Wondering whether to apply for a conventional loan or an FHA loan? It’s important to understand the difference between the two loan types. The loan type you ultimately choose will depend on the type of home you want to buy, your financial resources and the trade-offs you’re willing to make between the benefits that FHA and conventional loans offer.
FHA vs. Conventional Loans: The Loan-to-Value Ratio
FHA loans tend to have higher loan-to-value ratios than conventional mortgage loans. To explain why, it’ll help to explain what FHA loans are and why they exist. FHA stands for Federal Housing Authority. The FHA is part of HUD, the U.S. Department of Housing and Urban Development.
FHA loans aren’t actually issued or serviced by the FHA. Instead, they’re guaranteed (a.k.a. insured) by the FHA but issued and serviced by regular private mortgage lenders. Since 1934, FHA loans have been helping first-time homebuyers go from renting to buying.
Driven by the mission to help more Americans become homeowners, FHA loans offer a higher loan-to-value ratio. To put it in simpler terms, FHA loans comes with lower down payment requirements than conventional loans do. With an FHA loan, you can put as little as 3.5% down. The goal of the program is to help put homeownership in reach of more people.
FHA vs. Conventional Loans: Getting Approved
In part because of their low down payment requirements, FHA loans are easier for those with less-than-perfect credit to obtain. If you have a bankruptcy in your past or your credit score isn’t in the top part of the range, you could still qualify for an FHA loan.
Another difference between FHA loans and conventional mortgages is that FHA loans let you enlist the help of a co-borrower. You can score an FHA with help from a blood relative who won’t be living in the home with you but who will help you with payments. If you opt to partner with what FHA calls a non-occupying co-borrower, your income and debt levels will be combined into a single debt-to-income ratio for the purpose of calculating your credit worthiness. The non-occupying co-borrower amendment is another feature that makes it easier to get an FHA mortgage than a conventional mortgage.
FHA vs. Conventional Mortgages: Mortgage Insurance
If you put less than 20% down on a conventional mortgage, you’ll have to pay what’s called private mortgage insurance (PMI). It’s a compensation to the lender for taking a chance on a borrower with a lower down payment. But once your loan-to-value ratio dips below 78% your lender will stop adding PMI charges to your monthly mortgage payment. And if you put 20% down, you’ll never have to pay PMI.
FHA mortgages, on the other hand, all come with mortgage insurance. When you take out an FHA mortgage you’ll pay an up-front mortgage premium, plus a monthly premium. If you put less than 10% down on your FHA mortgage, that monthly mortgage insurance premium will stay on your mortgage bill for the length of your loan, no matter how much equity you build up.
FHA vs. Conventional Mortgages: Refinancing
If you’re not familiar with refinancing, it may surprise you to learn that when you refinance you’re really getting a new mortgage. That means going through the application process again and paying closing costs and fees. For conventional mortgages, this can be costly and time-consuming.
FHA mortgages come with something conventional mortgages don’t offer: a streamlined refinance process. The FHA Streamline Refinance lets you refinance your FHA loan with minimal hassle. Borrowers usually don’t have to go through the appraisal process and will fill out less paperwork than they would to refinance a conventional mortgage.
FHA vs. Conventional Mortgages: Flexibility
When it comes to flexibility, it’s hard to say whether FHA or conventional mortgages have the edge. Conventional mortgages are available for jumbo loans and vacation homes, neither of which are options if you’re taking out an FHA loan. On the other hand, FHA loans let you use a non-occupying co-borrower and are assumable by another borrower if you decide to move.
For many people, the decision of whether to use an FHA mortgage or a conventional mortgage doesn’t depend on the specific features of each. Instead, it’s a matter of balancing the cost of borrowing by considering the interest rates and mortgage insurance requirements you’d face with one loan type or another.
If you’re having a hard time deciding, consider consulting an expert. A financial advisor can help you figure out which choice is right for your personal financial situation. A matching tool like SmartAsset’s SmartAdvisor makes it easier to find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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