Buying a house can be a stressful yet rewarding process. Depending on how long you’ve been saving up for your dream home, it’s likely that you’ll need to take out a loan to make payments towards it. In fact, over 80 percent of home buyers finance their purchase with a mortgage. There are multiple types of mortgage loans that someone can take out to purchase a house. Two options include FHA and conventional loans. Each differ in their individual requirements and characteristics, so it’s important to learn about each of them to determine which is best for you.
What is an FHA Loan?
An FHA loan stands for a Federal Housing Administration loan. The Federal Housing Administration is a government agency that insures mortgages. FHA loans were created just after the Great Depression to subsidize and back mortgages, as home ownership status was difficult to achieve at that time due to a lack of both savings and credit history. Essentially, the FHA has approved lenders that have more reasonable credit score and down payment requirements. These types of mortgages act as a safety net for a lender, as there is less risk for them if the borrower can’t make their payments.
What is a Conventional Loan?
A conventional loan is the opposite of an FHA-backed loan, as they are not insured by a government agency. These are also known as private loans. Often, to obtain a conventional loan, borrowers must have a higher credit score and larger down payment. This is because they are at a higher financial risk if the borrower defaults.
Conventional loans may also be called conforming loans. This comes from the idea that they conform to both Fannie Mae and Freddie Mac mortgage standards. Fannie Mae and Freddie Mac are types of government-sponsored enterprises that buy mortgages from lenders. They then can either hold these mortgages or convert them into mortgage-backed securities.
One of the most prevalent concerns that potential homeowners have when it comes to acquiring a mortgage is their credit score. After all, your credit score tells lenders what a borrower’s capacity of repaying a loan is. The credit score requirements for FHA loans and conventional loans tend to differ. Credit scores range from 350 to above 800, where the former indicates a poor capacity for repayment while the latter indicates an excellent capacity for repayment. In other words, the higher the credit score you have, the less risk you portray to a potential lender.
FHA loans allow potential mortgage holders to have a lower credit score than conventional loans do. Specifically, you can take out an FHA loan with a credit score starting at 500. However, the lower your credit score, the higher the down payment you must put down.
Conventional loans, on the other hand, typically require a higher credit score for approval. The specific credit score requirement differs from lender to lender, but generally a minimum credit score of 620 is needed to qualify for a conventional loan. The higher credit score is required for private loans because the lender has a higher risk compared to FHA loan lenders.
A down payment is a lump sum of money that a borrower must apply towards their home purchase. This number works as a sense of security for the lender since the borrower is paying a portion of the purchase price upfront. The amount of money that someone must apply for a down payment varies vastly depending on the cost of the home in interest, credit score, and the financial institution of the mortgage.
For an FHA loan, down payments are usually lower in cost than conventional loans. However, that is only if your credit score is fair. More specifically, if you have a credit score over 580, you can put down as low as 3.5 percent of the purchase price upfront. If your credit score is between 500 and 579, though, you’ll likely be required to put a higher down payment down of 10 percent of the purchase price.
Down payments for conventional loans also vary depending on which lender you’re working with. Most people fear that they must put down upwards of 20 percent of the purchase price down upfront, but this may not be a requirement. In fact, the percentage varies from 5 to 20 percent depending on your credit score. If you can’t afford to pay the down payment upfront, conventional loan lenders may have you pay PMI, or private mortgage insurance, which is built into your monthly mortgage payments.
Determining the interest rates of mortgages is an interesting science. An interest rate is a percentage of the principal, or the total amount of money loaned, that the lender charges you monthly in order to obtain the loan. There are many factors that play a role in the interest rate that are out of your control. Such factors include the current state of the economy, the demand of the investor, and the Federal Reserve. The Federal Reserve, or the central bank of the United States, is in place to promote the function of the U.S. economy and control financial institutions to alleviate financial crisis. Despite the factors that you can’t control, you can control your credit score, the amount of money that you want to borrow, the total percentage of your down payment, and whether you choose a fixed-rate or adjustable mortgage.
When taking out an FHA loan, you can expect a more competitive interest rate when compared directly to conventional lenders. This is because the federal government is backing your FHA loan which decreases lender risks. The exact percent of your interest rate will depend on the aforementioned factors, but they tend to average at under 5 percent.
Conventional loan holders vary significantly as well. These loans differ from FHA loans in that your loan-to-value ratio, or LTV, is analyzed when calculating interest rates. LTV is the lending risk that lenders have dependent on the amount of the loan you plan to take out compared to the value of the assets of the borrower.
There are limits to the amount of money that one person can borrow from a lender for both FHA and conventional loans. This means that you are not allowed to borrow more money than the limit allows you to.
FHA loan limits are set yearly and depend on your location. For example, more rural counties have a higher limit of about $420,000, yet more high-cost counties have their upper limits set to about $970,000. It’s important to determine the upper loan limit that you are eligible for before searching for a home, as this number can limit the purchase price of your dream home.
Conventional loan limits also vary significantly depending on location and home type. For example, the loan limit for single-unit homes is about $647,000 in 2022. However, this number increases in higher cost areas like the District of Columbia, California, New York, Wyoming, and elsewhere.
Should You Choose an FHA or a Conventional Loan?
There are many factors that should go into your decision to choose a specific loan type. Such factors include your credit score, ability to pay a down payment, and your debt-to-income ratio. For example, an FHA loan might be more beneficial for people who have a lower credit score, less ability to pay large sums on a down payment, and have a higher debt-to-income ratio. On the other hand, conventional loans may be desirable for borrowers with a higher credit score, lower debt-to-income ratio, or who want more flexibility in their repayment terms.
Regardless of which type of loan you choose, be sure to understand all of the implications that your loan has on your lifestyle and your choice of home purchase so that you can make the best decision for yourself and your family.