One of the first steps to buying a home is securing financing. If you are buying a house with cash, you don’t need to worry about getting a loan, and you know exactly how much you can spend.
For most people, buying a home means getting a loan. This involves finding a lender, figuring out how much you are preapproved for, and discussing which loan options will best meet your individual needs.There are various loans to choose from, but the most common are the conventional loan and the Federal Housing Administration (FHA) loan. Read on to learn about what these loans are, how they work, and how to decide which one is best for you as you continue on your home buying journey.
What Is A Conventional Loan?
This first question you may be asking yourself is ”what is a conventional loan?” Conventional loans are the most common types of loans people use to buy houses. The loan funds are lent to home buyers by financial institutions and then those mortgages are sold to government-backed agencies like Freddie Mac and Fannie Mae.
Conventional loans are not backed by a government agency like some other types of loans, and they can be either conforming or non-conforming. Conforming loans are below a set loan limit for the United States. In 2022, that limit is $647,200 for most of the country. The loan limit can vary somewhat depending on the area of the country based on the cost to live and home values.
Non-conforming loans are also called jumbo loans, and they refer to loans that are higher than the conforming limit. Unlike conventional conforming loans, jumbo loans cannot be sold to companies like Freddie Mac and Fannie Mae on the secondary market.
In general, conventional loans are harder to qualify for than other loans. If you do qualify, they offer some benefits that other loans don’t (more on that later).
What Is An FHA Loan?
The Federal Housing Administration backs an FHA loan. This organization sets the standards for home construction and financing in the United States. An FHA - insured loan is protected by the FHA, but a private financial institution does the lending to the borrower. That means if the borrower forecloses on the loan, the FHA will cover all or part of the losses the lender incurs.
FHA loans can be fixed-rate or adjustable-rate mortgages. Fixed-rate loans have the same interest rate from the beginning of the loan to the end. Adjustable-rate loans have an interest rate that can rise and fall during the loan.
FHA Mortgage Programs
There are a variety of FHA mortgage loans and programs that have specific goals for specific types of homes and homebuyers. Read below to see how they differ and what they offer.
203 (b) Loans
The most common FHA mortgage loan, a 203 (b) loan, is a mortgage backed by the FHA that can be used for single-family or small multi-family homes. The borrower must live on the property and can purchase real estate with as little as 3.5% of the sale price as a down payment. 203 (b) loans can also be used to refinance an existing mortgage.
203 (k) Loans
Commonly called rehabilitation mortgages, the 203 (k) home loan is another mortgage backed by the FHA. 203 (k) loans allow homebuyers and homeowners to take out one mortgage to finance the refinancing or purchase of a home along with the cost to rehabilitate the house.
The property must be at least one year old, and there are restrictions on the types of home projects the funds can be used for. The following rehabilitation projects are allowed:
Home Equity Conversion Mortgages (HECMs) are sometimes referred to as reverse mortgages. HECMs are available for people who are 62 years old or older and want to create income from the equity in their home.
Using the equity in their home, reverse mortgage recipients receive a lump sum or monthly payments. They don’t need to make monthly payments as they would on a traditional home loan as long as they live in the home. If they pass away or move out, the loan must be repaid. This is usually done by selling the home. The requirements to qualify for a reverse mortgage are:
An Energy Efficient Mortgage (EEM) is available for home improvements that reduce energy use. These loans can be used for things like insulation, solar and wind power technologies, and other items that improve the energy efficiency of your house.
In addition to the positive environmental impact, EEM loans save you money on your monthly utility bills by reducing the cost of cooling and heating your home.
FHA Streamline Program
This program is geared toward helping homeowners with an existing FHA loan lower their interest rate and monthly payments. By adding time to your loan (no more than 12 years), you create more time to pay it off. This means your payments each month are reduced.
Unlike most refinances, the FHA streamline program is even available to homeowners “underwater” on their mortgage, meaning they owe more on the home loan than their house is worth. They can also skip an appraisal of the home, but closing costs are associated with the FHA Streamline Program.
How Do I Compare Conventional Loans And FHA Loans?
There are plenty of differences between conventional loans and FHA loans and understanding the pros and cons of each will help you make the best choice for your situation. Comparing the qualification requirements, interest rates, down payment minimums, and other loan terms with an attention to detail is the best way to approach this comparison. Read on to find out how FHA and conventional loans differ regarding a number of key loan requirements.
Credit Score Requirements
The best place to start when comparing FHA loans and conventional loans is with the requirements for approval. After all, if you find that you don’t qualify for one or the other, the decision on which one to choose is made for you. Credit score minimums will tell you pretty quickly which options you can consider.
One of the first questions to ask yourself before you begin searching for homes is, “what credit score is needed for buying a house?” The answer varies by loan type, but a general rule is that the better your credit score, the more likely you are to qualify for a loan.
This doesn’t mean that you can’t buy a house with bad credit, because you can. It just means the terms of the loan aren’t going to be as good and there are certain loans (and loan amounts) you won’t be able to qualify for.
For a conventional loan, you typically need a credit score of 620 or higher. This can vary by lender and the better your score, the better the terms of your loan will be. For an FHA loan, your credit score needs to be at least 580, but, like conventional loans, this minimum can vary by lender. In fact, some FHA borrowers can qualify for a loan with credit scores as low as 500.
Conventional loans and FHA loans both have limits on the amount of money you can borrow, which vary based on the region of the country where you are purchasing a home. In 2022, the FHA loan maximum is $420,860 in lower home cost areas and $970,800 in more expensive home markets. As previously mentioned, the limit for conforming conventional loans (not jumbo loans) in 2022 is $647,200.
Understanding loan limits is a critical component of selecting the right loan for you. If you know your general price range for house hunting, determine if these loan limits align with your budget.
Debt to income (DTI) ratio is an important factor lenders look at when deciding whether or not to approve you for a loan. This calculates the amount of income you earn each month compared to your outstanding debts like your mortgage, auto loans, student loans, and credit card balances.
Your DTI needs to be 50% or less to qualify for an FHA loan. To be eligible for a conventional loan, your DTI needs to be at 50% or less as well, though most lenders require a DTI of 43% or better. It’s important to note that these minimums can change depending on the lender you are working with, so it pays to shop around.
Down Payment Minimums
If you qualify for an FHA loan, your down payment minimum is going to be 3.5% of the purchase price if your credit score is 580 or higher. You can put down more if you are able to, which will reduce your overall loan amount and monthly payments. Borrowers with a credit score between 500 and 579 may acquire an FHA loan, but only if their down payment is 10% of the purchase price.
The minimums are variable and usually higher than 3.5% for conventional loans. That said, some lenders will allow for a minimum down payment amount of 3% percent of the purchase price for borrowers with higher credit scores.
Mortgage insurance exists to cover the losses a lender incurs if a borrower defaults on their loan. You must pay for mortgage insurance for a conventional loan if your down payment is under 20% of the purchase price. FHA loans always require mortgage insurance, no matter what down payment amount you have.
Your credit score doesn't affect the amount you pay for mortgage insurance on FHA loans. For conventional loans, the lower your credit score is, the higher amount you will pay for mortgage insurance.
For FHA mortgages, you pay mortgage insurance for 11 years if your down payment amount is 10% or more. If your down payment amount is less than 10%, you will pay mortgage insurance for the entirety of the loan term.
Once your equity in the home reaches 78% of the price you paid for it, your private mortgage insurance on a conventional loan goes away. The only way to get rid of mortgage insurance on an FHA loan is by changing it to a conventional loan through refinancing.
Property Condition And Use Requirements
The condition of the property you are considering purchasing is an essential factor when deciding what loan to use.
During the home buying process, your lender orders an appraisal to determine the home's value. This ensures that they don't loan you more money than the house is worth in case they need to sell it to recoup their loan.
In general, FHA appraisers are more strict than conventional loan appraisers. In addition to the home's value, FHA appraisers pay attention to safety and building code regulations as well. This can make passing the appraisal harder for FHA loans.
In terms of property use, FHA loans are only available for purchasing homes you are planning to use as your primary residence. You will need to use a conventional mortgage for investment properties or second homes.
As previously mentioned, FHA streamline refinancing is an attractive option for borrowers with an existing FHA loan. There are requirements for qualifying, but if you can refinance with this type of loan, the benefits include no appraisal, no credit check, and no income verification. Conventional mortgage refinancing is trickier, as it often requires appraisals, credit checks, and income verification.
Who Is A Conventional Loan Right For?
A conventional loan is an excellent option if you have a good credit score and a good amount of savings to put into a down payment. For example, If you can put down 20 percent of the purchase price for your new home, you can avoid paying private mortgage insurance. A good credit score will also help you qualify for a lower interest rate.
Who Is An FHA Loan Right For?
FHA loans are great for first-time homebuyers, as they may not have the savings necessary to put 20 percent down on the purchase of their home. They are also easier to qualify for than conventional loans. This makes them a good option for borrowers with less than perfect credit.
What Type Of Loan Do Home Sellers Prefer?
The sales price is, of course, the most significant deciding factor but loan type matters as well. Sellers consider many different parts of an offer when they receive one for their home. Usually, home sellers will prioritize a conventional loan over an FHA loan if the offer prices are the same. This is because the larger down payment that generally accompanies a conventional loan shows them the buyers are both serious and financially qualified.
Summary Of The Differences Between FHA And Conventional Loans
Now that you have all the facts on conventional vs. FHA loans, let’s look at a side-by-side comparison to help you choose the best option.
When comparing conventional loans to FHA loans, think about the requirements and benefits compared to your financial situation and home buying goals. Both of these home loan options can be good choices, depending on your specific needs.
Consider your credit score, savings amount for a down payment, and the property's condition when deciding between an FHA mortgage and a conventional mortgage. Using these variables, and the other factors discussed in this article to make your decision, will set you up for success.