One of the first decisions that first-time home buyers make when purchasing a home is whether to secure a conventional loan or an FHA loan guaranteed by the Federal Housing Administration. Down payment funds, credit history, interest rates and fees all play important roles in making this decision. And although many borrowers may wind up preferring the terms of a conventional loan, some may find securing an FHA loan to be much easier.
The Down Payment
Borrowers who put less than 20 percent down often prefer the terms of an FHA-backed loan. The FHA only requires a down payment of 3.5 percent of the purchase price, and the home buyer can use gift funds from an individual or an organization for this purpose. Since conventional mortgages are not government-backed, terms favor buyers with bigger down payments — in many cases, 20 percent or more. And usually, all or most of the down payment must come from the home buyer — not from another individual or organization.
Private Mortgage Insurance (PMI)
Both conventional and FHA loan lenders require buyers who put down less than 20 percent to pay a mortgage insurance premium. Buyers who secure FHA loans pay 1.75 percent of the loan amount at the closing. In addition, these buyers pay a 0.85 percent annually — even after the buyer’s equity exceeds 20 percent of the home’s value. Although conventional borrowers also pay PMI, lenders eliminate the annual premium once the buyer’s equity exceeds 20 percent — a significant advantage. The FHA borrower may elect to refinance to a new conventional loan once he reaches the equity target — which may eliminate the PMI payment and result in a lower interest rate.
According to Bankrate.com, FHA loan interest rates are typically higher than rates for a conventional loan. Buyers who secure FHA loans pay a higher rate in exchange for the privilege of having the federal government guarantee repayment — a significant benefit to which any FHA-sponsored homeowner who was underwater but refinanced anyway following the housing crisis can attest. Nevertheless, many buyers accept this risk in exchange for paying a lower rate over the life of the loan. It’s worth noting that if your credit is anything less than excellent, you’ll probably pay a higher interest rate anyway.
Buyers who have less-than-perfect credit also find FHA loans appealing, simply because the lending standards aren’t as strict as those of conventional loans. Private lenders cherry-pick deals because they risk their own capital — and if the borrower defaults, the resulting foreclosure often results in a steep loss for the lender. In addition to credit, lenders — both FHA and conventional — consider employment history, income and savings when reviewing loan applications. If you’re deciding between both loans, review your credit history and analyze your finances through the eyes of a lender. The more risk you present, the higher your loan costs will be.
So What’s the right choice?
Making a decision whether to consider conventional or FHA financing is tied to the borrowers current situation, and there is no right or wrong answer. A borrower who does not qualify for conventional financing can be the perfect candidate for an FHA loan. But, It is always best to consult a mortgage professional for advise because they are more in tune with the banks lending practices and requirements.