Buying a home is a significant investment and one of the most important decisions you’ll have to make is what kind of mortgage loan works best. FHA loans and conventional loans are among the most popular options but they offer two very different ways to complete your home purchase. This brief guide explains how they compare so you can decide which one is the right fit.
How FHA Loans Work
An FHA loan is a mortgage that’s backed by the Federal Housing Administration. Participating lenders issue the loans to homebuyers and the FHA guarantees them in the event that the buyer defaults on the payments. According to the National Association of Realtors, 35% of first-time buyers chose an FHA loan in 2014.
The most appealing feature of an FHA loan is the fact that you only need a 3.5% down payment to get a home. On a $250,000 mortgage, the down payment would come to $8,750. Compared to a conventional loan, an FHA loan also offers easier credit approval. As of 2016, the minimum credit score that the Department of Housing and Urban Development requires is 580. Individual lenders, however, may set the minimum cutoff higher.
In terms of the downsides, the biggest one is the mortgage insurance requirement. FHA buyers are required to pay an upfront mortgage insurance premium equal to 1.75% of the purchase price, plus an annual premium of 0.85%. The upfront premium is usually included as part of your closing costs while the annual premium is tacked onto your payments monthly. For new FHA borrowers, the only way to get rid of the annual premium is to refinance into a conventional loan.
Conventional Loan Guidelines
A conventional mortgage is a loan that adheres to the underwriting rules established by Fannie Mae or Freddie Mac. This is what most people think of as a standard, 30-year, fixed-rate loan.
As far as the down payment goes, it’s possible for qualifying buyers to get financing with as little as 3% down. You don’t have to be a first-time buyer to qualify, unless you’re trying to get a loan through Fannie Mae’s HomeReady program, which is geared towards buyers in the lower to middle-income range who are credit-eligible for a loan but don’t have a huge down payment saved.
The minimum credit score required for a conventional loan is 620, which is higher than what you’d need for an FHA loan. Again, lenders have the option to narrow eligibility to borrowers whose scores are in a higher range in order to minimize credit risk.
Conventional loans don’t require an upfront mortgage insurance premium but you will have to pay private mortgage insurance (PMI) if you’re putting less than 20% down on a home. On a $250,000, 30-year loan with a 4% interest rate, PMI would add approximately $232 a month to your payments. Private mortgage insurance can only be cancelled when the mortgage balance hits 80% of the home’s value.
Which Is Better?
FHA loans and conventional loans serve the same purpose but they’re suited to different kinds of buyers. An FHA loan may be better for a first-time buyer whose credit is less than perfect and can’t put together a 20% down payment.
On the other hand, a buyer who can put down 20% and has a better credit score may be able to save more money over the life of the loan with a conventional mortgage. If you’re eligible for both types of loans, running the numbers for each one can tell you which option is going to be the least taxing on your wallet in the long run.