What is the Difference Between FHA and Conventional Financing?
For first time home buyers the terminology of loans can be confusing, and sometimes the answers are misunderstood when explained in real estate jargon. The three basic categories of financing are either FHA, VA, or Conventional. Here’s a brief rundown:
1. FHA – Insured Financing.
FHA stands for Federal Housing Administration and was created in 1934. The Federal Housing Administration doesn’t actually lend money to home buyers. Rather, it insures the loans that are given to qualified home buyers, by FHA-approved lenders. FHA loans are a type of government assistance and have lending standards that are less stringent than other types of loans.
The minimum credit score of 580 is a bit lower than that required by lenders of conventional loans. [And 580 is just the FHA’s guideline – individual banks and mortgage lenders still need to agree to offer such loans. So there’s a very good chance you’ll need an even higher credit score.]
Also, the credit score isn’t the only aspect of the buyer’s credit-worthiness; FHA takes into consideration the buyer’s payment history, and what they refer to as common sense lending standards. If you have had credit problems in the past, the FHA recommends a Consumer Credit Counseling program to avoid being denied an FHA loan.
The downpayment required on an FHA loan is 3.5%, this is less than conventional loans. The maximum seller contribution allowed is 6%.
Historically, FHA-insured loans have made it possible for lower income Americans to purchase a home that they otherwise wouldn’t have been able to afford. FHA loans are the most popular choice of first-time home buyers, mainly because they often don’t have the money for a higher downpayment. They also don’t have the mortgage history which so often helps in building a higher credit score.
In today’s real estate market, with historically low interests rates that are poised to go up as the economy recovers, many first time buyers are opting for FHA loans with lower down-payments. Rather than waiting to save enough for a 20% downpayment that is necessary for many conventional loans, taking advantage of an FHA loan at today’s interest rates is a smart move. In the time that it would take to save that amount, interest rates will very likely rise and mitigate against the monthly savings from a higher down-payment.
FHA loans require private mortgage insurance to protect lenders from possible default. Every month, a mortgage insurance premium, MIP is added to the monthly payment. This mortgage insurance was just lowered in 2015 from 1.35% of the premium amount, to .85%. This will save an average of $900 a year.
The other change that just took place is that the MIP is now a permanent part of the loan. Previously, the MIP was dropped from the monthly payment when the loan was paid down to the point where the buyer owed less than 78% of the original loan. The UPMIP (upfront MIP) is currently at 1.75% of the base loan amount.
FHA has loan limits, which are different, based on local markets. In Maryland: in Montgomery and Frederick Counties, the limits is $625,500, while in Howard and Carroll Counties, the limit is $517,500, and in Washington County the limit is $271,050, for a single dwelling.
More information: FHA Connection
2. VA Loans – Loans for Veterans.
Since 1944, introduced in the GI Bill of Rights, the Housing Administration has been providing VA guaranteed loans for our Veterans. Like FHA loans, VA loans are made through approved private lenders. The guaranty to lenders means that in both VA and FHA loans, the lenders are protected against loss in case of the default of the buyer.
VA loans are the only loans today which offer a no-down payment loan, no MIP, and often have a lower interest rate. VA loans require no private mortgage insurance, and allow financing up to 103.3% of the value of the home.
The VA does not have a minimum credit score used for pre-qualifying for a mortgage loan, however, most Lenders require a minimum credit score of at least 620.
The maximum amount of a VA home loan is typically $417,000, although it can be higher in certain “high-cost” counties. In Hawaii and Alaska, for instance, the limit is $625,500.
Both VA and FHA have their own guidelines which describe all allowable loan traits, as well as the going terms of an Federal Housing Administration-backed loan. The rules can differ regarding closing cost help, property condition, and type of property that can be financed, as well as other items.
3. Conventional Loans.
Conventional loan products are not guaranteed by the VA or insured by the FHA. A non-GSE loan, non-government sponsored entity. Private, conventional loans are secured by investors. Thus, the requirements are often more stringent than FHA or VA loans.
Unlike FHA loans, conventional loans can be used for second homes and investment properties. The minimum credit score is typically 620.
Conventional loans have various terms and loan-to-value ratios. Loan-to-value ratio (LTV) means how much you are borrowing compared to the overall value of the home. The more you put down, the lower the LTV. The higher the LTV, the more risk the lender is taking, and the more costly the loan for the buyer, in terms of interest rate.
The down-payment required on a conventional loan can vary. The Conventional 97 program only requires 3% down, and is available to U.S. homebuyers through Fannie Mae and Freddie Mac. Conventional loans can cover much higher loan amounts than FHA, called Jumbo loans, and offer more types of loans.
If the LTV is lower than 80%, the lender often requires that borrowers pay for private mortgage insurance, or PMI. The PMI is only a single premium, whereas with FHA, there are both upfront and monthly premiums, and the PMI with FHA loans never drops off. The term of the loan can be longer or shorter, 15 years, or 30 years or even 20 or 40. With each there are different interest rates.
Ask Your Lender
Your lender can help you determine which loan product is best for your needs. Your loan officer will be able to tell if you qualify for both types of loans, and determine which will cost less both short and long-term. Ask for a side-by-side cost analysis.
Contact us for our list of preferred lenders in Central Maryland.