Which Type of Mortgage is Best for Me?
When looking for a mortgage, understanding the different loan options available can be challenging. Different situations work best with different products and the type of loan you get influences your terms, rate and qualification requirements. Here, we will look at the differences between FHA and conventional loans as well as the pros and cons of each.
FHA loans are loans backed by the Federal Housing Administration and are generally easier to qualify for than conventional loans. They also tend to have smaller down payment requirements, however, do require you to pay mortgage insurance.
Conventional loans, unlike FHA loans, are not insured or guaranteed by any federal agency. They come with stricter lending standards and larger down payment requirements. Contrary to FHA loans, private mortgage insurance is only required with down payments below 20%. In this case, you can request your lender to cancel your PMI when your loan balance drops under 80% of the home’s original value.
Credit Requirements:
For some FHA lenders you can qualify with as low as a 500-credit score although, it is preferred to have at least a 580. Lenders that do accept lower scores may have stricter Debt to Income or down payment requirements. It will also be considered a subprime loan, meaning you may have a significantly higher interest rate compared to an FHA loan with above a 580-credit score or a conventional loan.
Conventional loans, on the other hand, typically require a credit score of 620 or above.
Down Payment Requirements:
If you have above a 580-credit score, you can qualify for an FHA loan with a down payment as low as 3.5%. Those with credit scores between 500 and 579 must put at least 10% down.
Conventional loans have options for first time home buyers with as little as 3% down however, to avoid paying mortgage insurance you would need to put at least 20% down. If it’s not your first time buying a home, and you make less than 80% of the median income, the lower limit goes up to 5%. For second homes it jumps to 10% and 15% for multi-family dwellings.
Debt to Income Ratio:
Your debt-to-income ratio compares your total monthly expenses with your total monthly income. Lenders use this number to determine what you can afford when it comes to taking on a mortgage payment.
Expenses that will be considered include:
- Rent or mortgage payment
- Minimum credit card payments
- Student loan payments
- Auto loan payments
- Personal or other loan payments
- Any other recurring monthly costs
With an FHA loan, the maximum DTI allowed is 45% if your credit is below 580. Most conventional and FHA mortgages require you to have a DTI of 50% or less.
Mortgage Insurance:
Depending on the size of your down payment as well as your mortgage terms you may have to pay mortgage insurance. Mortgage insurance, unlike other insurances, doesn’t protect you. Instead, it protects the lender if you stop making payments.
FHA loan borrowers are required to pay mandatory minimum mortgage insurance premiums, regardless of the amount you put down. There is both an up-front payment that can be rolled into the loan as well as monthly premiums. If you put at least 10% down must pay this for 11 years. If you make a down payment of less than 10% then you must pay these premiums throughout the life of the loan.
Overview of FHA Loans:
FHA loans are issued by FHA approved lenders including credit unions, banks and other lending companies and federally insured. They are intended for borrowers with either limited savings or lower credit.
Since FHA loans are federally insured, these lenders can typically offer more favorable terms including lower interest rates and can lend to borrowers who might not otherwise qualify for a home loan. This also means it can be easier to qualify for an FHA loan compared to conventional financing.
Property Types eligible:
- Single family homes
- Multi-family homes (Up to 4 Units)
- Condominiums
With an FHA loan you can borrow up to 96.5% of the value of the home. If your credit score is above a 580, you can get approved with putting as little as 3.5% down. If your credit is below 580, you may still be able to get approved with as little as 10% down.
Overview of Conventional loans:
A conventional loan is a mortgage that is not backed by a government agency, which is both originated and serviced by a private mortgage lender. Since these loans aren’t secured, lenders typically have stricter credit requirements. Conventional down payment requirements range anywhere from 3%to 40%, depending on the terms.
To qualify for a conventional loan, customers must have a much higher credit score (680 or above) with no significant blemishes. Interest rates vary depending on the size of the down payment, current market conditions and choice of mortgage product. Most conventional loans come with fixed interest rates, meaning the rate won’t change throughout the life of the loan. Borrowers can however, refinance in the scenario rates drop.
Bottom Line:
An FHA loan and a conventional loan both have their advantages. FHA loans have less strict requirements than conventional loans and can be a better option for borrowers with lower credit or a higher DTI. On the contrary, a conventional loan may be more favorable for those with better credit.
