FHA vs Conventional Financing. Which is better?
When it comes to purchasing a home, one of the most important decisions you'll make is how to finance it. Two popular options are FHA (Federal Housing Administration) loans and conventional financing.
How to qualify
One of the fundamental differences between FHA and conventional loans lies in the qualification criteria.
FHA loans may be better a better choice for first-time homebuyers or those with lower credit scores.
To qualify for an FHA loan, borrowers typically need a credit score of at least 580 and a minimum down payment of 3.5% of the purchase price. Moreover, FHA loans allow borrowers with a credit score between 500 and 579 to still qualify, but with a higher down payment requirement of 10%.
Conventional loans generally require higher credit scores and down payments. While a credit score of 620 or above is typically necessary, borrowers with excellent credit may qualify for competitive interest rates. Additionally, conventional loans generally require a down payment of at least 3% to 5% of the home's purchase price.
Mortgage Insurance Premiums
One of the key distinctions between FHA and conventional loans is the requirement for mortgage insurance. FHA loans mandate the payment of both an Upfront Mortgage Insurance Premium (UFMIP) and an annual Mortgage Insurance Premium (MIP).
The UFMIP is a one-time fee. The MIP, paid monthly, protects the lender in case of default and is required for the entire loan term, even if the borrower's loan-to-value ratio falls below 80%.
Conversely, conventional loans typically require Private Mortgage Insurance (PMI) when the borrower puts down less than 20% of the home's purchase price. PMI protects the lender in the event of default and allows borrowers to access conventional financing with a smaller down payment.
Unlike MIP, PMI can be canceled once the borrower's loan-to-value ratio reaches 78% or less, based on the original property value. This is an important distinction because the monthly payments may be reduced once the insurance premium drops off.
Loan Limits
In 2023, there are limits to how much money you can borrow when getting a mortgage. These limits, called conforming loan limits, are set by the Federal Housing Finance Agency (FHFA) and apply to loans that meet the standards of Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac buy mortgages from lenders and package them into securities for investors. To ensure liquidity for lenders and affordable loans for borrowers, these government-sponsored enterprises have specific criteria for the loans they purchase, including credit scores, down payments, and debt-to-income ratios. One important criterion is the loan limits.
The baseline conforming loan limit for 2023 is $726,200, an increase from $647,200 in 2022. However, in Alaska and Hawaii, where home prices are higher, the limit is $1,089,300 for a 1-unit property.
If you want to borrow more than the conforming loan limit in your county, you'll need a jumbo loan. These loans have higher limits but are typically more difficult to qualify for, requiring higher credit scores and larger down payments.
Conforming loan limits are adjusted annually based on the FHFA House Price Index (HPI) report, which tracks changes in home values. The new limits are calculated using third-quarter data from the FHFA HPI. In 2023, there is an expected increase of about 12.21%.
Conforming loans generally have lower interest rates than non-conforming loans, making them favorable for borrowers. If you're buying a home with a price that exceeds the conforming loan limit for your area, increasing your down payment can help you stay within the limit and enjoy the benefits of a conforming loan without needing a jumbo loan.
Since home prices vary across states and counties, the FHFA designates certain areas as "high-cost" and allows higher conforming loan limits in those areas. The exact limit depends on the median home value in the area, up to 150% of the baseline conforming loan limit. You can check the FHFA's interactive map to see the current limit in your county.
For example, if you're considering buying an $800,000 house in California, the loan limit would be different depending on the county. In San Bernardino County, which is not a high-cost area, you would likely need a jumbo loan since the baseline limit is exceeded. However, in Los Angeles County, a high-cost area, you may be able to buy the house within the conforming loan limit without requiring a jumbo loan.
In Alaska and Hawaii, the highest conforming loan limit for a given number of units is also the loan limit for those states.
HUD has an online search tool to help you find FHA loan limits. You can search by county or state.
Credit Score Considerations
The credit score requirements for FHA and conventional loans differ in terms of the minimum credit score needed for eligibility:
FHA Loans:
FHA loans are insured by the Federal Housing Administration and are designed to help individuals with lower credit scores or limited credit histories become homeowners. The minimum credit score requirement for an FHA loan typically ranges from 500 to 580, depending on the lender. However, having a higher credit score can improve your chances of loan approval and may allow for more favorable terms, such as a lower down payment requirement.
Conventional Loans:
Conventional loans are not backed by any government agency and are offered by private lenders. These loans generally have stricter credit score requirements compared to FHA loans. To qualify for a conventional loan, lenders typically prefer a credit score of 620 or higher. However, to secure more competitive interest rates and terms, a credit score of 700 or above is often desirable.
It's important to note that credit scores are just one factor that lenders consider when evaluating loan applications. Other factors, such as income, employment history, debt-to-income ratio, and down payment amount, also play a significant role in determining loan eligibility and interest rates for both FHA and conventional loans.
Offer considerations
The type of financing may play a role in getting your offer accepted by a seller Some sellers may have concerns or preferences regarding FHA offers on their property for several reasons:
Stringent Appraisal Requirements: FHA loans have specific appraisal requirements that aim to ensure the property meets certain standards for health, safety, and structural integrity. If the property fails to meet these requirements, the seller may be required to make repairs or address issues before the loan can be approved. Sellers might be worried about the potential costs or delays associated with these requirements.
Strict Property Condition Guidelines: FHA loans have guidelines regarding the condition of the property, and sellers may worry that their property won't meet those standards. This could include issues such as peeling paint, damaged roofs, or other issues that need to be addressed before the loan can be approved.
Longer Closing Time: FHA loans may take longer to close compared to conventional loans. The loan process involves additional inspections and paperwork, which can result in delays. Sellers who need to sell quickly may prefer offers with shorter closing times to expedite the transaction.
Limited Negotiation Flexibility: FHA loans have certain restrictions on seller concessions, which are concessions made by the seller to help cover the buyer's closing costs or other expenses. The limitations on these concessions may impact the seller's ability to negotiate and potentially reduce their net proceeds from the sale.
Perception of Buyer Financial Stability: There is a misconception among some sellers that FHA loans are more likely to be associated with buyers who have weaker financial profiles or lower credit scores. Sellers may prefer offers from buyers with conventional financing, as they perceive them to be more financially stable and less likely to encounter loan approval issues.
It's important to note that not all sellers have these concerns, and some may be open to FHA offers. Every seller's situation and preferences can vary, so it's crucial to communicate with the seller or their real estate agent to understand their specific reasons for favoring or disfavoring FHA offers on their property.
Modification options
An often overlooked advantage of FHA loans is the option for a 40-year modification if the buyer faces financial hardship.
FHA mortgage modification refers to a program offered by the Federal Housing Administration (FHA) to assist homeowners who are facing financial difficulties and are at risk of defaulting on their FHA-insured mortgage loans. This program aims to provide struggling borrowers with a viable solution to make their mortgage payments more affordable and avoid foreclosure.
Under the FHA mortgage modification program, eligible borrowers may have their loan terms adjusted in various ways to achieve a more sustainable payment plan. The FHA has instituted a new policy allowing financially strapped borrowers to have the term of their mortgage lengthened to 40 years, thereby reducing the monthly payments. The previous term limit for a loan modification was 30 years (360 months).
Conclusion
FHA and conventional financing are the most popular among homebuyers, but there are many more available. Before deciding on a product, buyers should talk with several mortgage professionals to find out what options are available and what product fits their specific needs.
Keep in mind that the cheapest rate does not always equal the best product. Some loans have higher upfront fees with a low rate and other products could have zero fees but a higher rate. Again, sitting down with multiple mortgage professionals who can calculate the true cost of the loan can be a big advantage.
