’s great that you picked up on that. You need to look at both the rate and the costs to get an accurate picture of which mortgage may be best for you. The FHA has increased mortgage insurance premiums several times now to shore up its capital reserves after making a bunch of high-risk, bad loans in the past. So essentially today’s FHA borrower is paying for the offenses of the past. If rates and costs were low, the FHA would be inundated with loan applications, as it was before their most recent cost increases.

  5. Andrew March 31, 2014 at 6:06 am -

    yes betty it is pointless im paying almost 300 a month on mip which when u add it up is way more than a regular high interest conventional and Im stuck with it for 9 yrs so point is don’t just look at the low interest rate from fha

  6. Chandru August 31, 2014 at 8:14 am -

    Hi

    I am planning to purchase a house worth 670k in Culver City area. I heard FHA has a maximum financing of unto 625,500. So, i am making 7% down payment as against 3.5%. I am also paying MIP. So i would want to know can i get any conventional loan with 7% down payment for purchase price 670k….i was told minimum is 10% down for conventional loan for loan value above 430k. Please let me know if i have any option……

    Best Regards
    Chandru

  7. Colin Robertson September 2, 2014 at 11:44 am -

    Chandru,

    It’s possible to go conventional with just 5% down (or even lower in some cases), though it might be difficult to find such a lender at the higher loan limits you mentioned. You’re probably better off putting 10% down if possible to expand your options and lower your interest rate. In any case, shop around with a broker and local banks/lenders to see who can do what. Offerings will vary from bank to bank.

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