The Conventional Loan vs. FHA Loans
Home buyers have several financing options to choose from, and two of the most common are conventional loans and FHA loans. If you’re thinking about buying a home, it’s important to understand the differences between the two loans so you can choose the best mortgage for your needs.
How Do Conventional Loans Work?
The term “conventional loan” refers to any loan that’s not backed by the government. They are offered by banks, credit unions, mortgage companies, and other private lenders.
Conventional loans usually have fixed interest rates. The rate is locked in prior to closing, and you’ll make fixed monthly payments until it is repaid. Your mortgage officer can assist you with deciding when the best time to lock your rate is.
With a fixed interest rate, once locked, you don’t have to worry about rates increasing in the future. It can also help with budgeting. You can easily estimate your monthly payments before applying by entering your loan amount, the current interest rate, down payment, and other information in a mortgage payment calculator.
A down payment will be required to qualify for a conventional loan, and the amount will depend on your lender and credit score. If your down payment is less than 20%, you’ll be required to have private mortgage insurance (PMI). The cost of PMI varies but can be anywhere from 0.2% to 2% of the loan amount annually. The good news is that PMI will automatically end once your loan has been paid down. For most owner-occupied properties, PMI terminates once your balance falls below 78% of the lesser of the original purchase price or appraised value. And if you have done improvements, paid down your loan balance, or values have appreciated, you may be able to request PMI be waived sooner.
Conventional Loan Eligibility Criteria
When considering you for a conventional mortgage, your lender will evaluate your current financial situation to make sure you can make the monthly payments. Your credit score will also be checked. Although each lender has its own criteria for evaluating credit scores, applicants with higher scores usually receive lower interest rates and have lower PMI rates.
Your lender will also make sure you don’t have too much debt. A high level of debt could indicate that you’ll miss payments or default on one or more loans in the future.
Lenders use a simple metric known as the debt-to-income (DTI) ratio to evaluate your current debt level. As the name implies, it’s a comparison of how much you earn and your monthly debt payments. The DTI ratio is always expressed as a percentage, and lenders prefer to see ratios of 43% or less for mortgages.
How Do FHA Loans Work?
FHA loans are mortgages that are offered by banks, credit unions, and other lenders that are backed by the Federal Housing Administration. These loans are not need-based and they don’t have any specific income requirements.
Because they are backed by the government, they are less risky for lenders and are easier to qualify for than conventional loans. This makes them attractive financing options for first-time home buyers.
A popular benefit of FHA loans is that you’re only required to make a down payment of 3.5%, as long as your credit score is at least 580. And your down payment can even be a gift from an eligible family member. FHA also allows higher DTI, sometimes as high as 57%, although it’s decided case by case. Additionally, FHA has less stringent seasoning requirements if you had a prior serious credit event like bankruptcy, foreclosure, or short sale.
It’s important to point out that although you can qualify for an FHA loan with a low credit score, you’ll have to pay a higher interest rate than you would if you had a higher score.
If you buy a home with an FHA loan, you’ll also be required to purchase FHA mortgage insurance premium (MIP). This protects the lender if you default on the loan. You’ll be required to pay two MIP premiums. The first is an upfront premium, currently 1.75% of the loan amount, which can either be paid upfront or be financed and added to your base loan amount at closing. You’ll also have to pay a premium each year that you’re repaying the loan. The annual premium will depend on your loan to value, loan amount and loan term. The annual MIP for a loan to value greater than 95% with a loan amount of $625,500 or less and a term over 15 years is .85% annually.
FHA Loan Eligibility Criteria
To qualify for an FHA loan, borrowers must meet certain criteria. These requirements are intended to make sure you can repay the money you borrow. They are:
- Have lawful US residency
- Have a Social Security number
- Have a steady employment history
- Must not have a foreclosure within the past three years
- Down payment of at least 3.5% with a credit score of 580
- Must not have a bankruptcy within the previous two years
- Be old enough to sign for a mortgage in the state you live in
- Property must be appraised by an FHA-approved appraiser and meet certain standards
How Are the Two Loans Similar and Different?
Conventional loans and FHA loans are similar in several ways. They are both issued by banks and credit unions, they both have fixed interest rates, and they are both repaid with fixed monthly payments.
The primary difference between the two loans is that FHA loans were designed primarily for those with low to moderate incomes, fair to average credit scores, and limited savings. Conventional loans, on the other hand, are best for those with good credit scores and larger down payments.
An important difference to consider is the mortgage insurance requirements. With an FHA loan, you’ll be required to pay for mortgage insurance for as long as you have the loan. The total you’ll have to pay for this over the years could be significant.
With a conventional loan, however, you are not required to have private mortgage insurance (PMI) if you have at least 20% equity in your home. Not having to carry PMI, or being able to cancel it once eligible, could result in significant savings.
Home Loans With TEG Federal Credit Union
Applying for a mortgage is an exciting time in your life. You get to put down roots somewhere, have an asset that can increase in value over time, and, most importantly, have a place to call home.
If you’re a first-time home buyer, TEG FCU offers first-time home buyer loans with low rates, flexible terms, and low closing costs. Additionally, one of our mortgage experts can connect you with special programs to help you buy your first home.
Click on the following link to learn more about our first-time home buyer loans.
TEG FCU also offers conventional mortgages with great rates and low closing costs. Our loans also have fewer fees than other lenders. We don’t charge application, origination, processing, or underwriting fees.
Click on the following link to visit our Mortgage Center to learn more about our home financing options.