Federal Housing Administration loans and conventional loans remain the most popular financing types for today’s mortgage borrowers. But which program makes the most financial sense for you? Here’s how to decide.
The Nuts & Bolts of FHA Loans
FHA loans are insured by the Federal Housing Administration. The program contains two forms of mortgage insurance; an upfront mortgage insurance premium calculated at 1.75% of the loan amount, and a monthly premium based on 0.8% of the loan amount. These forms of mortgage insurance make the FHA loan pricey, however the program is very flexible:
- New mortgage post-short sale or foreclosure is a three-year wait time
- New mortgage post Chapter 7 bankruptcy is a three-year wait time
- Payment-to-income ratios can be as high as 55%
- Co-signers are permitted
- Borrowers can finance up to 97% loan-to-value paying off a first and a second loan under rate and term avoiding “cash out” (a lender term that refers to the structure of a mortgage where you’re receiving funds to pay off debt beyond what you owe. It is usually subject to more restrictive guidelines, but that’s not the case with FHA loans.)
- Very attractive interest rates as low as 3.25% on a 30-year fixed rate mortgage
When FHA Makes Sense
The FHA program makes sense when you have little equity to work with or a unique financial situation. You’ll need at least a 3.5% down payment to purchase a home using an FHA Loan. The program will go as high as the maximum county loan limit in the area in which you are looking. For example in Sonoma County, California for a single-family home that means a loan size all the way to $554,300. If your credit score is anything under 680, an FHA loan generally is optimal.
The Nuts & Bolts of Conventional Loans
Conventional loans are loans bought and sold by Fannie Mae and Freddie Mac, and represent the lion’s share of the mortgage market. These loans, while the most popular, also contain tighter qualifying guidelines than FHA:
- No mortgage insurance with just 10% down
- The wait for a new mortgage post-foreclosure is seven years; there’s a four-year wait post short-sale; and four-year wait post Chapter 7 bankruptcy
- Offers the lowest possible payments
When a Conventional Loan Makes Sense
If you have a credit score over 680 and a 5% down payment, you have the bare minimum required to explore working with a conventional loan. Conventional loans also are stricter on employment history, requiring two years in the same field, as well as payment-to-income ratio, which is a max of 45%.
Which Loan Program Is Most Suitable for Me?
- Your credit score is 680 or higher
- You have a big down payment
- If you have a big down payment and a so-so credit score under 680, then conventional could be a good vehicle, but your interest rate will be higher due to credit score.
- Your credit score is below 680
- Divorced? Have a previous derogatory credit event such as a foreclosure? Then FHA would be the route to take.
- Small down payment but great credit score? The FHA primarily would be your vehicle, although a 5% conventional loan would be a solid choice as well.
The key is to understand the characteristics of both programs and how they relate to your financial picture. Right out of the gate you might be a good candidate for either program. Selecting the right loan is a function of choosing the one that is best in alignment with your payment and cash flow expectations.
Remember, if you’re considering applying for a mortgage, it helps to know not only how much house you can afford, but also where your credit stands before you begin the process. That’s because your credit scores help determine what types of rates and terms you may qualify for. You can get two free credit scores, updated every 14 days, on Credit.com.