Difference Between FHA Loan vs. Conventional Loan?
A home purchase is likely the largest purchase you will ever make. Even if you get a good deal on a smaller home, you will still be spending thousands of dollars on it. Most people cannot afford to purchase a home outright with cash. Usually, a mortgage loan is required. There are different types of loans, and not all of them will suit every home buyer. Let’s look at two of these loans, FHA Loan and Conventional Loan, and the differences between them.
FHA loans are federally insured, backed by the Federal Housing Administration. This takes the burden of risk off of private lenders and makes the lenders more willing to grant the loan.
Because FHA loans are provided by lenders and backed by the federal government, there are two sets of criteria that borrowers must pass to qualify. Those with poor credit and insufficient income will find it difficult to pass all these criteria.
However, in general, it is still easier to qualify for an FHA loan than a conventional loan. This is partly due to the requirements set by individual lenders. Because the lender has less risk, they are more relaxed with their requirements, making it easier for borrowers to qualify. Even borrowers with a few marks against them on their credit reports may be able to qualify.
That being said, qualifying for an FHA loan is not worry-free. There have been changes in the requirements over the last few years that have made the qualification process stricter. For instance, there are now stricter guidelines for borrowers with a credit score lower than 620 or a debt-to-income ratio above 43 percent. Other changes include higher mortgage insurance fees and longer mandatory coverage periods.
FHA loans come with a low down payment requirement. Borrowers can put down as little as 3.5 percent of the home’s price.
FHA loans require an additional cost in the form of a mortgage insurance premium (MIP). This replaces the private mortgage insurance required by conventional loans. Whereas private mortgage insurance is paid by an insurer to a lender in the event of default, mortgage insurance premiums go into the Mutual Mortgage Insurance Fund, from which the FHA draws money to pay lenders’ claims. Mortgage insurance premiums are required for all FHA loans, regardless of how much down payment you provide.
FHA loans enable you to enlist the help of a co-borrower who will help you make payments. This co-borrower doesn’t even need to live in the home with you. This can help you if you don’t have the best credit, since you can combine your credit and income with your co-borrower’s for a better debt-to-income ratio.
FHA loans offer a streamlined process for refinancing, making it easier to obtain a new loan with a lower interest rate, sometimes without the need for an appraisal.
Conventional loans are funded by private lenders. These loans are not insured by the government, so the lender has no guarantees that they will be repaid if you default on the loan. Because the risk is higher for the lender, they will likely be more particular about who they lend money to. There are stricter guidelines for both credit and income requirements as a result.
Most lenders require a down payment of at least five percent for a conventional loan. However, any down payment lower than 20 percent requires the purchase of private mortgage insurance, which adds to the cost of the loan.
Private mortgage insurance protects the lender in the event of default. If a foreclosure occurs and the proceeds from the sale do not cover the outstanding debt, the insurance will repay the lender the rest of the amount.
Conventional loans allow you to refinance. However, this involves a lengthy application process, complete with appraisal costs, application fees, closing costs, and other fees.
FHA Loan vs. Conventional Loan
Both loans originate in the private sector and are provided through mortgage lenders. These lenders have their own minimum guidelines and underwriting processes, which must be met before any loan can be granted. Both loans require certain qualification criteria, such as steady income, decent credit, a manageable debt-to-income ratio, and savings for a down payment.
FHA loans are easier on both lenders and borrowers. Lenders are guaranteed to be repaid, even if the borrower cannot keep up with payments. Borrowers have an easier time qualifying for loans as a result, since lenders are more confident. However, FHA loan have a two-tiered system for qualifying, while the process for Conventional loan is more streamlined. The two-tiered system is not necessarily a disadvantage, though, since lender’s requirements are more relaxed.
Less down payment is required with an FHA loan. The minimum is 3.5 percent, while the minimum for a Conventional loan is five percent. However, all FHA loans come with mortgage insurance premiums, but conventional loans can avoid private mortgage insurance if the down payment is 20 percent or higher.
FHA loans allow you to apply for the loan with the help of a co-borrower. You combine your credit and income into a consolidated debt-to-income ratio, which might be a better ratio than you could accomplish on your own. With a conventional loan, you are pretty much on your own.
Refinancing is possible for both types of loans. However, conventional loans require a long and costly process for refinancing, while FHA loans have a streamlined process that doesn’t require an appraisal.
Which Type of Loan is Best for You?
The type of loan you apply for to purchase your new home will depend on several factors, including your financial situation and goals for the future. Conventional loans are geared towards individuals with better credit, while FHA loans are more forgiving for those struggling with poor to average credit. FHA loans involve lower up-front costs, but they may take longer to pay off. You should carefully review your credit, income, savings, and goals to determine which type of loan will better suit your needs and help you to purchase your new home.