Few homebuyers can afford to purchase property out of pocket. Even if you are financially secure, odds are you may need to take out a loan to buy or invest in property. However, those who are not financially secure have no choice but to take out a home loan if they want to become homeowners. Fortunately, there are many mortgage options out there. Two of the most popular to consider are conventional loans (provided by banks and other lenders) and FHA loans (loans guaranteed by the federal government).
Conventional loans and FHA loans each have their own set of eligibility requirements as well as terms and conditions. Before choosing to apply for a conventional loan or an FHA loan, be sure to compare the different requirements and terms to determine which type of home loan suits your needs. The following is a breakdown of FHA vs. conventional loans to help you do just that.
FHA loans are issued by qualified lenders and boast a number of favorable terms for borrowers, including low-interest rates and low down payments. They are also easier to qualify for because FHA loans are insured. As a result, lenders are not taking as big of a risk. If the borrower defaults, the lender doesn’t lose money because the loan is insured by the federal government (via the Federal Housing Administration.
FHA loans are available in 15 or 30-year durations. The shorter the loan is, the higher the payments will be; however, you’ll end up paying less interest over the long term. These loans will be available in fixed or adjustable rate options as well. Fixed rate means that the interest rate at the time you take out the loan will remain permanent throughout the duration of the loan. The interest on an adjustable rate loan may go up or down from month to month based on the market. There’s also a third option: hybrid FHA loans, which start off with a fixed interest rate and then transfer to an adjustable rate.
There are several requirements that you will need to meet to qualify for an FHA loan. These requirements include the following:
- Generally speaking, you’ll need a credit score of 580 or above, although you can still qualify if you have a score between 500 and 579 (you will be required to make a larger down payment if your credit score falls below 580).
- You will be required to pay mortgage insurance every month.
- The house you wish to buy using the FHA loan must become your primary residence.
- You must be able to prove that you are employed and earning a steady income.
- You cannot have significant amounts of debt. Your debt-to-income ratio has to be below 43 percent.
- You must be able to make a down payment of at least *3.5 percent of the home’s total cost.
Conventional loans are home loans that are not insured by the federal government and that are offered by a variety of lenders, including banks. Conventional loans adhere to a set of guidelines established by Fannie Mae (Federal National Mortgage Association), which sets the maximum loan amounts and borrower requirements.
Because conventional loans are not insured, qualifying requirements are more stringent. Borrowers who are financially secure and have good credit histories will qualify more easily and at more favorable terms. Lenders are less likely to take risks approving borrowers with poor financial histories because they will be forced to foreclose if the borrower defaults, which can be a costly process and does not necessarily guarantee that the lender gets their money back.
Conventional loans, like FHA loans, are available in 15 and 30-year durations with fixed or adjustable interest rates. Conventional loans can also be taken out for other lengths of time, including 10 and 20-year durations; however, 30-year conventional loans are the most common.
Requirements for qualifying for a conventional loan do vary slightly from lender to lender. The following are some of the standard requirements that you can expect:
- You will need to have a credit score of at least 620.
- You will need to make a down payment between 5 and 20 percent, although some lenders allow a three percent down payment depending on several factors (such as your credit score).
- You will need to pay mortgage insurance if your down payment is less than 20 percent. If you make a down payment of 20 percent or more, mortgage insurance is not required. You can also cancel your mortgage insurance once you obtain 20 percent equity in the house.
Difference in Credit Score Requirements
Your credit score provides lenders with a way to judge how financially responsible you are and how capable you are of making your payments on time and in full. The lower your credit score is, the more of a risk you’ll be deemed. To offset this risk, your interest rates will likely be much higher and you may be required to put down a larger down payment.
However, when it comes to conventional loans, most lenders won’t be willing to approve loans to borrowers with anything less than a 620 credit score. Because FHA loans are insured, borrowers are given a bit more flexibility. Generally, borrowers can qualify with credit scores as low as 580. You may still be able to qualify with a credit score of 500 to 579, but you’ll have to make a larger down payment of 10 percent to offset your perceived risk.
Minimum Down DPyment Differences
For the most part, expect to pay a minimum of a 5 percent down payment for most conventional loans. In some cases, you may be able to qualify for a 3.5 percent down payment, but this is not as common. Many factors go into the cost of your down payment as well. The better your credit score is, the better your odds are of a smaller down payment. This is because lenders will assume that you will have no trouble paying back the rest of the loan. If your credit history isn’t great, lenders will want a larger down payment to offset the risk of a potential default.
The down payment for an FHA loan is not as dependent on your credit history and credit score. As long as you have at least a 580 credit score, you’ll qualify for a 3.5 percent down payment, which is why FHA loans are so attractive to borrowers with less than stellar credit scores and financial standings. Of course, as previously mentioned, if your score is below 580, you’ll be expected to pay a 10 percent down payment.
Debt To Income Ratio Rules That Apply
Lenders will look at your debt-to-income ratio whether you’re applying for a conventional loan or an FHA loan. Your debt-to-income ratio shows lenders how much you owe vs. how much you make. If you already have too much debt vs. what you make, lenders will assume that you will be unable to take on more debt.
For conventional loans, the maximum debt-to-income ratio lenders generally accept is 43 percent, meaning that if more than 43 percent of your monthly income is going towards the debt you owe, they’ll deem you incapable of handling more debt in the form of mortgage payments. However, if you have a high credit score and/or large cash reserves, you may be able to qualify with as much as a 50 percent debt-to-income ratio.
FHA loans are similar in this respect. The front-end debt-to-income ratio (which refers to housing expense-related debts) is generally 31 percent, while the back-end debt-to-income (all debts) is 43 percents. These limits are raised a bit based on factors like cash reserves, high credit scores, and residual income. In some cases, a minimal increase in housing payments can offset a higher debt-to-income ratio as well. More details concerning FHA debt-to-income ratios are available on the FHA website.
Purchase Restrictions for FHA
Conventional loans carry no purchase restrictions. You can use them to buy whatever you want, including different types of properties (townhouses, single-family homes, cabins, etc.) If you buy property, it doesn’t have to be a primary residence either.
FHA loans have more restrictions in place than conventional loans. You can only use FHA loans to purchase a home, and that home has to be your primary residence (FHA loans can’t be used towards investment properties or vacation homes).
The house will also need to pass the minimum property standards established by the FHA in the event that you’re foreclosed on so that they can sell the property with little hassle. These standards include safety standards, security standards, and soundness standards (which refer to the structural and physical integrity of the house).
Processing Times of Each Option
The last thing you’ll want is to have to delay your closing because your home loan hasn’t been processed. This could jeopardize your deal as well as cost you money, which means you’ll want to know how long it takes for your loan to process well ahead of time.
FHA loans will typically take 30 days to process from the date on which you submitted your loan application. The entire process from start to finish, including turning in supporting documents to your lender and completing the application, should take between 30 to 45 days. This process could take longer if there are appraisal issues or problems with your application or paperwork. In rare cases, a high number of applications may delay your loan application as well.
Historically, conventional loans have been processed quicker than FHA loans. You can expect it to take between four and six weeks from start to finish as long as there are no issues with your paperwork. However, the FHA has managed to streamline their process within the past few years to the point where their processing time is on par with that of a conventional loan.
How Are Loan Limits Calculated for Each
The amount you can borrow depends on a variety of factors (including your income, your debt-to-income ratio, and your credit score). However, there are loan limits in place for both FHA loans and conventional loans. These loan limits vary from county to county across the United States due to the varying cost of living in different parts of the country.
For conventional loans, the limit in most counties in the state of California for a single-family home is $484,350. The limit is higher in higher-priced areas. For example, in the San Francisco Bay Area, the loan limit for a conventional loan is $726,525. Be sure to check the county loan limits in California when considering a conventional loan.
The FHA recently raised its loan limit floor and ceiling for 2019. The loan limit for an FHA loan in high-cost areas is now $726,525, while the floor is $314,827. It’s worth noting that loan limits also vary based on the type of home you’re buying–loan limits for single-family homes will be lower for duplexes, triplexes, and four-plexes. A more detailed rundown of the FHA loan limits in California is available on the FHA website.
Refinancing means taking out a second mortgage in order to pay off the first one. It’s generally done to take advantage of more favorable terms, such as lower interest rates. For example, if your initial mortgage has a high interest rate because you had a poor credit score at the time, you might want to refinance if you’ve improved your credit score and interest rates have dropped in general. Many homeowners will refinance to lock into a low fixed interest rate or to get rid of their mortgage insurance. Whatever the reason, refinancing is typically a good way to save money long term. Consider exploring potential refinancing options for both FHA loans and conventional loans.
If you have an existing FHA loan, you can refinance through the FHA Streamline Refinance program. It’s actually one of the easiest ways to refinance a home mortgage because the FHA does not require another appraisal, will not check your credit score, and will not require additional income verification. The FHA assumes that if you already have an FHA loan, then you will most likely qualify in these respects and therefore bypass looking into these factors. The only requirements for qualifying for an FHA Streamline Refinance loan is as follows:
- Your existing loan must be an FHA loan.
- You must have been on time with all of your mortgage payments for the last six months.
- You must prove that you’ll receive a net tangible benefit, which means that by refinancing, you’re lowering your combined rate by at least one-half of one percent.
The FHA also has a cash-out refinance program if you need money back from the equity that you have in your property. To qualify for their FHA cash-out refinance program, you will need to meet the following requirements:
- You will need a credit score of 600 or higher.
- You must have a loan-to-value ratio of at least 75 percent.
- You can only use the cash-back refinance loan on an owner-occupied property.
- You cannot have any late mortgage payments on your record for the past six months.
- You can’t have more than one single late mortgage payment in the past year.
A conventional refinance can be used for any type of loan, including FHA loans. They can also be used to cancel mortgage insurance on your first loan and to tap into the equity of your home. For example, if your house is worth $400,000 and you have $200,000 in equity, you can take out a loan for $300,000, which will replace your first loan as well as provide you with cash back that can be used for anything you want, including home improvements or debt consolidation. Another perk of getting a conventional refinance is that you can use it for any type of home, including secondary homes and investment properties.
Although conventional refinance loans are more flexible in their use, they have stricter requirements. These include:
- You must have a credit score of at least 620, although some lenders require higher credit scores (usually from 640 to 680) to qualify.
- You must go through the same qualification process you had to go through for your initial loan, which means that your credit history will be checked, your income will be checked, and your debt-to-income ratio will be checked. This also makes the process take a bit longer than an FHA refinance.
Which is the best option for me?
There are many factors to consider when comparing FHA vs. conventional loans. If you don’t have the best credit score and you lack cash reserves, consider an FHA loan. Not only is it easier to qualify for than a conventional loan in this situation, but you’re more likely to get more favorable terms. However, if you have a high credit score and can make a substantial down payment, a conventional loan may benefit you more. Not only could you qualify for lower interest rates, but if you won’t have to pay mortgage insurance if you can put 20 percent down.
Consider your long-term goals
If you’re planning on living in the house you’re buying for a long time to come, then an FHA loan may be a good option. However, if you’re only going to live in your home for a few years or you want to buy an investment property that you plan on selling off in the near future, then a conventional loan is probably the better option.
Because there are so many factors to consider when buying a home and because there are quite a few differences between FHA loans and conventional loans, speak with a mortgage expert. Determine what your financial situation is, what your financial needs are, and what your home buying needs and wants are and a mortgage expert will be able to advise what type of loan will suit your specific needs and situation.