One of the biggest hurdles in buying a home is getting the right financing at the price. This is especially the case in the current market where banks are placing strict criteria, and requiring large down payments to get a conventional home loan. Due to the deep recession, stock market plunge and other constraints many homeowners cannot take advantage of historically low rates and the $8000 new home owner tax credit, because of the inability to get funds required for a 15% to 20% down payment. This is where FHA (Federal Housing Administration) loans can help borrowers with low cash reserves, spotty credit history or other extenuating circumstances. A FHA Loan is one that is insured by the federal government against default, which makes it more appealing to lenders. The lower risk profile of the loan means that FHA loans generally have lower interest rates than conventional loans.
Conventional or traditional home loans on the other hand have no guarantees other than the borrowers credit and financial record to repay the loan. The higher risk, means banks want more assurances and greater down payment for these types of loans.
Conventional and FHA loans may be “conforming” and “non-conforming”. Conforming loans (normally less than $417,000 in most states) follow the terms and conditions set by Government sponsored entities Fannie Mae and Freddie Mac that securitize these loans. Nonconforming loans are those that don’t meet Fannie Mae or Freddie Mac qualifications, and are also called jumbo loans. Both FHA and Conventional loans can be fixed rate mortgage or adjustable rate. To know which type of loan is right for you, it is worth looking at some of main differences between FHA and Conventional home loans.
- The main advantages of a FHA versus conventional loan is that the qualifying criteria for a borrower are not as strict as those on a conventional loan and the down payment or upfront equity requirements are significantly less. In today’s market, to get the best rate on conventional loans you need 15% to 20% equity (assuming good credit and employment history). FHA loans typically require around 5%, but can be as low as 3.5% of the purchase price, and most of your closing costs and fees can be included in the loan. You will to need to buy mortgage insurance though.
FHA loans will allow the borrower who has had a few “credit problems” or those without a credit history to buy a home. An FHA underwriter will require a reasonable explanation of these derogatories, but will approach a person’s credit history with a more lenient approach. Most notably, borrowers with extenuating circumstances surrounding a bankruptcy that was discharged 2 years ago can be approved for maximum financing. Conventional financing, on the other hand, would require multiple years to have passed to be eligible for consideration and relies heavily upon credit scoring. If your score is below the minimum standard, you will not qualify or you will be place in a higher rate Subprime, Alt A or A minus loan product. See this post on ways to improve your FICO Credit score
FHA loans are generally best suited to first-time homebuyer’s who don’t have a lot of money to put down on a house, average credit and worried about qualifying for a conventional loan. If a borrower does have past credit issues an FHA loan may be significantly cheaper than an alternative loan such as subprime, ALT A, or A minus. These other programs generally have higher interest rates or require a larger down payment or equity position. Many of these alternative loan products have pre payment penalties where as FHA loan do not have such penalties. However, it is important to compare the ongoing costs of a FHA loan and conventional loan to get an idea of the total cost to you.
Another advantage of a FHA vs conventional loan is that FHA is one of the few home mortgage programs that allow a borrower to have their down payment gifted from a family member, a governmental agency, or non-profit organization. This allows home buyers without the necessary money to buy a home today.
FHA Loan Disadvantages
- Conventional financing generally does not require an upfront mortgage insurance premium when a borrower closes on the loan. With FHA financing, that fee for a 30 year loan is 1.75% of the loan amount that the borrower can wrap into the mortgage. On a $100,000 for 30 years at 8%, that’s an additional $11.51 that the borrower must pay each month. That’s almost an additional $132 the borrower must pay each year (fortunately the interest a borrower pays on his or her mortgage on a primary residence is tax deductible).
Another drawback to FHA loans is that the loan limits set for FHA loans are typically less than the loan limits for conventional financing in most parts of the country. If a borrower is looking for a mortgage that exceeds the FHA loan limits for the area, the borrower would have to put additional money down on the property or finance under a conventional mortgage, Subprime, Alt A or A Minus product. Under the stimulus package FHA loan limits have been raised in many areas and FHA offer FHA Jumbo Loans (check for this option with your lender)
You will have to buy mortgage insurance on an FHA-insured loan. The upfront premium is an amount equal to the following percentages of the mortgage that ranges from 1.75% to 3%. Most conventional loans also require mortgage insurance when your down payment is less than 15 to 20% of the sales price. On conventional and subprime loans, mortgage – insurance is provided by private companies. Whether private mortgage insurance is less than, equal to, or more than an FHA-insured loan’s insurance will depend upon the loan program and your qualifications. Compare the cost of FHA to subprime and conventional types of loans over the life of your loan. Then compare how much each one costs monthly. The FHA deal will probably be better. However, if you can afford a 15 to 20% down payment on a conventional loan, you won’t have to pay any mortgage insurance. A potentially big saving for larger loans.
The time to process and to approve FHA loans is much longer than that for conventional loans due to the extra checks required for FHA approved loans. A conventional loan can take 2-3 weeks to process from application to approval. An FHA loan can take anywhere from 4 to 8 weeks, based on the credit and background checks required by various parties involved.
Conventional loans usually require a larger down payment than FHA and if you have less than perfect credit you may not qualify for an affordable mortgage with a low interest rate . The best thing to do is compare the cost of the conventional loan to an FHA-insured loan line-by-line. What are the fees for each? What is the interest rate? How much is the mortgage insurance? How much down payment is required? For some borrowers, a conventional loan may be less expensive. For many others, getting an FHA-insured loan is the way to go.
If you can afford to put down more than 15% or 20% – without jeopardizing your current and financial position, then go with conventional loan because you pay no PMI and will get a very competitive interest rate. Otherwise, consider going with a FHA loan.