When applying for a home mortgage loan, some buyers focus all their attention on conventional mortgages. However, these are not the only products on the market. The FHA mortgage loan is one alternative that may help you save money on your down payment and possibly qualify for a larger mortgage.
FHA is not a new product, as they have been available for years. However, talk of FHA loans has recently increased due to their attractive features and easier requirements. FHA mortgage loans are a government product insured by the Federal Housing Administration. However, it’s important to note that the Federal Housing Administration does not issue the home loan – this is done by your mortgage lender. However, if you default or stop making your mortgage payments, your home loan lender receives financial recourse from the FHA.
FHA Mortgage Loans vs. Conventional Mortgage Loans
Conventional mortgage loans certainly are not bad products, and they’ve helped countless home buyers. Even so, they are notably different than FHA mortgage loans. Recognizing and understanding these key differences helps you determine the best option.
1. Credit Requirements
Conventional home loans have stricter credit requirements. According to the Home Loan Learning Center, conventional mortgage lenders look for a good credit score no less than 680. But while this is the average national credit score for approvals, mortgage lenders vary and some require credit scores in the 700s.
The opposite is true with FHA mortgage loans. Because these types of loans are insured by the federal government, the guidelines for home loan approval aren’t as strict. The FHA considers applications for those with scores of at least 620.
2. Housing Ratio
When applying for a mortgage loan, the lender reviews your gross monthly income to determine how much you can afford to spend – “housing ratio” refers to the percentage of your gross income that you can spend on your mortgage payment. Income plays a major role in any type of mortgage loan, and as a rule, mortgage lenders don’t want you spending a great deal of your income on your house payment. Instead, lenders want you to have a financial cushion to save for emergencies and take care of other financial obligations.
With conventional mortgage loans, your home loan payment cannot exceed 28% of your gross monthly income. This ratio increases to 30% with an FHA mortgage loan. For example, if your gross monthly income equals $6,000, a conventional loan lets you acquire a mortgage with a payment up to $1,680, whereas an FHA mortgage loan lets you acquire a mortgage with a payment up to $1,800.
3. Down Payment
FHA mortgage loans are a popular pick because of their low down payment requirements. The minimum down payment on a conventional mortgage loan is 5% of the sales price – however, with an FHA mortgage, you’re approved with only a 3.5% down payment. If you buy a $200,000 house, that’s a difference of $3,000, and the more you spend on your home purchase, the more you’ll benefit from an FHA mortgage.
Let’s say you qualify for a $450,000 mortgage, but you don’t have the $22,500 down payment required by a conventional home lender. An FHA loan lets you acquire the same home with a down payment of only $15,750.
4. Closing Costs Assistance
Closing costs, such as the loan origination fee, title search fee, recording fee, survey fee, prepaid interest, prorated taxes, and insurances, are additional expenses associated with buying a house, and they can equal as much as 5% of the mortgage loan. It’s normal for buyers to ask for closing cost assistance from home sellers. However, lenders often cap the amount that a seller can contribute. With a conventional mortgage loan, sellers can only contribute up to $3,000 toward the buyer’s closing costs, but with an FHA mortgage loan, sellers can contribute up to $6,000.
Both types of mortgage loans factor in your current debts when determining affordability. An expensive auto loan or high student loans and credit card debt can increase your debt-to-income ratio (DTI) and reduce how much you can afford to spend on a mortgage. Debt-to-income ratio refers to the percentage of your gross monthly income that you spend on debt payments each month. FHA allows a DTI ratio of 41%, whereas conventional mortgages allow a DTI ratio of 36%.
6. Other Features
While there are key differences between these types of loans, there are also some similarities. For example, both types of mortgage loans require a steady source of income and consistent employment for at least two years. Additionally, you have to wait two years after a bankruptcy and three years after a foreclosure before applying for either loan type.
Both loans require that you provide all information related to your assets (personal property, cash in the bank, and investment account statements). This helps lenders determine the source of your down payment and closing costs.
FHA Mortgage Loan Rates
The interest rates on FHA mortgage loans are typically higher than conventional mortgages – but not much higher. Because mortgage rates vary by lender, shop around and compare different mortgage loan companies. Comparison shopping is a bit time-consuming, but it can save you a ton of money on interest and help lower your house payment. Start with your personal bank and acquire a free rate quote, and then talk with two or three other lenders.
Anyone can apply for an FHA mortgage loan. However, certain homebuyers are excellent candidates for this type of mortgage, including those in the process of reestablishing their credit and applicants with a short credit history. Because it takes time to rebuild a low credit score, it can take these applicants years to qualify for a conventional mortgage loan. With the FHA’s relatively low credit score requirements, these applicants can purchase a home much sooner.
There are no income restrictions with FHA mortgage loans, but each state has its own lending limits based on the type of property. Additionally, FHA lending limits vary by county or city within a state. For example, borrowers applying for an FHA loan in Los Angeles can receive up to $729,750 for a single family home purchase. Borrowers buying expensive properties that exceed the lending limit for their city or state are not good candidates for an FHA mortgage.
Basic Documentation Required for an FHA Mortgage
- Copies of paycheck stubs for the past 30 days
- Copies of W-2 forms or 1099 forms for the last two years
- Complete tax returns, including all schedules, for the past two years (if self-employed)
- Copies of all bank statements and investment account statements for the past two months
- Identification (driver’s license, passport, or military ID)
- Year-to-date profit and loss statement (if self-employed)
Applying for a mortgage loan and buying a house is an exciting time. While some borrowers don’t care about their type of mortgage loan, it helps to know your options. And by knowing your options, you can better determine which type of loan best suits your needs.
But don’t rely on your mortgage lender to recommend loan products. Do your own research, and familiarize yourself with the different requirements and features of each loan you review. Then choose the mortgage loan that’s right for you.
Which is the better mortgage option for your needs: FHA or conventional?
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