Are you house hunting? If so, there’s something else you should be thinking about before locking in your mortgage: wealth building.
In a perfect world, you’d find a lender who could outline hypothetical outcomes and give you the lay of the land when putting a comparable Federal Housing Administration (FHA)-insured mortgage against a conventional mortgage loan. You’d likely find that one had lower interest rates and lower monthly payments, resulting in greater overall benefits as the loan is paid down.
While any lender can model a particular homebuying scenario, you want to make sure you’re using the mortgage product that’s right for you.
Take a look at how FHA loans stack up against conventional mortgages. The key to deciding which loan you should get is understanding how both programs work and how they help or hinder your financial situation.
FHA or Conventional? The Key Differences
The Journal of Urban Affairs said it best in 2011 when it noted the FHA has had a particularly large impact on the mortgage and housing markets in the United States. It played a historic role after the 2008 financial crisis as a “lender of last resort” after subprime borrowers defaulted and conventional lenders pulled back and regrouped. In the process, FHA loans surged, accounting for 40% of home purchases by year’s end, a level not seen since World War II.
Today, the popularity of FHA loans stems from their modest requirements: lower credit scores and higher debt-to-income ratios are allowed when compared to a conventional loan.
But that’s not all. The FHA has less-restrictive qualifications, requires only a small down payment, and still offers fixed and variable interest rates at 15 or 30-year terms. Along with lower closing costs, these generous repayment terms make an FHA loan a solid choice. Still, the FHA vs. conventional loan debate comes down to the needs of the borrower.
Requirements for FHA and Conventional Loans
For those interested in applying for either an FHA or conventional loan, here are the standard requirements:
The FHA requires a score of 580 to qualify for the low down payment advantage.
Conventional loans usually require a credit score of at least 620 to 640 to qualify for a lower down payment.
The FHA lets you put down just 3.5% of the purchase price.
There are conventional loan options that let you put down just 3%, but many will require at least 5% down or more, depending on your credit score. Government-backed USDA and VA loanscan allow you to purchase a home with $0 down.
Debt-to-Income Ratio (DTI):
Are you worried about how much debt you can have and still buy a home? Your DTI includes the minimum payment due on each debt listed on your credit report, as well as other monthly debts. Factor in a mortgage, and you might be tipping the scales solidly in the wrong direction.
The maximum debt-to-income ratio will vary by lender, but for FHA-backed loansthe standard DTI is around 43%.
According to Investopedia, Lenders prefer to see aDTI smaller than 36% for conventional loans, with no more than 28% going towards a mortgage payment.
Loan limits can be one of the more confusing aspects of FHA-backed loans. That’s because the limits will vary by county, so where you plan to purchase your home could inevitably be affected. The FHA loan limits in 2020 range from $331,760 to $765,600. The upper limit on a single-family home in low-cost counties is $331,760. (You can visit the Housing and Urban Development website to find the loan limit in any county)
For a conventional loan, your loan must fall within the limits set by Fannie Mae and Freddie Mac. The loan limit changes annually, and in 2020 is $510,400.
For both FHA and conventional loans, there are exceptions to high-cost areas of the country. In 2020, the loan limits for places like Alaska, Hawaii, and other areas increased to $765,600.
With an FHA-backed loan, mortgage insurance is unavoidable. Initially, you’ll be required to make an upfront insurance payment (which can be rolled into the loan) and make monthly payments tacked onto the mortgage thereafter. If you make a down payment of less than 10%, you’ll continue to pay mortgage insurance for the life of the loan. If you pay at least 10%, you’ll pay PMI for 11 years.
If you put less than 20% down on a conventional loan, you’ll also be required to pay PMI. The good news is there are different ways to cover the cost (such as paying it upfront), and once you reach 20% equity in your home you can ask the lender to remove PMI from your mortgage payments.
Other Prerequisites and Rules:
When you’re buying a property with an FHA-backed loan, it will need to meet minimum property requirements. The FHA requires an appraisal to make sure the home is a good investment and it constitutes safe and secure housing.
Conventional loans also require an appraisal based on a home’s location, condition, and area comparables for similar housing. The big caveat is this — if you offer to pay more than the home is worth, you’ll have to make up the difference at closing.
Finally, it’s worth noting that interest rates for conventional loans change daily, but are usually slightly lower than FHA rates. That’s because FHA-backed loans tend to require more work on the part of the lender.
FHA or Conventional? What Makes Sense For You
The FHA vs. Conventional loan debate comes down to your specific needs, and also depends on your budget and financial goals.
FHA loans have often been the choice for first-time homebuyers, as well as those who lack the capital to consider a conventional mortgage loan. Remember, there’s no minimum or maximum income to qualify and a lower credit score won’t prevent you from owning a home. FHA loans overall offer a bit more flexibility than conventional loans.
On the other hand, the conventional loan option might be a better option for its simplicity. These loans are structured in a more straightforward and predictable manner, have more liberal standards, and tend to close faster than an FHA-backed loan might.
The Bottom Line
Different situations require different loans, and you’ll need to do your homework and figure out which one works for you. An FHA loan is sometimes the better option, but no matter how much money you put down, you’ll have mortgage insurance tacked on. Meanwhile, a conventional loan requires a higher credit score and usually a larger down payment, but you have the option to eliminate mortgage insurance.
Overall, an FHA loan makes sense if you: don’t have a higher credit score, you don’t have a lot of money to put down, and you have a higher DTI.
A conventional loan makes sense if you: Have better credit, have more cash to bring to the table at closing, have a lower DTI, and you want more flexible terms with your loan.
Your best move is to consult a financial adviser who can help you further weigh the pros and cons of each loan type, which will help you make an informed decision about your financial future.
- The Journal of Urban Affairs, From Minor to Major Player: The Geography of Fha Lending during the U.S. Mortgage Crisis. Accessed at https://www.tandfonline.com/doi/abs/10.1111/j.1467-9906.2010.00539.x
- FHA Lenders, 2020 FHA Debt to Income Ratio Requirements. Accessed at https://fhalenders.com/fha-debt-to-income-ratio/
- Investopedia, What Constitutes a Good Debt-to-Income (DTI) Ratio? Accessed at https://www.investopedia.com/ask/answers/081214/whats-considered-be-good-debttoincome-dti-ratio.asp
- HUD.gov, FHA Mortgage Limits. Accessed at https://entp.hud.gov/idapp/html/hicostlook.cfm
- The Mortgage Reports, FHA vs. Conventional: Which low-down-payment loan is best? Accessed at https://themortgagereports.com/17168/fha-conventional-97-low-downpayment-comparison
- Credit.com, Should You Get an FHA or Conventional Loan? Accessed at https://www.credit.com/blog/should-i-get-an-fha-or-conventional-loan-158710/