November 15th, 2013 1:19 PM by Gregg Mower
Should I get a FHA Loan or a Conventional Loan? This question is asked every day in our business. FHA loans are traditionally used when a home buyer has a low down payment and Conventional Loans are used for those who have large down payments. We will explore some of the reasoning your loan officer will direct you to one loan or the other. Both loans are the most widely used loan types in the Mortgage Industry today.
First, FHA Loans have a lower down payment requirement than Conventional Loans, however, we are talking about the difference between FHA with a 3.5% down payment requirement and a Conventional Loan with a 5% down payment requirement. Conventional loans used to have a 3% down program for years, however, as of December of 2013 they will no longer be offered at 3%, 5% will be the minimum down payment requirement for Conventional Loans. With FHA the 3.5% can all come from a gift, employer or government program, whereas, Conventional Loans require that all of the 5% be from the borrowers savings. This is significant for those home buyers that have the income to afford a home but may need assistance with the down payment. Conventional Loans will allow for gifts, but unless the gift ids for more than 20% of the sales price 5% must be from the primary borrowers own funds.
Another major difference that needs to be addressed is the fact that while both Loans will require Mortgage Insurance with a minimum down payment the FHA Mortgage Insurance is higher than that of Conventional loans. The Mortgage Insurance is always two fold with FHA loans which means that you will be required to have up-front mortgage insurance of 1.75% of the loan amount, generally added to the base loan amount, and you will have a monthly payment of 1.35% of the loan amount as well. With Conventional Loans you can pick the way you would like to pay for the Mortgage insurance, either up-front, monthly, or a combination of up-front and monthly. The rates for mortgage insurance for Conventional Loans will vary based on the Loan-to-Value (LTV) with a 95% LTV loan being at a higher rate than of a 85% LTV, and with Mortgage insurance not required if the LTV is less than 80%. FHA will have the same rates regardless of the LTV even below 80% LTV.
Now that we understand that Mortgage insurance rates are higher on FHA Loans, the next question would be, why use FHA and not always look at the Conventional Loan? There are several reasons for using FHA and not a Conventional Loan. We already talked about the down payment can be a 100% gift for a FHA Loan, but FHA also has some other guidelines that can be a deciding factor for using FHA. Traditionally FHA Loans have a little known clause call “compensating factors”, and these compensating factors will allow for the borrower to qualify with a higher debt to income ratio (DTI), a lower credit score, a spottier income history, and more creative ways to cumulate the cash to close the transaction. Some compensating factors FHA will take into consideration are the stability of income, a higher down payment, a good cash reserve after all down payment and closing costs are paid for, a low DTI, and high credit score. Conventional Loans have tighter guidelines to follow than does FHA.
With regards to refinancing your current home all the same rules apply, you just need to change down payment for equity. When refinancing and determining whether to use FHA or Conventional financing most of the time it will be determined based on the equity you have in the house. Equity is the difference between the appraised value of your home and the amount you owe against it. FHA will allow you, if you have a FHA loan on your home currently, to refinance with no equity or even if you owe more than the value of the home. This type of loan is called a streamline refinance. Conventional Loans currently have a program similar called HARP or Home Affordable Refinance Program but it is very limited in who it can help as the original loan has to have been taken out prior to May 2009 and the loan must be secured by FNMA or FHLMC.
So when deciding on which loan to choose, in most cases, your loan officer will do this for you, but you should be informed of the reasons why they are doing what they are doing. I hope this quick explanation was helpful. At MAE Capital we want our clients informed as to the reason things are being done. We understand sometimes it is hard to ask some questions at the risk of looking ignorant but we know that you are not doing this for a career and are going to have questions. Our staff and Loan Originators are highly trained and are ready to assist you with your Real Estate and Mortgage needs.