Chances are that if you are reading this, you’ve either come far enough in the process of buying a home or are getting serious enough to do the research that’s needed. After all, Mortgage isn’t something one has to deal with very frequently. For some, it’s a once in a lifetime kind of an event. Since it’s perhaps the biggest purchase most ever do, due diligence is of utmost importance.
Once you get into the home buying process and get to the step of finding the right mortgage, you hear of so many new related terms and options. These are likely to overwhelm you since this is stuff you’ve never had to encounter in the past. Amongst the so many different questions that people ask us, the one that is a fairly common one is: “What is the difference between a Conventional Mortgage and an FHA mortgage? And which is better for me”? Here, we try to take a deeper dive and help you answer that question.
How does a mortgage work?
Getting almost any type of mortgage in the US entails making a down payment (the fraction of the home price that the buyer pays) and borrowing the rest from a bank or a lender. The bank charges you a rate of interest on that amount that you borrow, for the term of the loan. The goal that every borrower has is to get as low a rate as possible. How good a rate one gets is dependent heavily on one major factor: the Median Tri-Merge credit score”. It is basically a score that tells the lender how diligent you have been about making payments on loans you’ve taken on in the past. The better your history of making those payments is, the more reliable you are in paying back a loan and the lower the rate you can get.
So let’s first look at what a Conventional Mortgage is.
The word ‘Conventional’ generally means something that’s more ‘common’ or ‘typical’, something that a majority of the people do. Now almost two-thirds of the borrowers in the US have a FICO credit score that is higher than 620. When you belong to that group (or thereabouts), you are amongst the majority and can get what is called a ‘Conventional Loan’. You get favorable rates because you are more likely to pay back the lender the amount you owe than those that have lower scores.
And what is an FHA Mortgage?
Everyone dreams of owning a home. To help people with lower scores own homes, the US Department of Housing and Urban Development (HUD) runs a program called the FHA Loan program. The way this program works is that within the HUD, there is an agency called the Federal Housing Administration (FHA) that primarily deals with residential lending for primary residences. (Read more about the HUD and FHA here). The main role of this agency is to insure residential loans made under the program so the FHA-approved lenders feel more comfortable making loans to lower quality borrowers.
Does a Conventional Mortgage not require insurance?
The short answer is: It does, but only in certain situations. Typically, if you make a down-payment of 20% or more, you are not required to buy any insurance on the loan. That saves you on the insurance premium that FHA borrowers have to pay. You get that luxury only if you are a high-quality borrower (with scores above 620, with little to no history of defaults and/or bankruptcies) and make a large enough down-payment to reduce the lender’s risk. Sometimes though, even people with good credit scores (above 620), do not have enough money to make a 20% down-payment. They can still get a Conventional loan but lenders then typically require the borrower to buy private insurance to reduce their risk.
Why not just get an FHA Loan when your situation requires insurance even on a Conventional Loan?
The obvious question people ask is: “If I am in a situation where I have to buy insurance even with a Conventional Loan, why not just get an FHA Loan? Is there any advantage of one over the other?”. That’s a very good question. The answer is: If the cost (i.e. interest rate + insurance premium) of getting both loans is essentially the same, Conventional turns out to be a better choice. And the reason is three-fold:
- The insurance on a Conventional Loan can be canceled once the outstanding loan amount goes lower than 80% of the original home price. In an FHA Loan, on the other hand, the insurance is to be paid through the life of the loan (unless of course the borrower refinances using a new loan).
- Conventional Loan does not have any upfront insurance cost where an FHA loan does. That further makes a Conventional Loan more attractive if the ‘running’ cost is the same for both.
- FHA has lower limits on how much one can borrow depending on the county the home is located in. So you can borrow larger amounts than FHA loans would allow.
Should I ever get an FHA loan even though I am eligible for a Conventional loan?
The answer again is: Yes, in some situations. For many borrowers, the interest rate on an FHA loan is lower than that on a Conventional Loan, sometimes half a percent lower, or even more. The only reason people may not still go for an FHA loan and instead get a conventional loan is because they’ll save more with the latter by not having to pay for insurance at all (or pay less overall).
So if you run into a situation where the cost of an FHA Loan (i.e. interest rate + insurance premium) is lower than that of a Conventional loan, it is not a bad idea to choose the FHA option. Of course, the loan amount has to be lower than the FHA limit. The one worry home buyers have is that if they get the FHA loan, they cannot cancel the mortgage insurance and it’s due for the life of the loan. In such a case, you have the choice to refinance later when conventional starts to become more favorable. There are closing costs for the re-finance that you still have to take into account, but something to think about if you are saving enough upfront.
That was a lot of information. Let’s summarize and give you some rules of thumb.
– If the loan amount is higher than the FHA limit for the county in which the home is located, conventional is your only real option.
– If the loan amount is below the FHA limit, look at which of the two is costing you less. By that, I mean look at the one where the monthly payment, including both the interest and the insurance premium, is lower. In most cases, lower is better.
– However, you have to take into account the upfront premium that FHA loans cost you and the fact that you might incur refinancing cost with an FHA Loan if later, when your credit improves, a Conventional Loan becomes cheaper and you decide to refinance.
– In the end, the best way to ascertain which one’s better is by talking to one of our trusted loan advisors at StemLending.com. We can not only advise you based on your specific situation, but also walk you through our Loan Comparison Suite that can clearly illustrate whether an FHA (or a Conventional) Mortgage is a more suitable option for you.