FHA vs. Conventional Mortgage Loans – Understanding the Differences

mortgage loan agreementBuying a house is complicated, with more than its share of intimidating paperwork and legalese – especially for first-time buyers. One way to minimize the stress is to get a loan pre-approval that you can hang onto while you shop for the perfect house.

But which type of loan should you try to acquire? The first decision to make is whether to look for an FHA mortgage loan or a conventional mortgage loan. There is no perfect choice for all home buyers – which one is right for you depends upon your specific circumstances.

FHA vs. Conventional Mortgages

1. Credit Requirements
FHA loans are insured by the Federal Housing Authority, so they’re less risky for lenders than a conventional mortgage. As a result, FHA loans have much lower credit score requirements. As of 2012, the minimum credit score for an FHA loan approval is 620. Conventional mortgages, on the other hand, are best pursued by those with credit scores of at least 680.

2. Down Payment Requirements
The minimum down payment for FHA loans is 3.5% of the purchase price. However, conventional loans require at least 5% down, depending on the buyer’s credit rating. Buyers with less-than-perfect credit may need to pay 10% or even 20% down in order to acquire a conventional mortgage.

The good news is that if you do pay a full 20% down payment, the lender won’t require you to get private mortgage insurance (PMI), which is a product that reimburses your lender if you default on the mortgage.

3. Insurance Requirements
When paying less than 20% down, conventional borrowers must pay for private mortgage insurance. They may have the  option to pay it as an ongoing premium that’s included with the monthly mortgage payment, as a single, upfront payment, or occasionally as a combination of the two.

FHA loans, on the other hand, have an upfront insurance premium of 1.75% (which can be financed on top of the loan amount), and also require a monthly premium that varies based on the term and amount of your mortgage. For conventional loans, if you don’t choose the upfront payment option, you will be required to maintain PMI coverage and pay the annual premiums until you have paid off at least 20% of your loan.

If you have at least 20% to put down, you can avoid PMI by getting a conventional loan. For FHA loans, you must get a mortgage with a term of 15 years or less and have a down payment of 22% or more to be spared the annual insurance payment.

4. House Requirements
FHA loans have much stricter rules regarding the type of house you can buy. For example, it is impossible to get an FHA loan for a manufactured home that’s been moved from its original location, something that’s usually not even a consideration with conventional loans.

If you choose to get an FHA loan, you’ll be required to have certain things repaired before you can close on the house. The list of mandatory repairs is shorter than it used to be, but still includes items such as leaky roofs, collapsed fences, non-functional kitchen appliances, broken rain gutters, and ongoing pest problems. Home buyers planning to purchase a fixer-upper and work on it over time need to pursue conventional loan options.

purchasing a home

5. Purchase Price Requirements
The FHA program sets a maximum mortgage limit based on the median home value in your area. Since 2009, the maximum loan value has been set to 115% of local median prices. Even in very expensive areas of the continental United States, FHA does not extend loans greater than $729,750 for a one-family home.

One reason that FHA loans fell out of favor during the housing bubble of the late 1990s to early 2000s is because the loan maximums were far below actual housing prices in many parts of the U.S. Conventional loans that fit the government guidelines for FHA, including purchase price limits, are called conforming loans, and because these loans stick to the government underwriting policies they are less risky for lenders. As a result, conforming loans usually have lower interest rates than non-conforming loans. Still, buyers looking at high-value homes may have no other choice than to pursue a non-conforming conventional mortgage.

6. Interest Calculation Requirements
Conventional mortgages offer a vast array of interest calculation options. The oldest and best-known mortgage is the fixed-rate mortgage loan – “fixed rate of interest” meaning that the interest rate is calculated at the time of the purchase and stays the same over the life of the loan.

Home buyers can also get adjustable rate mortgages (ARM), in which the interest rate starts out as fixed for a certain number of years but then becomes tied to an index, usually the prime rate (the prime itself is based on the federal funds rate, which is the interest rate banks charge on loans to each other). For example, if you have an adjustable-rate mortgage of prime-plus-2%, then when the prime rate is 4%, your interest due is 6%. If the prime rate later rises to 7%, your mortgage interest rate jumps to 9%.

Other interest types include interest-only loans. Adjustable-rate mortgages are riskier than fixed rate mortgages, but can save the buyer money if interest rates drop after purchase. However, FHA loans are only available at a fixed rate.

7. Debt-Income Requirements
When you apply for a mortgage, the lender refers to your credit report to see how much money you already owe, and then compares this number to your monthly income. The lower your debt-to-income ratio the better, because a low ratio means you’re living well within your means.

FHA loans allow higher debt-to-income ratios than conventional mortgages – up to a total of 41% of your monthly income, including your proposed mortgage payments – so if you already have a large load of debt, an FHA loan might be your only option.

Final Word

If you are a home buyer with little to spend on a down payment or have blemished credit, you should probably pursue an FHA loan. However, understand that you will pay for the privilege with a more complex loan process with strict regulations regarding the type of house you can buy. Buyers who can afford a conventional loan enjoy more freedom and less paperwork – especially after making a down payment of 20% or more.

Have you taken out an FHA or conventional mortgage loan?