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How do you know whether it’s better for you to get a conventional loan or an FHA (Federal Housing Administration) loan?
The two loan types are miles apart and it might be a confusing exercise to pick what you should take. Any borrower must make sure that he is getting not only the correct type of loan but also, that he will get the best deal for himself.
Based on data from the United States Census Bureau, there was a wide gap in both methods of acquiring mortgages in 2004, where FHA mortgages were at 77,000, while convention mortgages recorded 1.05 million. However, there was a sudden plunge of convection mortgages homeownership between 2005 and 2010, closing the gap between the two. But as of 2020, conventional mortgage was on an uptrend, with the gap between the two slowly widening since 2010.
Conventional Vs FHA: What's The Difference?
- When you say ‘Conventional’, you are referring to a mortgage product that the private financial sector offers and the government does not guarantee these loans.
- When you say ‘FHA’, you are referring to a mortgage product that originated from the private sector but which the government insures through the Federal Housing Administration. But unlike traditional insurance, this one protects the lender and not the borrower.
Let’s make one thing clear: a conventional mortgage can also get insurance. However, a third-party company within the private sector usually provides insurance. The insurance does not come from the government that is why they call it private mortgage insurance or PMI.
So, when you want to know the main difference between the two, that basically is it. Now, read on for some supplemental and in-depth information that could help you decide.
In this article, we compare between FHA loans and conventional loans plus, we hope to answer some of your questions. After you’ve read through, we hope you can make a more intelligent choice on which loan type would suit your purpose.
Do They Have Loan Limits?
The FHA has set limits on how much a borrower can borrow for an FHA loan and it has been set according to a country where the property lies. The rule is that areas with higher real estate prices will have higher FHA loan limits.
So, supposing the dream house you want to buy is above the FHA loan limit in that area, you should make a larger down payment. If you can’t, you can try to get a conventional mortgage. Conventional mortgage lenders do not normally put a borrowing limit on the amount that you can borrow from them.
Can I Get an FHA Loan if I have a Conventional Loan?
FHA loans are designed for your primary residence. This means that if you already have a conventional mortgage and want an FHA loan for a second home or vacation property, you will not qualify.
However, if you plan on buying a property and you have little equity in your current home, you may be able to obtain an FHA loan for your new home. You’ll simply pay off the conventional mortgage from the proceeds of the sale.
Can You Switch From FHA to Conventional?
Yes, it is possible to switch from an FHA loan to a conventional mortgage. However, you will need to meet the lender requirements for the new mortgage. Each lender has different qualification criteria, but if your credit score has improved or you have far more equity in your property, you are likely to find it fairly simple to move over to a conventional mortgage.
Your new lender will arrange to repay the outstanding FHA balance with the proceeds of your new conventional mortgage.
Should I Ever Apply For an FHA Loan Even if I am Qualified For a Conventional Loan?
As any other financial decision – it depends. For many borrowers, the interest rate on an FHA loan is lower than the interest rate on a conventional loan, sometimes by a half percent or more. The only reason people may choose a conventional loan over an FHA loan is that they will save more money with the latter because they will not have to pay for insurance at all (or pay less overall).
So, if the cost of an FHA loan (interest rate + insurance premium) is less than that of a conventional loan, it is not a bad idea to go with the FHA option. The loan amount must, of course, be less than the FHA limit.
The one concern that home buyers have is that if they get an FHA loan, they will be unable to cancel the mortgage insurance, which is required for the life of the loan. In this case, you have the option of refinancing later when conventional rates begin to rise. Closing costs for the re-finance must still be considered, but this is something to consider if you are saving enough upfront.
FHA Loans Benefits
Let’s face it: FHA loans have a lot of advantages that allows a borrower to be able to buy a home. The best advantage probably is the fact that borrowers who would never qualify for a conventional loan can get an FHA loan.
FHA loans are best for non-traditional borrowers. Here are the main advantages:
Apply With Lower Credit Score
When it comes to getting a mortgage and a desirable interest rate, your credit score plays the most influential part. It is always best to have a 620 credit score whether it’s a conventional or FHA loan you are applying for.
For borrowers with poor credit or whose scores fall below 620, FHA will be their better choice. The great thing is, if your score is anywhere from 500-479, FHA will only require a 10% down payment.
It gets better: if you have a score of 580 and higher, you will only need to make a 3.5% down payment. These flexible credit guidelines make FHA a very attractive option for borrowers with a not-so-ideal credit score (See how can you improve your credit score).
Reasonable Down Payment
Between FHA and conventional loans, the issue on down payment is quite clear. FHA loans will generally require a lower down payment compared to conventional loans. You can pay as little as 3.5% of the home’s purchase price or its appraised value – whichever is less. You can see why this program attracts a lot of first-time home buyers who have limited funds at the moment.
Some private conventional lenders offered mortgage loans with a down payment of as low as 3% in 2017. However, these are few and far in between. Generally, conventional loans will often ask for a 5% to 20% down payment. Because of this, FHA comes in handy for home buyers who are looking to minimize their outright, out-of-pocket cash outlays.
This chart shows that repeat buyers in the United States have consistently paid a higher down payment than new home owners. According to NAR research, new home owners paid at least 4% down payment, with the highest being 7% in 2018. Repeat buyers paid a down payment of at least 13%, and the highest payment was 16%.
Flexible Credit Rules
You might have guessed it correctly that FHA credit standards are a lot friendlier to most borrowers. As we mentioned, you will need a minimum credit score of 620 for conventional loans and only a minimum of 580 for FHA loans .
If you are the borrower who has either filed for bankruptcy or have been through foreclosure regarding your loan, FHA loans are still widely available for you.
In conventional loans, you must wait for 7 years before you can become eligible for financing again. With FHA loan, that period goes down to only 3 short years. If you have filed for bankruptcy, you must wait 4 years before you can reapply for a conventional loan. However, under FHA rules, you only need to wait for 2 years.
Save on Closing Costs
Here’s the deal: it’s not like FHA closing costs are way lower than conventional loans but rather, the system can allow you to not pay for it yourself. There can be “interested parties” like real estate agents, mortgage brokers, and sellers who can shoulder the closing costs up to 6 percent of the new loan amount.
In conventional financing, this can and does happen but only up to 3 percent of the new loan amount unless the borrower has put up a down payment of more than 10 percent of the property value. All-in-all, this translates to the borrower shelling out less money in an FHA loan and being able to put the unused amount in saving or for other expenses.
Why Choosing a Conventional Loan
Here’s a rather strange thing: the advantages of FHA loans may seem easier on your pocket. However, for borrowers who qualify for conventional loans, they might actually have to spend less compared to FHA loans.
You may not know this but both FHA and conventional mortgages have other options aside from the standard 30-year fixed-rate mortgage.
For example, there’s a 15-year fixed-rate or adjustable rate mortgage for both types. You can get more options for conventional loans such as a 10-year, 15-year, 20-year, 25-year, 30-year, and in some cases, as long as a 40-year fixed-rate mortgage option. You can always compare fixed vs ARM by using a calculator.
There are also other adjustable rate terms such as a 5/1 Adjustable Rate Mortgage (ARM). Generally, you can get lower rates (and of course, lower monthly payments) for ARMs compared to fixed-rate loans. After the initial 5-year period is over, the interest rate and monthly payment will increase on a yearly basis.
Private Mortgage Insurance (PMI)
Mortgage insurance actually protects the lender such that in case the borrower defaults on the loan, the lender can recover some of their losses.
FHA mortgage insurance comes in the form of a fee at closing and also as part of the regular monthly loan payment. In conventional loans, borrowers may also pay for a mortgage insurance but normally via a monthly premium.
Here’s the trick: if you make a down payment of 20 percent or more on a conventional loan, you probably won’t have to get mortgage insurance anymore.
No Upfront Mortgage Insurance Premium (UFMIP)
If you take out an FHA loan, you will have to pay a UFMIP premium that is equivalent to 1.35% of the base amount and the lender will add this to your loan balance. On a $300,000 loan, this will increase your total loan amount by $4,050 and you will have to pay it off over the life of the loan.
On the other hand, if you take a conventional loan, you won’t have to make a UFMIP even when the lender will require private mortgage insurance.
Easier Approval For Condominiums
Just in case, you want to buy a condominium unit, FHA has a different rule regarding what can qualify for their package. The condominium project must get an FHA approval before you can purchase it.
As it is, the list of FHA-approved projects is not very long so there’s no guarantee that there is one in the area of your choice. With conventional loans, the lender just has to certify that the condominium project that will be subject of the loan has met industry standards, then you’re good to go.
At first glance, you may think that FHA and conventional loans are similar but the way the lenders process and administer these loans are miles apart. A rule of thumb to follow then is: get the type of loan that will best provide solutions for what you need based on your condition.
To elaborate, find out which program will most closely fit your situation, financial and otherwise.
For example, let’s say you anticipate that the funds for closing will be a cause for concern later, then an FHA loan would be the answer. If you’re trying to buy a condominium and want to be able to choose from a wide range of projects, most probably a conventional loan is better.
Government Backed Alternatives to FHA Financing
There are two main government alternatives if you prefer to skip FHA loans:
Veterans Administration Loans (VA Loans)
This type, like FHA loans but unlike conventional mortgages, is backed by a government agency – the Department of Veteran Affairs (aka VA). You may be eligible for a VA loan if you are a veteran, active-duty service member, or veteran spouse.
No other loan on the market requires a 0% down payment. This is a huge benefit because many people do not have any money. Furthermore, the terms are significantly better than those of conventional loans.
The number of VA-guaranteed new home sales in the US has increased from 28,000 in 2004, to 62,000 in 2020, according to the US Census Bureau. There has been consistent growth over the years, with declines in 2007 and 2018, when new homes sales declined to 24,000 and 43,000 respectively.
Rural Housing Service (RHS), an agency of the United States Department of Agriculture (USDA), also provides affordable mortgages to people who live in rural areas. These loans have low interest rates and are available to people with low income. Single Family Direct Home Loans, also known as Section 502, are the most common program. Borrowers are typically offered these programs by local banks in collaboration with the USDA.
Borrowers must have a low income in order to qualify. Furthermore, families should not own a home. Some of the advantages include a term of up to 33 years and no down payment.
Refinance Your Mortgage: FHA Vs Conventional Loans
Both FHA and Conventional home loans are pretty even on the question of whether it allows you to refinance your mortgage.
Basically, both will let you get refinancing to avail of lower mortgage payment and a better interest rate. If you have an FHA loan, you may qualify for an FHA streamline refinance. A streamline refinance is very much like a traditional refinancing but it’s easier to avail because it will require less paperwork. The lender will not do a credit check or an income verification anymore.
Companies normally do these refinancing quickly and smoothly so they help many borrowers get low rates and even lower payments. If you have a conventional loan, refinancing is available for you as well when you need it. Most lenders follow a traditional rate and term refinance option for this type of mortgage. This will be to the borrower’s advantage because the lender lowers the interest rate and either extends or shortens the term when necessary. However, if it's not necessary – it's better to stay with your current loan. You can always check your refinance breakdown point by a calculator.
Or, if you are looking for another refinance option, there is yet another one available in the market for conventional loans. They call it the HARP program or the Home Affordable Refinance Program.
It was set up by the Federal Housing Finance Agency in 2009. If you have a loan from Fannie Mae or Freddie Mac, you can refinance your loan under HARP regardless of how much equity you have in your house.
If you have a good credit score and little debt, a conventional loan is a great option. You can avoid PMI by paying 20% of the loan in advance, which will lower your mortgage payments.
If you are unable to make a large upfront payment, conventional loans with down payments as low as 3% are available. Borrowers typically save money in the long run by using a conventional loan because there is no upfront mortgage insurance fee and the monthly insurance payments are lower.
Simply put, FHA loans are generally easier to qualify for and allow for lower credit scores, whereas conventional loans may not require mortgage insurance if a sufficient down payment is made. The best loan option for you is determined by your personal financial situation.
Generally speaking, the rates for FHA loans are slightly lower than conventional mortgage rates, while there are appraisal fees and other charges, these are not much different from conventional mortgage fees.
So, you really need to look at specific deals and your circumstances. If you have a good credit score and can put down a decent down payment, you may find a conventional mortgage will be cheaper.
The main advantage of FHA loans over conventional mortgages is that the qualifications are less restrictive. Not only can you access a lower down payment, but you don’t need to jump through as many hoops to qualify.
Conventional mortgage lenders can put their applicants through a vigorous process to qualify, whereas FHA loans simply require a credit score of at least 500 and MIP insurance.
On paper, FHA loans tend to be lower compared to conventional loans. However, you do need to look closely at the rates. Remember that your rate will depend on your credit score and other factors. If you have a score above 650, you are likely to secure a better deal with a conventional mortgage.
Most sellers prefer conventional loans, as there can be a number of issues with FHA loans. FHA loans have some strict guidelines, which predominantly relate to the appraisal.
For example, if the appraisal value is less than the agreed sales price, the deal will not go through if the seller does not reduce the price. There is no negotiation as with a conventional loan.
Additionally, FHA appraisals require checking for some very specific defects, such as safety hazards and expected useful lifespan on items like the roof and any appliances. The seller is required to repair any defects before the sale can go through.