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Mar 10, 2021 | By Adebayo Adeagbo
FHA Loan or Conventional Loan?

FHA Loan or Conventional Loan?

Are you a first time homebuyer wondering what type of home loan is right for you? 

There are so many different options but how do you know which loan to choose? 

In this post we will be talking about the differences between an FHA loan and a conventional loan. By the end of this post you'll have clarity on which loan fits your needs.

Please note that every mortgage company has different guidelines. The requirements mentioned in this article is what we at Coole Home offer.

What is an FHA home loan?

An FHA loan is a government loan that offers a low down payment (3.5%), low credit requirements (620), and is perfect for first-time homebuyers.

FHA loan program is only available for primary residences. If you are looking to purchase a home for investment purposes, then a Conventional loan is a better option.

What is a Conventional Loan?

A conventional home loan is considered a traditional mortgage and has stricter qualifying requirements. This loan is not offered by the government.

A conventional loan is perfect for those who have a larger down payment (for example, 20% down). The lowest down payment available is 3%.

The conventional loan program is not for those who have credit blemishes or a high debt to income ratio.

What are the down payment differences?

FHA loans require a minimum down payment of 3.5%. In some cases, if the credit score is below a certain threshold (580), a 10% down payment may be required. However due to Covid - we are currently not offering loans to individuals with less than a 620 credit score.

Conventional loans usually require a 20% down payment. Recently, lower down payment requirements have come available. There is a 3% down, 5% down the and even a 10% down conventional loan.

Differences in Loan-to-Value Ratio

FHA loans offer higher loan-to-value ratios than conventional mortgage loans. Why? FHA is part of HUD, the U.S. Department of Housing and Urban Development (it's a government program). Since 1934, FHA loans have been successfully turning home renters into home buyers.

With FHA loans, the mission is to help more Americans become homeowners; hence, they offer a higher loan-to-value ratio of 96.5%.

The lowest loan-to-value ratio for a conventional loan is 96%, this program does have an income limitation, whereas the FHA loan doesn't have any.

Funding Fee

One of the major differences between an FHA and Conventional home loan is the funding fee requirement.

Conventional doesn't have a funding fee requirement, but the FHA loan does. FHA requires a funding fee of 1.75% that is added to the loan amount. This fee is required on all FHA loans and cannot be waived.

The funding fee is rolled into the loan amount, so you don't have to pay for it at closing. You can also pay for it in cash at closing, but so far, a majority of our clients roll it in.

Differences in Loan Insurance

In the case of conventional loans, if you put down less than 20% payment, then you will have to pay private mortgage insurance (PMI). And once your loan-to-value ratio reaches below 78%, your PMI payment will be removed from your monthly mortgage payment. If you make a 20% down payment, you'll never have to pay PMI.

It's like a lender is charging for taking a chance with a lower down payment borrower.

When you take out an FHA loan, you'll pay a fixed PMI of .85% of the loan amount. FHA PMI remains on loan for life. The only way to remove the PMI on an FHA loan is by refinancing into another loan program.

Differences in interest rates

Since the FHA loan is considered a government loan, the interest rate is typically lower than a conventional loan; sometimes by a full percentage depending on your credit score and debt to income ratio and also the type of property you are purchasing.

What's the difference: debt to income ratio

Conventional loans are much stricter in regards to the debt to income ratio. Typically it is a max of 41% unless you have a very good credit score.

FHA loans are a bit more lenient and can go up to 49%. The higher ratio is accessible to those who have good credit scores. For those who have lower credit scores, the max is typically 41%.

Getting Approved. Which one is easier?

FHA loans are easier to get approved for as compared to conventional loans due to their low down payment requirements and credit requirements. FHA loans even show leniency in cases of bankruptcy in the past, a foreclosure, or in cases where your credit score is at the bottom part of the range.

Bankruptcy differences

FHA requires a two year waiting period for a Chapter 7 bankruptcy and a total of 12 months for a Chapter 13 bankruptcy.

Conventional requires a four year waiting period for a Chapter 7 and a total of 4 years for a Chapter 13.

Bankruptcy is never a good thing, but it doesn't necessarily disqualify you from getting a home loan in the future.

More info: Bankruptcy guidelines

Credit score requirements

FHA loans can go as low as a 560 credit score under certain conditions.

FHA will even approve your mortgage with a 0 credit score under certain conditions.

Conventional loans require a minimum of a 620 credit score, and there are no exceptions.

Differences when refinancing

Those of you who are not familiar with refinancing, there are two types. First is refinancing just to lower the interest rate or term, and the second is when you want to take cash out to make home improvements, invest, or pay a bill.

When refinancing with a conventional loan, an appraisal and income verification is required for a cash-out loan, or even a rate and term refinance.

However, FHA loans are somewhat more convenient and HASSLE-FREE than conventional loans. They offer a more efficient process for borrowers.

With FHA's Streamline Refinance process, which is a home loan for the purpose of lowering the interest rate or term, borrowers face a minimum amount of stress, with less paperwork to fill out, no income verification as in the case of refinancing with conventional loans and no appraisal required. It is a quick and easy process with FHA.

With an FHA cash-out, income verification is required, and an appraisal is required {similar to the conventional loan process}

Conventional loans offer options for jumbo loans and vacation homes, neither of which are the possibilities with FHA loans.

Is FHA better or Conventional?

It's difficult to say which is among the two loans is a better option; however, it all comes down to your financial situation.

Which type of loan are you able to afford? What flexibility options are you looking for? Lastly, it's not just about specific features; balancing the overall cost of buying a house, including the monthly mortgage payment and the maintenance cost of owning a home, are also a few factors to be taken into consideration.

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