Let’s go over the differences between FHA and conventional loans to determine which one is right for you. Whether you’re buying your first home or second home, or perhaps, you’re doing a refinancing and are trying to figure out what kind of loan fits your needs best, read along, as we’ll be touching on the essential things you need to know about FHA and conventional loans.
Differences Between FHA and Conventional Loans
There are quite a few differences between FHA and conventional loans. It’s best to be aware of these differences as they will guide you into choosing which one is right for you.
Down Payment Amount
The first thing to consider when purchasing a new house is the down payment amount. When it comes to a conventional loan, there’s a myth that you have to come in with 20%, which is not true.
If you’re a first-time homebuyer, you can come in with as little as 3% down with most banks for a conventional loan. However, if you’re buying your second house or upgrading, you will have to come in with a little more, something as little as 5% down. Bear in mind that you will pay the closing costs, both on FHA and conventional loans.
For an FHA loan, you have to come in with 3.5% down, whether it’s your first house or not.
If you’re a first-time homebuyer and are more concerned about how much you have to come in with for the down payment, especially if you’re looking to come in with as little as possible, I would consider the conventional loan the better deal for you, as you get to save half a percent. However, we’ll talk more about this when we get to the closing and the other different costs associated.
It’s essential to have the correct information regarding your mortgage processes. There are so many dishonest and misleading loan brokers who are simply out to price gouge. As the third or fourth lender that people talk to, I see some scheming deals like hidden fees in their loan estimates or terms that do not make sense. Knowing the correct information helps you to get a great rate.
The second thing that marks a difference between FHA and conventional loans is mortgage insurance. Mortgage Insurance (MI) is sometimes called Private Mortgage Insurance (PMI).
The mortgage insurance amount is a percentage of the loan, and it’s the same for everybody based on the loan amount.
On an FHA loan, your mortgage insurance is fixed. It does not matter your credit score or how much you’re coming in with for the down payment.
On a conventional loan, your mortgage insurance depends on your credit score and how much you’re coming in with for the down payment.
So if you’re not going to put down the minimum, perhaps you do not have the complete 20%, and you want to come in with 10% down, that 10% down will get you a smaller mortgage insurance payment than the FHA will every time unless you have a horrible credit score. But even then, if you’re coming in with 10%, it’s usually going to beat out the mortgage insurance payment.
What is Mortgage Insurance?
Let’s quickly go over what mortgage insurance is if you’ve never heard of it.
When you come in with 20% down on a house, you own 20% of the house. So in the case of defaulting on the loan, whether you can’t pay your mortgage anymore or you wake up one day and decide not to pay your mortgage, the bank will foreclose on you.
They will liquidate the house and foreclose on the property to get the loan of their books. To do this, they will sell it as fast as possible, at a low price. There’s no staging or cleaning involved. They are just selling the house fast and cheaply to get the loan off.
If you own 20% of the house, let’s draw an example using specific numbers. Let’s say you owe $400,000 against a $500,000 house. The house is worth $500,000, and you came in with 20%. So your loan is for $400,000. If the bank forecloses on you and has to sell the house, they have $100,000 of wiggle room. Hence, they can sell the house at worse case breaking and still be able to pay the realtors or any attorney’s fees if they need to. So usually, the bank still makes a little bit of profit. Now, this is precisely why you do not require mortgage insurance. If you’re coming in with 20%, there’s enough wiggle room for the bank to make themselves whole.
If you come in with 3% or 3.5% on an FHA and you default on the loan, they’re done as soon as they’re paying the realtor commissions. They’re losing money. So the reason you have mortgage insurance, if you’re coming in with less than 20%, is because in the event of a default and they have to liquidate the property, they need an insurance policy there to cover the spread between what they can sell it for and how much you owe on the loan.
Can I get rid of my mortgage insurance eventually?
Let’s discuss the next point, can you get rid of your mortgage insurance eventually? Yes, you can. Both FHA and conventional loans allow you to remove your mortgage insurance payment, which can be a significant amount of your monthly payment on an FHA loan. It could be several hundred dollars on a conventional loan as well.
It can be a lot lower on the conventional side. Depending on the numbers, it can be as low as 50 bucks or even $40. However, it’s usually a pretty sizable amount on an FHA loan every month.
This is where the differences start to become apparent on a conventional loan. You’re allowed to remove that mortgage insurance payment from your loan without having to even refinance it as soon as you own 80%. So there are two or three common ways people can get to that 80% threshold.
One of the most common lately in the market is when your house appreciates. So let’s say you bought your house right before COVID hit, and thanks to some real estate kind of Bonanza, your house suddenly was worth $150,000 more in three months than when you initially paid for it. Guess what? You might own 80% of the house’s worth now.
So I had a client who bought a house for around $700,000. Four months later, it was worth $850,000. They came in on a conventional loan, and they had mortgage insurance. So in less than a year, they were able to get rid of that mortgage insurance payment because the market shot up and it benefited them.
Bear in mind that there’s no time limit. As soon as your equity is worth 20% of the house on a conventional loan, you can request that the lender appraise the property and remove that mortgage insurance payment. This is only on a conventional; it doesn’t work the same way on an FHA.
For FHA loans, even when the property’s worth a certain amount, you still have to pay mortgage insurance for about nine or ten years. The only way to get rid of it is to either refinance the property, you can pay off the loan and refinance it into a conventional (not another FHA loan). If you refinance to another FHA loan, you will have a new mortgage insurance payment. So, if you are not willing to wait ten years on an FHA, and you want to get rid of the mortgage insurance on an FHA, refinance it into a conventional loan, pay the property off in full, or sell it.
Mortgage Insurance Amount
This is another vital thing to keep in mind. The amount of the mortgage insurance is going to be higher on the FHA loan. It depends on your FICO score and how much you’re coming down with on a conventional loan. But apples to apples, your mortgage insurance will usually be much on an FHA.
The one time you see it not being more is if you are coming in with just 3% on the conventional and your credit score is lower.
So for either loan in the market, currently, you’re going to need a minimum of about 620 credit score.
If you’re on a conventional loan and your credit score is around 620-640-660, you will have a bit of a hit on your mortgage insurance payment. On an FHA, whether you have 620 or 800, it will be the same high mortgage insurance. There’s not much you can do about it. It’s expensive and you’re stuck with it for ten years.
Benefits of FHA vs Conventional
Okay. So in case you’re wondering what the benefit of an FHA is since it seems like it’s all just extra fees, we’ll go over it.
One of the benefits of the FHA is the interest rate. Interest rates on an FHA loan are almost always much better. This is where they make up for the difference in that higher mortgage insurance (depending on your credit score). However, if your credit score is in the lower 700 range, your rate today might be close to 4% on a conventional loan.
Your rates might be closer to 3% or even under 3% in certain situations on an FHA loan. Interest rates on FHA tend to be much better, and that’s where you can make up some of that cost. If your credit score again is in that 620-640-660 range, then the FHA rate will usually make more sense there.
Upfront Mortgage Insurance Payment
This is another fee you get on the FHA. It’s another negative about the FHA loan. Sometimes, it’s called the UFMIP. Other times, people call it the Upfront. You have to pay an upfront amount into that expensive insurance policy to get the loan funded. You do not have to pay for this in cash since the whole point of the FHA is to come in with as little as possible.
After coming in with 3% or 3½%, you don’t want to start paying this huge amount of money for the upfront mortgage insurance. So they finance it. They actually put it into the loan, but it’s several thousand dollars. Just bear that in mind. If your loan is for $400,000, it’s going to be for around $407,000 to $409,000, depending on the regulations.
On a conventional loan, there is no upfront mortgage insurance payment. There is a monthly mortgage insurance payment, but they’re not collecting any extra upfront. This is one of the benefits for the conventional.
Who is the FHA loan for?
As a loan officer, I believe that the FHA loan is the best fit for people with mid to low credit who want to come in with as little as possible. Let’s look at a borrower who has perhaps had a bankruptcy years ago and has now worked on their credit. Let’s say they’ve built it up from 500 to 620. They’ve squeaked in and want to buy a house, but they do not have much money for a down payment. This kind of person is a perfect borrower for an FHA loan. There’s more flexibility on the rate and they are going to get approved a lot easier.
Otherwise, if you have good credit or a more down payment or both, the conventional loan is usually going to be a better product with a higher interest rate. Usually, what I do for my clients often is to prepare two loan estimates, about two to four pages, with a fully broken down line-by-line item, including the cost and loan estimates of an FHA at like 2½ and the other with a conventional at 3½.
Often, believe it or not, even though you’re paying a full percent higher, your monthly payment might be the same or lower. Even if it’s the same, the benefit is that you don’t have to worry about the Upfront or UFMIP. You’re not stuck with a mortgage insurance payment, as you will be able to get rid of it.
So even if the conventional was like $10 or $20 more, it’s worth it because you’ll have less than you owe, and you’ll be able to get rid of that mortgage insurance payment.
FHA vs Conventional: Which Wins More Bids?
The last thing to keep in mind when you are comparing the FHA and the conventional loans is that, when it comes to bidding on a house, especially in a big and active seller’s market, like the one we have right now, where there are fewer homes available than the buyers. There are multiple offers in every category, and every type of house receives from five to thirty offers the first week it’s on the market. In this kind of market, FHA loans rarely win bids.
Winning a bid with an FHA loan depends on the market you’re in. It could be as much as 20%, but it is a less favorable loan to sellers. At least, that’s the connotation that it has in the market.
A realtor will see three loans come in. There’s the all-cash buyer. Good as gold. They’re going to want to go with this kind of buyer first, but if the buyer is offering a low ball offer, they turn to the two other offers: the conventional loan and the FHA loan,n and they’re four around the same price. They’re going to push the client, most of the time, to go with a conventional. This is mainly because of the FHA appraisals.
FHA appraisals are more strict because it’s a government-sponsored loan product. They have stricter guidelines. So let’s say the water heater is not quite up to par, and there are some mold issues; you might be able to squeak by on a conventional loan, unlike on an FHA.
Also, FHA loans have a higher percentage of not closing. This is statistically speaking, mainly because mortgage brokers are not great at them. We specialize in so we know how to get an FHA loan through. However, we’ve seen many lenders mishandle an FHA loan and not do their due diligence on borrowers. Hence, many people are trying to get an FHA loan, and three weeks into the buying process, it falls flat on their faces. Sellers don’t want to deal with all of that, making FHA loans less accepted.
Condos and Town Homes
Lastly, let’s talk about condos and townhomes. For anything with an HOA specifically, FHA loans have to be approved with that specific condo community. This approval is not super common in a lot of areas. So if you’re buying a condo and planning on using an FHA, the number of condos you’re going to see with FHA approval is very narrow. You’re going to limit the number of condos you can buy just because you’re in the FHA category. Many condos are not approved, and they have to be approved for you even to be able to fund them. It’s always good to keep this in mind.
Now, if you are at the beginning of your home buying process and need a recommendation on a realtor anywhere in the country, we’re happy to connect you with one. If you have questions about this topic or other mortgage processes, I’ll try to answer them. You can always reach out to me through the contact form on my website here. I’m always happy to help.