FHA vs Conventional: Which Loan Works Best for You?

When you're ready to buy a home or refinance your loan, you may start wondering whether you should get a conventional loan or an FHA loan. Both loan types are very popular and will get the job done, but when it comes to an FHA vs conventional loan there are some noticeable differences between the two that you should consider when making your final decisions.

If you're not yet sure which one would be better for you, it is important to compare the features, benefits, and drawbacks of each so you can make your decision with confidence.

Conventional Loans

Home buyers with sufficient resources and a good credit standing will likely find a conventional loan appealing. Conventional mortgages are the most basic type of home financing and are not backed by government agencies. You can use a conventional loan to buy a primary residence, second home, or rental property.

Conventional mortgage lenders usually set the bar higher for credit score requirements. They typically expect a minimum credit score of 620 - 680 to apply. Conventional loans are available in either fixed rates or adjustable rates (ARMs). Lenders offer many loan terms usually from 10 to 30 years.

Generally, the conventional loan limit for 2017 is $424,100. However, lenders like Fannie Mae and Freddie Mac have designated high-cost areas where limits can be higher.

FHA Loans

FHA loans are a good choice for home buyers who can't afford the larger down payments that conventional mortgages often require. They're backed by the Federal Housing Administration, which secures the loan, allowing borrowers to make a lower down payment than with a conventional loan. Be mindful that the FHA doesn't lend the money, but they guarantee the loan. This helps if the lender is hesitant about taking a risk on a borrower.

However, as a result, the FHA requires borrowers to pay an upfront mortgage insurance premium. They typically roll the payments into monthly mortgage amounts. FHA loans are generally more lenient to applicants as well.

The FHA requires a minimum credit score of 580. Fortunately, there are FHA lenders who are willing to consider applicants who've had major credit problems sooner than a conventional mortgage lender would. FHA accepts up to 3 years vs 7 years for foreclosure and 2 years vs 4 years for bankruptcy.

FHA vs. Conventional Pros and Cons

When you're comparing FHA vs conventional loans side by side, you will find a lot of key differences. Each loan type has its own set of advantages and disadvantages. Here are some of the biggest factors you'll want to look at.

FHA vs Conventional Credit Standards

Pro: FHA Loan

FHA loans require a lower minimum credit score (580) and still provide competitive mortgage rates. Also, it's easier to get an FHA loan when you've had credit issues in the past.

Con: Conventional Loan

Conventional loans require a higher minimum credit score (620) and, even if you meet it, you shouldn't expect the best interest rate for your mortgage. Conventional lenders are also less lenient to applicants who have had credit issues in the past. For instance, if you ever had to file for bankruptcy, lenders may require you to wait several years before applying.

FHA vs Conventional Down Payments

Pro: FHA Loan

The minimum down payment for an FHA loan is only 3.5 percent. This allows home buyers who can't afford a large down payment the ability to get a mortgage.

Con: Conventional Loan

The minimum down payment for a conventional loan can range from 5 percent to 10 percent. This means that if you wanted to buy a $250,000 home, you would need to come up with at least $12,500 to $25,000 for the down payment alone.

Conventional vs FHA Mortgage Insurance

Pro: Conventional Loan

With a conventional loan, if you choose to put down 20%, your lender will allow you to avoid paying private mortgage insurance (PMI). However, if you put down less than 20%, your lender will stop adding PMI charges to your monthly mortgage payment only when your loan-to-value ratio dips below 78%.

Con: FHA Loan

While FHA loans require a low down payment, you'll most likely be paying for mortgage insurance throughout the duration of the loan. The annual mortgage insurance premium (FHA MIP) for FHA loans is based on the loan's amount and your loan-to-value ratio. For example, if your mortgage amount is $200,000 and your loan-to-value ratio is 78%, the annual insurance premium will be 0.80%, or $1,600. If your loan-to-value ratio was 90 percent or lower when you initially borrow the loan, the FHA's policy allows for cancellation of the annual premium after 11 years. If your loan-to-value ratio is above 90 percent, the FHA mortgage insurance remains in effect for the life of the loan.

FHA vs Conventional Loan Closing Costs

Pro: FHA Loan

Since FHA loan down payments can be smaller, it makes it cheaper to close on your home. Your 3.5 percent down payment can also be a gift that you receive from an acceptable donor.

Con: Conventional Loan

While both loans have similar closing costs, with a higher down payment for a conventional you will usually be paying more. You can also use gift money to fund your down payment. However, unless the gift will cover a full 20 percent of the down payment, most conventional loans require that the borrower contribute a minimum of 5 percent of the purchase price out of their own funds.

FHA vs Conventional Debt-to-Income Ratio

Pro: FHA Loan

For an FHA loan, the borrower's total debt load (including the monthly mortgage payments, credit cards, car payments, etc.) should not exceed 43% of his or her gross monthly income. You can use a cosigner to strengthen your application with an FHA loan. However, the FHA will consider you and your cosigner under a single debt-to-income ratio. This makes it easier to receive an FHA loan if you choose the right cosigner.

Con: Conventional Loan

While you can use a cosigner for a conventional loan, lenders require that both applicants meet certain debt-to-income ratios on their own. They typically require a ratio around 43%.

When Would an FHA Loan Be Better Than a Conventional Loan?

An FHA loan would be better for home buyers who have a lower credit score. They're also beneficial if you simply can't afford to contribute a large down payment.

It's also good for anyone who's had notable credit issues in the past and is looking for a second chance.

When Would a Conventional Loan Be Better Than an FHA Loan?

A conventional loan would be better than an FHA loan for home buyers who have a good credit standing and can afford to contribute a higher down payment.

If you're looking to buy an expensive property, a conventional loan will also give you more flexibility. Unfortunately, FHA loan limits tend to cap at $275,665 in most areas.

FHA vs Conventional: Which is Ultimately Better?

When it comes to deciding whether an FHA vs conventional loan would be better for you, it helps to look at monthly and overall costs.

An FHA loan will be better if you don't want, or can't afford, to put 20% down on your home. If you prefer to focus on other expenses and financial responsibilities like paying off debt, growing your family, and saving for retirement, you may have a hard time coming up with a large down payment.

While an FHA loan may save you money now by allowing you to be able to make a smaller down payment, you'll be stuck paying mortgage insurance for the entire life of the loan if your loan-to-value ratio is over 90 percent by the time you borrow. If the mortgage insurance is not that high, you might not mind it.

Also, if you're in a hurry to buy, but your credit is not as good as it should be, you'll find better luck with an FHA loan.

That being said, a conventional loan could help you save big on PMI over the life of your loan, though, you will need to put down 20% in order to avoid 20% altogether. If you are only going to be putting down 3-5 percent for a conventional mortgage, you will only be able to drop the PMI charge once you have achieved at least 20% equity in your home.

How long you plan on staying in your home can also help you decide. While it's best to stay in your home for at least 5 years before renting or selling it, with an FHA loan, you may need to stay longer if your down payment is smaller.

Look at your financial situation. Run some numbers to see if an FHA vs conventional loan would save you money now and in the future.

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