If you’re a first-time homebuyer, you have a lot of decisions to make, including what type of loan to choose. You may have heard that FHA loans are good options for first-time homebuyers, but why is that? What is the difference between an FHA and a conventional loan?
Well, FHA loans have a few benefits for first-time homebuyers that conventional loans don’t. You can get an FHA loan with a lower credit score, for example.
However, conventional loans come with their own set of benefits, like the ability to eliminate private mortgage insurance if you have a low down payment. If you’re torn between the two types of mortgages, here are the big differences between an FHA and a conventional loan.
FHA loans are insured by the FHA; conventional loans are not
FHA loans are loans that are backed by the Federal Housing Administration, and they must be issued by an FHA-approved lender.
Conventional loans are not backed by the FHA but are insured by private lenders and therefore they can be issued by a wider selection of lenders.
So what does it mean when the FHA insures a loan? If the buyer defaults on the home and the home forecloses, the lender is protected from a certain degree of loss by the FHA. This extra layer of protection encourages lenders to extend loans to borrowers with lower down payments and credit scores, expanding the opportunity of homeownership to borrowers that may otherwise be ineligible under traditional conventional loans.
In terms of credit scores, an FHA loan is more flexible than a conventional loan.
Conventional loans typically require a credit score of 620 or higher, while an FHA loan can be secured with a credit score as low as 500 if you have a 10% down payment, or as low as 580 if you have a 3.5% down payment. With FHA loans, “usually the credit score is a little bit less. They’re much more forgiving,” says Phoenix-based agent Andrew Monaghan, who has 19 years of experience placing buyers in their dream homes. “It provides a different opportunity for homeownership.”
While conventional loans typically require a higher credit score than an FHA loan, if your credit score is high, you can still secure a conventional loan with a 3% down payment. However, most conventional loans typically require a down payment of between 5% and 20%.
The minimum down payment for an FHA loan is 3.5%, making FHA loans more accessible to first-time homebuyers who might not have a large amount saved for a down payment.
Also, for FHA loans, there are down payment assistance programs available that can help ease the burden of coming up with a down payment. FHA loans will allow 100% of the down payment amount to be a gift, while conventional loans only allow a portion of the down payment to be a gift.
Mortgage insurance, private or otherwise
Mortgage insurance is insurance that lenders require for certain loans that the lender considers more risky. The acronym PMI stands for private mortgage insurance, which is issued for conventional loans; government-backed loans also require mortgage insurance, but that insurance is coming from the FHA, not a private institution.
If a buyer defaults on their loan and the home goes into foreclosure, the price the house will get at auction may not cover the balance of the loan. In a situation like this, mortgage insurance makes up the difference to the lender.
If you have less than a 20% down payment on a conventional loan, you’ll have to pay PMI. The good news is, you can arrange to have PMI removed once you have 20% equity built up in your home. However, the lender will not automatically remove PMI once you hit your 20% equity threshold — so be sure to keep an eye on it and contact your lender when you know you have 20% equity built up.
With an FHA loan, buyers are required to pay a 1.75% upfront mortgage insurance premium (MIP) at closing, regardless of the size of the down payment. And if you don’t have at least a 10% down payment, you will have to pay mortgage insurance for the lifetime of the loan, until you refinance the loan or sell the home. If you have a 10% down payment or higher, the FHA requires you to pay MI for 11 years.
Your debt to income ratio is exactly what it sounds like: the amount of debt you have divided by your income. Debt includes anything that would appear on your credit report, including:
- Credit cards
- Auto loans
- Student loans
- Alimony or child support payments
- Installment loans
- Business debt
DTI ratio calculations do not include:
- Medical debts
- Child care
- Union dues
- Commuting costs
As of 2019, the FHA’s maximum qualifying debt ratio is 43%. That means your total debt should not exceed 43% of your income.
Conventional loans, on the other hand, have a maximum qualifying DTI ratio of 45% to 50%. In this case, your total debt payments generally shouldn’t exceed 45% of your income, but in some cases, lenders will allow up to 50% debt to income.
|Credit score||As low as 500 with a 10% down payment; 580 or above with a 3.5% down payment||620 or higher|
|Down payments||3.5% to 10%; can be 100% gifted or through a down payment assistance program||3% to 20%, depending on credit score; only a portion can be gifted|
|Mortgage insurance||– 1.75% payment at closing
– 10% plus down payment – required for 11 years
– Less than 10% down payment – required for the life of loan
|Required with less than 20% down payment; can be automatically removed once 20% equity in home is reached|
|Max DTI ratios||43%||45% to 50%|
Loan limits are the amount of money an institution will lend to a buyer under a given program and generally vary based on where the subject property is located. At the end of 2019, Fannie Mae raised their limits for a single-family conventional conforming non-jumbo loan to $510,400 from just over $484,000 for most areas of the U.S. (Alaska, Guam, Hawaii, and the U.S. Virgin Islands excluded) with higher loan limits in certain high-costs areas.
FHA loan limits depend on the county the property is located in. In high-cost counties, the limits are as high as $765,000. If you’re thinking about an FHA loan, their mortgage limits calculator by county is a good way to gauge whether or not an FHA loan will work for you. Below are some examples run through the mortgage limits calculator for different counties.
|County||FHA Loan Limit|
|San Francisco County, California||$765,600|
|Anne Arundel County, Maryland||$520,950|
|Marion County, Indiana||$355,350|
|Grand Forks County, North Dakota||$331,760|
|Tarrant County, Texas||$404,800|
FHA loans have what they call a streamline refinance option. They’re called streamline refinances because there is not as much documentation required by the lender; they don’t require an additional credit check, income verification, or re-appraisal of the property. This refinance option is only available to borrowers who currently have an FHA loan.
Streamline refinances have a few criteria:
- The loan must be FHA insured
- Payments must be current
- The refinance must result in a net tangible benefit for the borrower
- Cash out must not exceed $500
If you have an FHA loan and are looking to refinance, a conventional loan may be an option if you have enough equity built up in the house. If you have 20% equity built up, refinancing into a conventional loan will get rid of mortgage insurance on your FHA loan, which can save you hundreds of dollars a month.
On the other hand, refinancing a conventional loan does require a credit check, income verification, and often a second appraisal.
After a foreclosure or bankruptcy, lenders require a certain amount of time before they will consider lending to you. These periods differ for FHA and conventional loans, and depending on the type of bankruptcy. The table below outlines the different waiting periods and conditions for each loan.
|Chapter 7 Bankruptcy||1-year waiting period if you can prove extenuating circumstances; 2-year waiting period otherwise||2-year waiting period if you can prove extenuating circumstances; 4-year waiting period otherwise|
|Chapter 11||No waiting period||2-year waiting period if you can prove extenuating circumstances; 4-year waiting period otherwise|
|Chapter 13||1-year waiting period from your discharge date||2-year waiting period from your discharge date|
|Foreclosure||3-year waiting period||3-year waiting period if you can prove extenuating circumstances; 7-year waiting period otherwise|
Qualifying for an FHA loan
While FHA loans are popular because of their lower credit score and down payment requirements, they do have some specific qualifications that buyers need to meet. FHA-backed lender requirements include:
- FHA loans can only be used on owner-occupied residences, so they cannot be used for investment or vacation properties.
- Down payment: 10% for credit scores 500-579; 3.5% over 580.
- 43% maximum debt-to-income ratio.
- Two years of employment history.
- Proof of steady income verified by paystubs, W-2s, and tax returns.
- No non-occupying co-borrowers.
- Bankruptcy/foreclosure requirements as listed above.
Conventional loan appraisals and FHA loan appraisals are different as well. In a nutshell, FHA loan appraisals have more conditions that need to be met in order to meet the minimum standard of living requirement set by the Department of Housing and Urban Development.
A conventional appraisal will appraise the house as-is, while an FHA appraisal often leads to certain things needing to be repaired or completed before the lender will finance the house. “Let’s say for instance you’ve got a home that needs paint. Whereas in a conventional financing, they’ll say, ‘Okay, it needs paint, here’s your value based on the condition of the house,’ on an FHA loan they’ll say, ‘You need paint, it’s a habitability issue, you need to get the house painted before we’ll finance you,’” explains Monaghan.
There are many loan options you can look at to finance your home. FHA and conventional loans are two great options with different requirements so that you can make the best decision based on your needs.
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