Should you buy with Conventional or FHA? Here’s your answer!
Last time I checked, purchasing a home wasn’t as easy as going to the store, saying “…this one,” forking over some cash out of your wallet, and then walking to the car with your new home in your shopping cart. Purchasing a home requires a careful understanding of your financial health – whether that’s purchasing a home for your family, or purchasing your next investment property. Many of you have heard of Conventional and FHA mortgages, so which one suits your needs and your budget?!
If you can qualify, going with a conventional loan will help you save thousands over the life of the loan. It will help keep your monthly mortgage payments down and make the home buying process a lot smoother. This is your standard type of loan available to you by all mortgage companies and lending institutions. They are loans that are not insured by any government agency such as FHA or VA (Federal Housing Administration and Veterans Affair). This type of loan is more suited for traditional buyers.
Usually require a higher down payment
Conventional loan minimum down payments can go as low as 5% which is higher than the FHA’s infamous 3.5% down payment. Don’t be surprised if your lender requires 10, 15, or 20% as a down payment when going after a conventional loan. This is one factor that helps make your mortgage payments cheaper. The higher the down payment, the lower the monthly mortgage.
Dealing with PMI. What is it?
Private mortgage insurance is exactly what it sounds like: mortgage insurance. It is the “in case you default” fee the lenders charge when you put down less than 20%. If you put down only 10% and now you’re paying PMI on your monthly mortgage, the good thing is, once your equity in the home has reached 20%, you’ll be able to request that your PMI be removed from your mortgage. Equity is how much of the home you own as you pay down debt with your monthly payments. For example, if you purchased a home with 10% down, technically you have 10% equity within the home – your Loan-to-value (LTV) ratio is now at 90%. If your equity in the home reaches 22%, by law, the PMI will be removed. This is also another factor which helps you save thousands in the long run. Here’s how PMI is calculated for a conventional loan:
Amount of Loan: $200,000
Insurance Rate (Lender rates vary) 0.51% (FHA can go up to .85%+)
Annual Insurance Premium $1,020
Monthly PMI $85
Conventional offers incentives and loan options
Because conventional loans are not government backed, lenders are able to offer more incentives to help buyers such as allowing them to pull money from other investments such as stocks or a retirement account which they would otherwise not qualify. They can also get financing on 2nd and 3rd homes and investment properties. With FHA, you are required to be an owner occupant of the home you purchased with an FHA loan. Also, you will only be able to use this loan for one property at a time; you won’t be able to have multiple homes under multiple FHA loans.
Less stringent on property conditions
Before your lender will commit to providing you with the funds needed to purchase your new home, they will send out an appraiser who will give the official value of the home to make sure the bank is not lending you more than what the home is currently worth. During this inspection, the appraiser may require a few repairs to be made in order to adhere to the guidelines set forth by the lending organization. Conventional loans are less demanding when it comes to the repairs that are needed while FHA loans are a lot more strict with the conditions of the homes they lend on. Chipped paint, cracks in walls, and rotted wood can all raise a red flag for FHA loans. Conventional loans could care less.
Easier to purchase a condo with a conventional loan
All condos can be purchased with a conventional loan, but all condos cannot be purchased with a FHA loan. FHA require condo associations to be “FHA Approved” and unfortunately the list of FHA approved condos is relatively short in NJ. If you’re searching for a condo with a FHA loan, be sure to check to see if the condo association you’re interested in is FHA approved.
The Upside to FHA Loans
A FHA loan is better suited for non-traditional buyers who may not have as much cash handy as a conventional buyer. Insured by the Federal Housing Administration, this type of loan offers a low down payment option, more money for closing costs, lower credit scores, and easier qualification with co-signers.
3.5% Down Payment
This is what the FHA loan is famous for, a very low down payment. This means you could purchase a $200,000 home with only $7,000 down. Compared to $10,000 if you were to use a conventional loan’s low down payment option of 5% (that’s even if your lender allows that low of a down payment). The spread doesn’t seem that large until you look at a $500,000 home. FHA will allow a minimum down payment of $17,500 while conventional would require $25,000. This helps if you don’t have a ton of liquid cash in the bank to serve as a down payment.
Less Cash Needed for Closing Costs.
The purchase of a home really takes a hit on your wallet in two instances: Down Payment and Closing Costs. Closing costs are estimated between 3-5% of the purchase price so for the same $200,000 loan, closing cost can be around $6,000-$10,000. Closing costs include attorney fees, mortgage fees, prepaid taxes /utilities, and upfront PMI to name a few items. It is common for buyers to ask for a “Seller’s Concession” which will allow you to roll the amount of closing costs into the overall balance of the mortgage. You are essentially asking the seller to credit you a predetermined amount to help you pay for closing costs. For example, say you would like to purchase a home the seller has listed for $200,000 and your mortgage officer is estimating about $7,000 in closing costs. You would write an offer for a purchase price of $207,000. While the seller sees an offer $207,000, in the contract provisions you will be asking them to credit $7,000 towards closing costs, thus giving a net purchase price of $200,000 to the seller – exactly what they were asking for. FHA allows up to 6% of the purchase price to attribute towards closing costs while conventional loans put the cap at 3% unless you put a minimum of 10% of the purchase price as a down payment. What does this mean? With FHA, on a $200,000 home, you could get up to $12,000 in closing costs rolled into the amount of your mortgage, but with a conventional loan you can only get $6,000 – unless you had put down $20,000. For both types of loans, the state places a ceiling of 6% when asking for a seller’s concession.
Although FHA offers a low down payment incentive, FHA in some cases, require PMI charges even after you have obtained the 22% equity mark. A Conventional mortgage’s PMI will cease as soon as you hit the 22% equity milestone. Also, FHA’s PMI is more expensive in both the short and long term life of your mortgage. You will have to pay an upfront PMI fee which could equate to 2.25% of the total value of the purchase price which will be added to your total mortgage amount. On a $200,000 loan, upfront PMI will add an extra $4,500 to your loan balance. With a conventional loan, you don’t have to worry about an upfront PMI charge, just the monthly PMI charge. There’s some confusion about how PMI works for a FHA mortgage so I’ll explain. If your initial Loan-to-Value (LTV) percentage is 10% or LESS, than you will be expected to pay PMI on a FHA mortgage for as long as the loan is active. That means if you were to put down anything less than 10%, you will be paying PMI as long as the loan is active. If you put down MORE than 10%, than you will only be expected to pay for PMI for an 11 year period (even if you have more than 22% equity) and then you will no longer have to pay for PMI. The only way to get rid of PMI at any time, is to refinance your existing FHA loan with a Conventional Loan. Be advised that in most cases you will be required to have at least 20% in equity before becoming eligible to refinance.
Credit Score Requirements
For FHA loans, the minimum credit score is 580 which is 40 points lower than its counterpart, the conventional mortgage, which sets the minimum at 620.
The Use of a Co-Signer could boost your Buying Power
Both Conventional and FHA loans authorize the use of a cosigner to help boost purchasing power. Conventional loans, however, still require the OCCUPYING buyer’s debt-to-income ratio (DTI) to be sufficient enough. A universally respected maximum DTI ratio is 43% meaning your monthly liabilities cannot exceed more than 43% of your gross income. So if you earn $120,000 gross ($10,000 monthly gross), your monthly liabilities cannot be more than $4,300 a month.
($4,300 monthly expenses / $10,000 gross monthly income) = 43% DTI.
When calculating, be sure you use hard monthly expenses that you are guaranteed to pay each month. For example, expenses that are tied to your credit report (cell phone, student loans, credit cards, current rent, etc.) This is not including gas, food, tolls, etc, although you probably pay for these often on a monthly basis. While including those types of expenses can give you an overall picture of your financial health, it does not affect your DTI ratio when applying for a mortgage.
FHA looks at the total DTI of ALL borrowers combined instead of just the occupying borrowers like conventional loan requirements.
And there you have it folks! This serves as an in depth guide of the various incentives and drawbacks both loan types offer. This will help give you an idea of which type of loan will best serve your financial health and budget. While both loans are totally different in the way they operate, they both serve the same purpose, to help you purchase your next home!