Are you in the market for a mortgage? Then you may be looking at two distinct choices: a conventional loan and a government-backed FHA loan. Which should you choose? There are several factors to consider in making this important decision. Let’s break down the basics of each.
Most home loans that don’t come with backing from a federal agency fall into the class of “conventional mortgages.” These then fall into two sub-categories: conforming and non-conforming. If a mortgage goes over the maximum loan limit, it’s considered non-conforming, also termed as the objectively more-fun phrase “jumbo loan,” which usually comes with the not-so-fun requirement of bigger down payments. Whether you go conforming or non-conforming, lenders of conventional loans usually insist on good credit scores and low debt-to-income ratios; conventional loans aren’t government-insured, so there’s a greater risk to the lenders.
How much do you have to put down with a conventional mortgage?
That varies, but some conventional home loans go as low as 3% down. With a catch. If you’re putting down less than 20%, most lenders will insist you get private mortgage insurance or PMI. This insurance policy, paid monthly or in a lump sum, protects the lender in the event you stop making mortgage payments. The cost of PMIs varies, determined by credit score, type of loan, and the amount of the down payment. In general, for every $100,000 that is borrowed, insurance payments are often between $30 and $70 per month. But you may be able to recoup some of this cost — PMI payments are tax deductible for many. Once your loan-to-value ratio hits 80%, you can usually lose the PMI.
FHA Mortgage Loans Explained
While issued by traditional lenders, FHA mortgages are insured by, as you’ve probably guessed, the Federal Housing Administration. Most kinds of mainstream lenders, including brokers, credit unions, and banks, are approved by the U.S. government to make FHA loans. These loans carry less risk for these private lenders, who make them available to borrowers who have lower credit scores than those needed for most conventional mortgages. How low? You might find a lender willing to make a loan to someone with a credit score as low as 500, but, practically, 600 and above is a common threshold for getting an FHA loan.
How much you have to put down with an FHA loan depends on your credit score; the down-payment range usually runs from 3.5% to 10%. Keep in mind that you pay fees for the privilege of an FHA loan, costs you don’t have with conventional loans. These fees include an MIP, or mortgage insurance premium, which carries an upfront fee of 1.75% of the loan amount, and a per-year fee of 0.85%. Plus you’ll have mortgage insurance payments, due monthly and often costing 0.45% and 1.05% of the loan balance. The upfront fee doesn’t have to be out of pocket; some lenders allow you to add it to the loan amount. FHA borrowers who put down less than 10% need to pay insurance for the life of the loan, while those who plunk down 10% or more can lose the MIP payments after eleven years.
How should you decide between a conventional and an FHA mortgage?
If your credit isn’t perfect, a government-guaranteed loan could be a good route, as these loans often have lower standards for qualifications, though you are apt to pay higher fees and have more restrictions compared to a conventional loan. While the fees and rates vary from lender to lender, in general, you can expect conventional loans to be more affordable. In one sense, the loan you most qualify for will be the best one for you. But there are other factors to consider.
You need to take the current state of the housing market into account. When housing inventory is low, and things have trended that way of late, it’s a sellers’ market, and prices go up as prospective homeowners engage in bidding wars. In this climate, home sellers favor bidders with conventional loans, perceiving FHA loans as less reliable. So if you’re competing for a home, a conventional loan will work to your advantage. And if you can swing 20% down, and thus avoid paying a PMI, this can also be your most affordable financing option.
While the general rule that prospective borrowers with less-than-stellar credit should turn to FHA loans applies, other considerations come into play. Such as employment history. Conventional loans take harder lines on work records, while FHA loans are more forgiving in this area. The same is true with bankruptcy; a recent bankruptcy is usually a non-starter with a conventional mortgage, while a borrower may be able to qualify for an FHA loan two years or less after filing for bankruptcy. And a low credit score also doesn’t influence the maximum insurance premium with an FHA mortgage, holding payments to 1.05% of the loan.
With a credit score in the mid-to-high 600s, you’re in the sweet spot to choose between an FHA and a conventional mortgage. Your DTI (debt-to-income) ratio is also a big deal. A ratio of 40% or less, meaning your debts take up 40% or less of your gross income, leaves you similarly well-positioned to choose between types of mortgages. Lenders of conventional mortgages usually won’t make the loan if your DTI is over 43%. FHA loans are more lenient with DTI, with some lenders going as high as allowing 50%. But you’ll have to look pretty hard for that deal, as most FHA lenders want a DTI of 45% or less. DTI plays less of a part in markets where homes are more affordable, but can often be a deciding factor in places like New York or San Francisco where housing prices are high.
What’s the final answer?
There’s no one correct answer for everyone. Just gauging by credit scores, most borrowers with scores of 620 or less go the FHA route, while those with credit scores of 720 and higher choose conventional mortgages. But, of course, you’ll need to decide which is right for you.