Differences Between FHA and Conventional Loans

The Federal Housing Administration, or FHA, was established during the Great Depression with the primary objective of making home ownership possible for more people.  FHA mortgages are backed by the Federal Housing Administration in case you default on the loan.  The FHA does not actually lend people the money to buy a home – the FHA guarantees the loan, so if a borrower defaults on his mortgage, the FHA will reimburse the lender.  Mortgages obtained on the private market without FHA help are known as "conventional" mortgages.  With a conventional mortgage, lenders do not have the same guarantee.

Fannie Mae and Freddie Mac are also government sponsored enterprises (GSEs). Their objective is to provide stability and liquidity to the U.S housing and mortgage markets. These GSEs also do not lend directly to borrowers, but they help to ensure that the banks and mortgage companies have funds to lend at affordable rates. These types of loans are typically conventional loans.

In the past, FHA was viewed as an alternative form of financing for those with credit problems. However, because the conventional guidelines have become extremely restrictive, many people with excellent credit but lacking the 5% down payment to meet the conventional requirement are turning to FHA loans for home financing.

Conventional and FHA loans are similar, but there are important differences.  While this article addresses the primary differences between FHA and Conventional loans at the time it was written, changes to both programs are continually being made.  It is recommended, therefore, that you contact your loan officer in order to determine the best program for your situation.

The U.S. Department of Housing and Urban Development Web site (www.hud.gov) can help you find HUD-approved counselors in your area who can answer your specific questions regarding FHA loans.

Credit History
The FHA tries to help those with no established credit history and those with a less-than-excellent credit history.  The credit qualifying criteria for a borrower are not as strict for an FHA loan as for a conventional loan.  Also, borrowers who do not have an established credit history or credit score, or have a reasonable explanation for a few "credit problems", may still be eligible to qualify for an FHA loan if they can show a history of on-time payments with utility companies or other companies.

People with an excellent credit history will typically find it easier to qualify for conventional loans than those with shakier credit histories.  There is no credit score above which you are guaranteed to qualify for a conventional loan, but a score of 720 is generally considered excellent credit.  If a score is below the minimum standard, the borrower will be denied qualification, or may be offered a sub-prime loan with a higher interest rate.

The FHA uses a credit score of 620 to determine whether you can qualify automatically for a loan, but a credit score below 620 does not necessarily disqualify you, as it might with a conventional mortgage.  The minimum credit score that most lenders will allow on an FHA loan is 580.

Down Payment
The FHA requires a down payment of at least 3.5% for its guaranteed loans, though some lenders may require you to put down more money.  The minimum down payment on a conventional loan is 5% - 10%, although some lenders require down payments of as much as 20 percent.  On a positive note, the larger down payment means you will probably gain equity in your home more quickly with a conventional loan.  For a down payment of 5% to 10%, most lenders are requiring that the borrower have a minimum credit score of 720.

For an FHA loan, you might not have to come up with the down payment yourself.  It can be a gift from a family member or friend, although it cannot come from anyone who would benefit from the transaction, such as the home seller.  A conventional loan may require you to pay the down payment out of your own funds.

On a conventional loan, the seller can pay up to 3% of the purchase price toward the buyer's closing costs; however, they can only pay the non-recurring costs. They are not allowed to pay the recurring costs such as taxes, insurance or pre-paid interest.  On an FHA loan, the seller can pay both recurring and non-recurring costs.

Debt-to-Income Ratios
FHA loans have higher limits for debt-to-income ratios than conventional mortgages, meaning your monthly mortgage payment can take up a larger percentage of your monthly income.

Loan Limit
A drawback to FHA loans is that there is a maximum loan amount set.  The FHA sets limits on mortgage amounts by county, meaning that areas with higher real estate prices will have higher FHA loan limits.  If you want to buy a home that is above the FHA limit in your area, you will either have to make a larger down payment or try to qualify for a conventional, subprime, or other type of mortgage.  In general, conventional mortgage lenders do not place limits on the amount they will lend.

Mortgage Insurance
The biggest disadvantage of FHA loans is the mortgage insurance premium (MIP).  The FHA gets the money it uses to reimburse lenders when borrowers default from the borrowers themselves.  People who take out FHA loans with a down payment of less than 20 percent must pay insurance on the mortgage.  Speak with your loan officer regarding the requirements for removing the MIP.

Conventional loans may require insurance as well, which is called private mortgage insurance (PMI), but the rates will usually be lower than the FHA MIP rates.  In addition, on a conventional loan, you generally pay premiums for a shorter time, because of your larger down payment, and you pay premiums only until you reach 20 percent equity in your home.  Speak with your loan officer regarding the requirements for removing the PMI.

Other Considerations

1)  FHA loans are assumable, i.e., you can transfer your loan to the new owner if you sell your house, which allows the new owner to take over your FHA loan without having to incur the cost of obtaining a new loan.  In order to assume the loan, the buyer must meet the current credit standards for the loan.  This feature can make it easier to sell your home.  Your loan officer can explain the current rules for assuming an FHA mortgage.

It's very likely that interest rates will rise after the economy recovers, and having an assumable mortgage can be a great benefit for you if you decide to sell your home and the interest rates are several points higher than they were when you opened your mortgage. In addition to increasing the likelihood that your home will sell more quickly, it's not unreasonable to expect that homes with FHA financing will command a premium sales price in the resale market over the next seven to ten years.

2) There is also an Energy Efficient Mortgages program that allows homeowners to finance adding energy-efficient features to new or existing homes as part of either their home purchase or FHA refinancing.

3) Another benefit of an FHA loan is that a non-occupant co-borrower is allowed to co-sign on the loan.  The income of both the borrower and co-borrower will be combined and used for qualifying.

On a conventional loan, the owner occupant must qualify at the established debt ratios unless higher ratios are approved by the Automated Underwriting System.

4) Many loan products, including conventional loans, have pre-payment penalties, whereas FHA loan do not have such penalties.  In fact, FHA loans can be easily refinanced under the Streamline program.