Lending money is a risk, and lenders help manage that risk by obtaining insurance for their mortgages. Different insurers have their own rules about what types of loans they will back, so loans’ insurers significantly influence the nature and purpose of different types of mortgages.
Some mortgages are insured by government agencies such as the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA) and even the U.S. Department of Agriculture (USDA). Loans that are not government-backed are often referred to as conventional home loans, and these are insured by private finance companies, most notably Fannie Mae and Freddie Mac.
These days, nearly two-thirds of mortgage originations are for conventional loans, though that percentage can change drastically over time, depending on economic conditions and policy changes.
Read on for descriptions of the government-backed and privately insured mortgage options, so you can start to see which may be best for you.
The FHA works with private lenders to insure mortgages that meet certain conditions. FHA mortgages were created to support the housing industry during the Great Depression, and from those beginnings in 1934, the FHA has grown to be the world’s largest insurer of mortgages.
FHA mortgages require a fairly low down payment and less strict credit standards than privately insured conventional loans. For these reasons, they are often seen as ideal for first-time home buyers, but they are not strictly limited to first-timers.
FHA loans are intended for residential properties of one to four units, where the property will be the borrower’s primary residence. As of 2017, FHA loans were generally available up to $275,665 for a single unit property, though they can go up to as much as $636,150 in designated high-cost areas or even $954,225 in Alaska, Guam, Hawaii and the Virgin Islands.
The willingness of the FHA to insure these loans means lenders may take risks on borrowers they might otherwise not approve for a mortgage. While that helps make mortgages available to more would-be homebuyers, there’s a catch: The FHA funds its insurance by charging a mortgage insurance premium (MIP) both upfront and annually for most or all of the length of the loan, depending on your down payment.
This MIP requirement is heavier for FHA loans than for other types of insurers, so while FHA loans may be the most easily obtainable loan type if you have a weaker credit history, they also tend to be the most expensive option.
VA loans are available to active-duty service members in the U.S. military, honorably discharged vets and some surviving spouses of deceased veterans or service members.
Like FHA loans, VA mortgages are insured by the federal government and are subject to the same loan limit guidelines, which vary from county to county depending on local housing costs. Despite sharing the same loan limits, VA loans have a couple of important advantages over FHA loans.
VA loans are available with little or no down payment. Also, VA loans do not require the borrower to pay mortgage insurance. This means that VA loans have a distinct cost advantage for those who qualify. There is, however, a funding fee for VA loans, which ranges from 1.25 to 3.3 percent of the loan. The fee you pay depends on your type of military service, your down payment amount and whether you’re using a VA loan for the first time.
If you’re accustomed to seeing USDA ratings on food products like meat and eggs, you may be surprised to find out the department also has a hand in home loans.
Like the FHA and the VA, the USDA provides government-backed mortgage insurance to encourage private lenders to make home loans in certain circumstances. In the case of the Department of Agriculture, its interest is in making sure rural areas remain populated enough to support the farming industry that is essential to the nation’s food supply. So, USDA loans mean insurance is provided for mortgages in designated rural areas.
You can find out if a given address qualifies as a rural area on the USDA website. Besides being limited to these designated rural areas, USDA mortgages are subject to income limits. Benefits vary according to your income level and are not available for borrowers with high incomes. The definitions of these income levels vary according to county, and again, can be found on the USDA website.
In short, USDA loans can help you qualify for a mortgage without having to pay mortgage insurance, but are only available in a limited set of circumstances. If you are a would-be homebuyer with a low to moderate income and are interested in residing in a rural area, USDA loans are worth a look.
Mortgages insured by private companies rather than the government are referred to as conventional mortgages. The most prominent private insurers are Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.), so they effectively set the standards for conventional loan eligibility. (While the government chartered Fannie Mae and Freddie Mac, they are owned and operated by private shareholders, making them government-sponsored entities rather than wholly owned by the government.)
Because they are not backed by the government, conventional mortgages generally apply stricter underwriting standards. This means you should expect to need a stronger credit rating and lower debt-to-income ratio to qualify for a conventional loan, or else you should be ready to make a larger down payment.
If conventional loans are harder to get than government-backed loans, why bother? Well, first of all, not everybody meets the requirements for VA or USDA loans, which, as mentioned above, come with some restrictions and limitations.
As for FHA loans, remember that these require both upfront and ongoing MIP payments. Conventional loans also require mortgage insurance, but without an upfront payment, and you can get rid of these premium payments when the remaining loan-to-value ratio drops below 80 percent. Put simply: With a conventional mortgage, you can avoid paying for mortgage insurance altogether if you put down at least 20 percent on the purchase.
If your credit is pretty good (including a credit rating at least in the 620 range, though the vast majority of conventional mortgages are approved for borrowers with credit ratings of at least 700) and you don’t meet the requirements of a VA or USDA loan, a conventional loan may be your best option. The milder mortgage insurance requirement can make it less expensive than an FHA loan.