There are many decisions to make during the home buying process including the type of home, neighborhood, payment range, and mortgage type.
Often, the mortgage decision comes down to comparing FHA vs. conventional loan programs. On the surface, it just sounds like making one choice. Although, there are many key points to consider in this decision. Such factors include:
- Interest rates
- Mortgage insurance (PMI)
- Credit score requirements
- Down payment requirements
- Residency types
- Renovation options
- Seller paid costs for the buyer
- Co-Signor options
So, no matter if the borrower is a first-time buyer, move up buyer, downsizing buyer, purchasing a retirement home, or somewhere in between, FHA and conventional loans could provide helpful options.
FHA vs. Conventional Interest Rates
Typically, government rates for loans such as VA and FHA are a little lower than conventional loans. As you will see, there are more choices to consider other than just the interest rate.
For instance, credit scores are a major factor that will affect an interest rate. To receive the top rate for conventional loans, a borrower needs a 760+ score. As the score drops every 20 points from there, it increases the interest rate. Conventional loans compete very well for rate with FHA on higher credit scores, but as the scores reduce, FHA has more of an advantage because FHA rates are less affected by lower scores. Similarly, mortgage insurance fluctuations vary between the loan types.
FHA vs. Conventional Mortgage Insurance Comparison
Ask someone what they think of mortgage insurance, and often the answer is negative. Buyers want to avoid private mortgage insurance (PMI) at all costs. Although, most buyers with less than 20% in down payment do not fully understand the purpose & benefits of PMI. The biggest buyer benefit is that PMI allows for less than 20% down payment. Fortunately, both FHA and conventional loans provide very low down payment options with varying mortgage insurance amounts. Like the interest rate comparison, conventional compares very well with FHA mortgage insurance for higher credit scores. Usually, conventional PMI beats FHA PMI at the high-end scores or as the LTV decreases, but if the credit scores are in the 600’s (especially at low down payment options), FHA PMI usually wins.
FHA Mortgage Insurance
FHA loans charge what is called a split mortgage insurance premium meaning that FHA charges two fees. First is the up-front mortgage insurance premium which is 1.75% of the base loan amount. Although the fee is charged at closing, FHA allows for this fee to be financed on top of the loan amount. Furthermore, FHA charges a monthly mortgage insurance premium which is added to the monthly mortgage payment. The amount varies based on down payment and loan term. Most often, the charge is .85% of the loan amount which is then divided by 12 to come up with the monthly amount. It is most popular because this is the cost for less than 5% down and a 30-year loan term. 20-year terms or lower and 5% or more down payment reduces the PMI rates.
Conventional Loan Mortgage Insurance
Conventional loans which exceed 80% of the purchase price require mortgage insurance. Although, conventional loans do not need a set option as FHA loans require. Options include monthly, single premium, split premium, and lender paid PMI. To choose the best fit, a loan officer will price each option and discuss the ones that make the most sense. Credit score, loan percentage of appraised value, debt ratio, and other factors determine conventional PMI. The higher the risk, the higher the mortgage insurance premium. Higher risk examples include lower credit scores and higher debt ratios.
How to Get Rid of PMI – FHA vs. Conventional
Most of the time, the choice between a conventional or FHA loan comes down to which has the lowest payment, but one-factor clients often ask about is “How can I get rid of PMI?” or “When does PMI stop?” The rules vary between FHA and conventional.
FHA requires that the monthly mortgage insurance continues for the life of the loan. The exception is if buyers put 10% or more down. Although, the monthly amount does go down based on the new balance each year.
Conventional PMI allows for a borrower to cancel a monthly premium. First, the balance must be under 80% of the original purchase price. Furthermore, once the balance meets 78% of the original price, the lender cancels the PMI automatically. Another option exists when a borrower believes the new balance is less than 80% of the current appraised value. In this case, a lender will require an appraisal to verify the equity, and the borrower must pay the appraisal cost.
FHA vs. Conventional Credit Score Requirements
Every mortgage loan looks to credit scoring as a primary qualification factor. Primarily, lenders underwrite based on the middle of three credit scores. Lenders use the lower of two scores if only two scores are available. If only one score, then it is used.
Technically, FHA doesn’t have a minimum credit score, but FHA does require a 580 score for the minimum down payment. There are other requirements and compensating factors required to buy with such a score.
The minimum conventional loan credit score is as low as 620. Although to go as low as a 620 score, we require either a Fannie Mae or Freddie Mac automated system approval. Keep in mind how we explained that lower scores mean higher rates & PMI for conventional loans. Typically, FHA is a better option unless the buyer is putting down a higher down payment. This is especially true with 20% down or more as conventional loans would not require any PMI. However, FHA requires up-front and monthly mortgage insurance no matter the down payment.
FHA vs. Conventional Loan Down Payment Requirements
Too many believe that mortgages, in general, require a 20% down payment. Especially, buyers believe this about conventional loans, but today’s conventional loans allow as low as 3% down payment with other wonderful features such as possible reduced mortgage insurance. Fannie’s HomeReady & Freddie’s Home Possible loans feature these benefits. FHA has been known to offer a low 3.5% down payment.
Additionally, both loans allow gift funds for the required down payment. No matter if the down payment comes from the actual buyer, selling an asset like a home, or from a gift, it must be documented. Remember, it cannot be undocumented cash. Certainly, buyers may pay higher down payments, and that is something that an experienced loan officer can discuss with buyers.
Residency Requirements for FHA and Conventional Loans
Residency means how will the home be occupied – meaning occupying as a primary residence, a vacation home, or use as a rental or investment property. FHA is strictly for a primary residence property. It is meant to promote homeownership, but not for buying an investment or vacation home.
Although, conventional loans allow for all three residency types. Requirements such as down payment percentage, other guidelines, and interest rates could vary among these types. For instance, primary residence requires 3% down. Second or vacation homes need at least 10% down. Finally, investment properties require a minimum of 15% down.
FHA 203k vs. Fannie Mae Homestyle Renovation
What if a buyer desires to combine their purchase with a renovation? We have several great options to solve this prevalent issue. Whether it is by choice or appraiser required repairs, renovation loans provide solutions for buyers. The basic structure of a renovation loan is that the purchase price and the renovation cost is combined. Then the new loan amount is figured based on the loan type chosen.
The most popular renovation/home improvement loan is the FHA 203k loan, and there are two other types. Together they provide from very minimal improvements up to significant renovations including structural. Just like a regular FHA purchase, 203k loans require only a 3.5% minimum down payment of the total purchase price + renovation costs.
Another fantastic, but lesser-known renovation product is the Fannie Mae Homestyle Renovation loan. Just like FHA, it allows small to large home improvement projects including teardowns. Furthermore, Homestyle Renovation has other conventional loan benefits such as able to provide financing for the purchase and renovation of a primary, secondary, or investment property.
FHA vs. Conventional Loan Seller Paid Closing Costs
Sometimes the choice between FHA and conventional comes down to the need of seller paid closing costs for the buyer. Mostly, this comes into play on lower-priced homes. Each mortgage loan program has limits on how much the seller could contribute towards the buyer’s closing costs.
FHA is plain and simple – 6% of the sales price is the maximum allowed.
Conventional loan seller paid maximums to depend on the down payment percentage and residency type:
Primary or secondary residence:
- 3% of sales price if less than 10% down payment
- 6% of sales price if between 24.99% – 10% down payment
- 9% of sales price if 25% down payment
- 2% of sales price no matter the down payment percentage
If buying a $100,000 primary residence, a seller could only pay $3,000 towards buyers costs on a 3% down payment conventional program, but FHA would allow up to $6,000 towards buyer costs on a 3.5% down payment loan. In this case, FHA’s higher seller paid costs could make the difference in a buyer’s choice.
FHA vs. Conventional Non-Occupant Co-Borrowers
Sometimes buyers cannot qualify on their own. If the reason isn’t lack of down payment, it is usually insufficient income (high debt ratio). Both FHA and conventional loan guidelines allow what are called non-occupant co-borrowers. This means that buyers may have a co-signor to help them qualify. The co-signor does not have to live in the property. The most common type of non-occupant, co-borrowers are parents of the borrower. In addition to allowing a co-signor, both programs allow the following:
- One spouse occupying the new home and other spouse occupying another residence
- Co-signor may pay the down payment
- Occupying borrowers are not required to have any income (co signor’s income only is okay if there’s enough income for all borrowers to meet the program’s debt to income ratio requirements)
- Buying for a college student rather than paying rent
Every buyer scenario is different from the next which also means there are different strategies for each buyer. Sometimes it is cut and dry, but other times there are advantages of both loan types. If you are wondering if conventional, FHA, or maybe another mortgage type works best for you, give us a call or start the process below.