If you are a first-time home buyer in the US, you will agree that the process can be both exciting and challenging. As a newbie, you are likely to make costly mistakes if you are not aware of how the home-buying process works. Among other steps and requirements, it is vital to be well-informed about the home financing process and the different mortgage options.
Home loans fall into two broad categories: conventional loans and loans that are offered through the FHA program. In this article, we will look into the pros and cons of these two most popular loan options, FHA and conventional mortgages, and help you decide which is the most suitable one for you.
Understanding FHA and Conventional Mortgages
FHA loans are government-backed home loans insured by the Federal Housing Administration (FHA). These loans have been created to help home buyers easily qualify for a mortgage. Home buyers get the backing of the FHA on the loans provided by FHA-approved lenders, protecting them from the risk of borrower default.
They are non-conforming loans, denoting that they need not meet conventional lending standards set by Fannie Mae and Freddie Mac. These loans are available as fixed-rate or adjustable-rate mortgages.
These are the most common loans in the mortgage industry, funded by private financial lenders. These mortgages are not insured or guaranteed by any government agency. They can be either conforming or non-conforming loans. Similar to FHA loans, conventional loans are also available as fixed-rate or adjustable-rate mortgages.
Now that you know what FHA and conventional loans are, let us delve deeper and compare the two on different factors so that you know which is more appropriate for you.
Comparing FHA vs. Conventional Mortgages
Let us compare FHA and conventional mortgages with respect to factors such as credit score requirements, down payment, and interest rates.
1. Credit Score
Whether you pursue an FHA or conventional mortgage, lenders will consider your credit score. With a higher credit score, you are less of a risk and can qualify for a lower rate.
Credit score requirements for FHA loans:
Even with a credit score as low as 500, you can qualify for an FHA loan. However, you will need to put down a 10% down payment to avail of the loan. This means the greater your credit score, the lower your down payment for an FHA loan.
Credit score requirements for conventional loans:
For a conventional mortgage, you will need a credit score of a minimum of 620 to qualify. This is based on your median score if you are an individual. However, if you have co-borrowers, the average median score will be taken into account rather than the lowest median score, making it easy to qualify.
2. Down Payment
Let us examine how much down payment you need for each loan type:
To avail of an FHA loan, you will need to shell out a down payment of 3.5% for a credit score of 580 or more. For example, if your house is worth $600,000, your down payment will be $21,000. In case your credit score is between 520 and 579, you will be required to provide a 10% down payment.
For some conventional loans, you will need to make a 3% minimum down payment. For example, for a $500,000 house, at 3%, the down payment will be $15,000. Generally, for most conventional loans, you need to make a 5% down payment.
3. Interest Rates
Let us examine the differences in interest rates for FHA and conventional loans.
Interest rates for FHA loans are usually more competitive than conventional mortgages because of the government backing for the loan that reduces the risk for the lender. However, your interest rate is dependent on factors like your income, market interest rates, your down payment amount, or the amount you plan to borrow.
They depend on the factors that you can influence, including your credit score or the loan-to-value (LTV)ratio. With a higher credit score, you can avail of a lower interest rate. Conventional loans usually come with fixed or adjustable interest rates with an option to refinance later.
4. Mortgage Insurance
Mortgage insurance acts as a protection if you default on your loan. Let us study how the premiums vary in FHA and conventional loans.
You will be required to pay for PMI (Private Mortgage Insurance) if you don’t put in at least 20% as a down payment. It can come in forms like these:
- You may pay a monthly premium, which is an annual rate divided by 12.
- Another option is a single premium policy that requires an upfront payment.
- There is yet another option called split premium, which involves an upfront payment as well as a monthly premium.
- Lender-paid PMI is also an option by which the lender includes your mortgage insurance in the monthly principal and interest payment with a slightly higher interest rate.
These loans require the following two types of mortgage insurance payments:
- You may have to pay either an upfront MIP (Mortgage Insurance Premium), that is, 1.75% of the loan amount, either rolled into the loan amount or paid when you close on the loan.
- Monthly MIP that is part of your regular monthly payments
In case your down payment is less than 10%, you will need to pay monthly mortgage insurance for the life of the loan. If your down payment exceeds 10%, you need to pay mortgage insurance only for the first 11 years of the loan.
5. Appraisal Process
The appraisal process is very different in FHA and conventional mortgages.
The appraisal standards of FHA loans are more demanding than those required by conventional lenders. The appraisal approval and value come late in the process.
For conventional loans, lenders require a home appraisal to ensure the house you are buying with the loan has sufficient value. This ensures they can sell the house in case of foreclosure to recover their losses.
6. Loan Limit
Both loans have upper limits over which a borrower cannot get loans.
The loan limits are determined by the FHA based on the area where you want to live and the type of property you are buying. The loan limits are generally lesser than conventional loans, and the lowest for a one-unit FHA loan is $472,030. This can be higher in high-cost areas.
The limit for these loans is higher than that of FHA loans, with a standard limit set for the area where you want to reside. For a loan greater than the set limit, you may have to opt for a jumbo loan. The limit set for a one-unit property in most areas is $726,200, though it can go up based on the area you live in and the number of units.
Choosing between an FHA loan and a conventional loan is a personal decision. FHA loans make sense if you do not have a high credit score or cannot afford much money for a down payment. Conventional loans can be a better option if you want flexible repayment terms and can afford a down payment of at least 3% but want to avoid PMI. Ultimately, to know which loan is right, you will need to properly assess your financial situation and your needs.
At Bond Street Loans, our experts have extensive experience in providing affordable mortgages with excellent client service, whether for first-time home buyers or real estate investors. We will help you decide the most suitable loan for your needs with affordable interest rates and down payments.
Reach out to us for more information on suitable mortgage loans for your home. We will guide you through the entire process, making your home-buying experience pleasant and stress-free.