FHA vs Conventional | Choosing Your Mortgage

Which is Best for You? FHA vs. Conventional Mortgage

FHA or Conventional loan? Those are the two most popular home purchase mortgage programs. FHA loans are particularly popular with first-time homebuyers due to their relaxed credit requirements and low down payment options.

However, before you choose one program over the other, learn about the differences and how to compare an FHA vs. Conventional mortgage. In the bottom line, you need to fit into the program requirements, qualify based on a lender’s often stricter rules, and shop around for the best terms.

Qualifying for an FHA vs. Conventional Loans

To qualify for a conventional mortgage loan vs. an FHA loan, your lender will look at your credit score, down payment, and debt-to-income level.If you have a steady income, a low debt load, and a good-excellent credit score, then a conventional loan is a great option. Conventional loans are available with a small down payment, even as low as 3%.

FHA vs. Conventional Loans - Credit Score Requirements

One of the most significant differences in the two programs is the credit score requirements. FHA loans allow for much lower credit scores than conventional loans.

Conventional loan program requirements are generally as low as 640. However, FHA loans have much more flexibility. If your loan-to-value ratio (LTV) is 90% or less, you can qualify for an FHA loan with a credit score as low as 500. Even for people who take FHA purchase loans with the minimum down payment of 3.5%, the minimum FICO score is 580.

The actual lender requirements vary and are usually higher than the program requirements. For example, conventional loan lenders typically require a higher credit score, most likely over 640-680. Even if your credit score is a bit over 620, you will need to consider an FHA loan.

FHA vs. Conventional: Low Down Payment Requirements

The FHA targeted first-time home buyers with low down payments. You can qualify for an FHA loan with an LTV as high as 96.5%. For example, if your home costs $250,000, then you need a down payment of $8,750.

Many homebuyers are under the mistaken impression that a conventional loan requires a higher down payment. Some even think that you need to make a 20% down payment, or given our example $50,000.

However, when it comes to low down payment options, conventional loans are not much different than FHA loans. For many years both Fannie Mae and Freddie Mac Conventional loan programs allowed for an LTV up to 95%. However, in recent years they introduced more conventional low down payment mortgages. Today, it is possible to qualify for a conventional loan with a down payment as low as 3%, which means for a $250,000 home you only need $7,500.

Conventional vs FHA Mortgage Insurance Requirements

FHA and Conventional loans have very different mortgage insurance requirements. The programs differ in who is required to take out Mortgage Insurance, how much it costs, and when you can cancel the insurance.

Who Needs Mortgage Insurance? All FHA purchase loans require mortgage insurance whereas a conventional loan requires mortgage insurance only if you make a down-payment less than 20%. If your credit score is high enough and you have a substantial down payment, then when comparing conventional vs FHA loans, first consider the conventional loan.

Whenever you compare your options remember to compare both interest rates and mortgage fees. When comparing your mortgage insurance options look at both premiums and cancelation rules.

When Can I Cancel Mortgage Insurance? In general, your mortgage insurance, or private mortgage insurance (PMI), on a conventional loan will automatically expire when your Loan to Value ratio (based on your original payment schedule and the original value of your home) reaches 78%. You can ask to have the mortgage insurance canceled when your actual LTV reaches 80.

FHA cancelation rules are less favorable than conventional loans. According to FHA mortgage insurance rules set in 2013 (and still valid https://www.bills.com/mortgage/home-purchase/fha-loans/FHA-mortgage-insurance-2015), your FHA loan's Mortgage Insurance will not expire for the entire life of the loan unless the original LTV was 90% or less, in which case it will expire after 11 years.

Which Mortgage Insurance is More Expensive? Calculating the actual mortgage insurance premium for a conventional loan is a bit tricky as it depends on a large number of factors; however, you CAN save a lot of money if you have a good-excellent credit score and/or a larger down payment.

FHA loans have an upfront Mortgage Insurance Fee (UFMIP), currently set at 1.75% of your loan. Conventional loans do not have an upfront fee. The FHA upfront fee can be rolled into the loan and repaid over 30-years. For example, if you take a loan to buy a home for $250,000 and put down $8,750, your Upfront Mortgage Insurance Fee would be $8,750. If you roll that into your 30-year loan at 4.25% your monthly payment increases by about $21. Both FHA and conventional loans have annual premiums. As of 2019, the annual premium for an FHA loan, under $625,000 and LTV equal to or more than 95%, is 0.8%. If the LTV is under 95% and the loan amount is equal to or less than 625,000, then the annual premium is 0.8%.

Calculating mortgage insurance premiums for a conventional loan is more complicated. In general, they are higher than FHA loans, although certain low down payment programs have discounted rates.

Here are some examples of PMI premiums for a 30-year conventional loan, based on the MGIC Rate Tables from their website (March 2019):

If for example, you are taking out a very high LTV conventional mortgage, up to 97% and your credit score is 720, then your PMI annual premium is 0.87%. If you qualify for a special low down payment program, your premium will drop to 0.7%, lower than the FHA premium.

DTI Requirements when Comparing a Conventional vs. an FHA Loan

The most significant difference is that FHA loans have two DTI requirements. The first one looks at your total housing expenses (rent and renter insurance, or mortgage payments, property taxes, and property insurance) as a percentage of your gross monthly income. The second one is your total DTI, which adds on to your housing expenses your total monthly debt (credit cards, personal loans, auto loans, court-ordered payments).

The FHA DTI requirements are a Front-end DTI of 31% and a Back-End or Total DTI of 43%. It is possible to qualify with higher DTI rates if the lender uses a manual underwriting system. On the other hand, the general rule of thumb for conventional lenders is a DTI of 36%, although many programs allow for DTI rates between 45-50%.

FHA vs. Conventional Loans: Other Considerations

Besides credit, mortgage insurance, and your down payment requirements, there are a few other differences. Mortgages are complicated, and rules change. It is essential to talk to lenders, compare rates and fees, and also get pre-qualified.

Whenever there are exceptional circumstances, it is tough to compare the various programs. This is especially true if you have any particular credit issues such as bankruptcy, collections, or even student loan debt. For example, both FHA and conventional loans allow for manual underwriting if you don’t have traditional credit. To see if you qualify for a loan with a lender, get a pre-qualification, and then submit your documents.

Loan limits is another consideration, although for most borrowers both the FHA and conventional loan limits are sufficient. The maximum FHA loan limits are similar to conventional limits (set by the Federal Housing Finance Agency). As of 2019, the maximum amounts for most of the US is $726,525. The lower limits for FHA loans are as low as $314,827, whereas conventional loan limits baseline amount is $484,350 /

FHA vs. Conventional Loan - Two Scenarios

Ok, you are now asking yourself, how do I choose a mortgage. Here are some examples to help demonstrate the advantages of each loan.

The Tylers - Struggling with their Credit Score - Going with an FHA Loan

The Tylers had some problems when Roger lost his job, and they went through their emergency fund. To keep up with their payments, they maxed out their credit cards, pushed off a few payments and watched their credit score drop. Once he found new work, he and his wife Sally started to rebuild their savings, pay down some debt, and put away some money for a down payment. They improved their credit score, but it is hovering around 620. When comparing their options, an FHA vs. conventional loan, on paper they could qualify for either one. Their DTI, credit score and down payment fit program requirements. However, even with the upfront mortgage insurance payments, the overall costs tipped in favor of the FHA loan. In the bottom line, when they started talking to lenders, the Tylers realized that they would not qualify for the conventional loan. They figured that even if the FHA mortgage insurance is for the life of the loan, they would most likely sell the home and move into something larger in the next ten years.

The Rodriguez - Substantial Down Payment - A Conventional Loan

The Rodriguez’s are great savers. They keep a strong savings account, top up their retirement accounts, and years ago started special savings account to buy a home. Betsy is an avid planner and uses a budgeting app to track her spending and cut her expenses. Brian got a nice bonus last year and put that money to pay down his remaining student debt. The Rodriguez’s have more than 20% down payment, and their credit score is over 740. The conventional loan option was a no-brainer. They easily qualified and did not have to pay any mortgage insurance.

What about You? FHA or Conventional Loan

Is your case so cut and dry? if not, it is important to shop around. When comparing the offers keep these points in mind:

1. The APR is based on keeping the loan for the entire 30-years. If you pay off the loan earlier, then your APR will change considerably.
2. Make sure that you include all costs including mortgage insurance premiums. The FHA loan comes with a hefty upfront fee (UFMIP) of 1.75% of the loan.
3. The conventional loan’s mortgage insurance will be canceled after 7, whereas the FHA loan requires payments for the entire length of the loan.

Don't forget to compare all the lender’s fees and costs when choosing between different mortgages.