Simply put, FHA loan is a mortgage loan that is insured by the government. If you are planning on obtaining one of these loans, you would have to meet the guidelines of the FHA as well as the lenders. In a case where a borrower stops making his loan payments, the government insurance comes into play and covers the lender’s losses.
A conventional loan is not insured or guaranteed by the government. In this type of loan, the lender assumes all the risk of being paid back.
For an FHA loan, the down payment amount could go down as low as 3.5% of the home price. Unless you are obtaining other types of government insured loans such as VA (limited to veterans) or USDA (limited to rural areas), 3.5% is as low as it goes.
The conventional loan also comes with different options for the borrower, but it primarily benefits those who are willing to make the down payment of at least 20% to avoid the mortgage insurance entirely.
It’s generally easier to qualify for an FHA, as compared to a conventional mortgage. If you make down payments lower than 20% on your conventional loan, you will also be required to obtain private mortgage insurance (PMI). The PMI will protect the lender against loss in the event that the borrower defaults. Since the PMI comes from a private company, they usually require you to have a high credit score to qualify.
The FHA mortgage insurance comes from the federal government. One of the main purposes of this mortgage program is to give more people the opportunity of becoming a homeowner. For that reason, they are less strict on their qualification standard.
Credit Score Requirements
The FHA loan is a popular option for many first time homebuyers who haven’t had the chance to build up their credit. A borrower with a credit score of 580 or higher will be able to make a down payment of just 3.5%. A credit score between 500 and 579 will need you to put down at least 10%. Any lower, you probably won’t be able to qualify.
The convention mortgage usually requires a higher credit score. A borrower with a credit score below 620 will many times have a hard time getting approved for this loan. Even if you can find a lender, it’s important to keep in mind that credit score impacts the interest rate. A score of 680 will usually grant you the best possible rates assuming you meet the rest of your loan application requirements.
With an FHA loan, it’s possible to get approved with a debt-to-income ratio higher than 50%. In some cases, you can even see the borrower getting accepted at a DTI ratio of 55%. The same scenario would not be possible for a conventional loan as the lenders would usually cap the DTI at 45%.
What counts to DPI: Anything that would show up on your credit reports such as your car payment, credit card debt, student loans, etc.
Government Insurance vs. Private Mortgage Insurance
The main benefit of a conventional loan is when you can make a down payment amount of 20% or more. In this case, you do not have to worry about any mandatory insurance cost being applied to your monthly payment. You have the option of putting down the whole 20% initially or pay the PMI until you reach the 20% equity of your house. You can request your lender to cancel your PMI once your home equity reaches 20%, or it will be canceled automatically by the lender at 22%.
For FHA loans, the mortgage insurance comes in the form of mortgage insurance premium (MIP). Unlike the Conventional Loan PMI, you are required to pay the MIP for the life of the loan unless you refinance your loan with enough equity built up. Historically, the FHA loans tend to come with lower interest rates compared to conventional loans. Remember, though; the difference becomes relatively minor once you count the MIP.
FHA Property Restrictions:
Because FHA loans are meant to assist people in home ownership, they place more restrictions on who can qualify for this program.
Property must be owner-occupied
Property must be your primary residence and cannot be an investment property.
Property must be suitable to be lived in
It all depends on your situation. Purchasing a home is a great investment one can make, and FHA loan makes it possible for many people to become a homeowner at 3.5% down payment. It means that you choose to start investing in their property instead of renting a place much sooner.
If you can make a down payment of at least 20%, it makes sense obtain a conventional mortgage loan to avoid the PMI entirely. Even then, you may find it more beneficial to pay for much lower down payment and invest your money somewhere else. 20% of a price home is a large sum of money after all.