Should You Go With A Conventional Loan or An FHA Loan? Here’s How To Find The Best One For You!
If you have decided to purchase a home of your own congratulations! Owning a home is a great investment and could likely be the most important decision you will ever make in your financial life.
As you have likely already discovered there are different ways to go about obtaining a mortgage loan and with just a little bit of knowledge, you can make sure you choose the option that's best for you. Don't let yourself be overwhelmed, with the handful of simple facts we layout in this article you will quickly know exactly which loan option and which mortgage provider is the best one for your situation.
The two most common types of loans available for homebuyers are FHA loans and conventional loans. An FHA loan is guaranteed by the government, specifically, the Federal Housing Administration and it is referred to as a government-backed loan.
A conventional loan is one that is backed by either Fannie Mae or Freddie Mac and is also called a conforming loan.
The key factors that decide which loan is best for you are; down payment, credit score requirements, interest rate, loan limit, and mortgage insurance.
Down Payment - The down payment is a lump sum amount of money the buyer puts down towards ownership of the home. The balance of what is owed is then carried as a loan or mortgage.
Credit Score - Whenever you decide to purchase a house, lenders will take a look at your credit score. This 3 digit number is what a lender uses to decide how much risk they'll take in loaning you money and is based on your past history of getting and paying on other loans. The number can range from 800 (very high) to 350 (very low) and is a huge deciding factor in how much a lender will lend as well as the interest rate and the length of the loan.
Most mortgage providers will also look at your FICO score which is another credit scoring tool developed by the Fair Isaac Corporation and operates from 350 points (considered low) to 850 points (considered very high).
There is also a score that is generated from the credit bureaus which include TransUnion, Equifax, and Experian. All of these different entities base their ratings on similar key issues which are:
>The credit type you use
>How you use your credit
>Whether you make payments on time
>The length of your credit history
>Your new credit accounts
For a break down of how your credit scores are created by these different entities, you can read this.
Interest Rate - the interest rate is the amount paid to the bank or mortgage provider for the use of ‘their’ money so you can make payments over time. Essentially they pay the lump sum of the cost of the house to the seller then you make smaller monthly payments to the mortgage provider until you pay off the amount they paid to the seller on your behalf PLUS the interest which is a percentage of the amount borrowed.
Loan Limit - the loan limit is the total amount the mortgage provider is willing to lend you toward the purchase of a house.
Mortgage Insurance - mortgage insurance is insurance that offsets losses incurred by the lender should the borrower default on the loan. The insurer decides whether this insurance private or public.
Federal Housing Administration or FHA Loan Specifics
FHA loans offer much fewer restrictions than conventional loan sources do. This can be very beneficial if you are concerned about a less than a stellar credit score or not having a lot for a down payment.
FHA loans allow you to purchase a home with a credit score as low as 500 but there is normally a requirement of at least 10% down if your credit score is that low. If you have at least a 580 credit score you can get an FHA loan with as little as 3.5% of the total cost of the house as a down payment. Most lenders have their own minimum score requirements beyond these.
This can make a huge difference in comparison with a conventional loan provider which is normally 20%. The breakdown would look like this:
On a $200,000 house, you would need a lump sum of $40,000 for the down payment on a conventional loan.
However, if you have at least a 580 credit score, the same $200,000 house would only require a lump sum payment of $7,000 for the down payment.
There is also something called a debt to income ratio or DTI. This is basically how much debt do you already have in relation to your current income. If you are living right up to your means that indicates a high debt to income ratio. If you couple that with a lower credit score (600 or below) your only viable option will be an FHA loan. Conventional lenders want lower DTI and higher credit scores before they will offer much to a potential home buyer.
The loan limits on FHA loans top out at around $700,000 in more affluent areas and as low as $350,000 in rural areas. Traditionally you can get higher loan amounts using conventional loans.
Interest rates remain competitive on both types of loans with FHA loans sometimes being lower because of the government guarantee. Your credit score and FICO scores will affect your interest rate as well. Other factors that can cause higher interest rates are the economy and general state of the world economy at the time you are purchasing your home.
On FHA loans you will also be required to pay what’s called a mortgage insurance premium which is normally paid for the entire life of the loan unless you pay a 10% or higher down payment then the MIP will drop off after 11 years. You are also required to pay an Upfront Mortgage Premium which in most cases is 1.75% of the amount of your base loan.
Conventional Loan Providers
Because they are not guaranteed by the government, conventional loan providers as a general rule are going to require at least a 620 credit score and in most cases a 20% down payment.
There is a way around the 20% down payment requirement and that is to purchase PMI or private mortgage insurance. The payment on this insurance is built into your monthly mortgage payment or paid upfront at closing. The insurance allows the lender to take a bigger risk in allowing you a smaller down payment (as low as 3 %) because the insurance will help offset the losses should you default on your payments and lose the home to repossession.
“So What Is The Best Loan For Me?”
Taking all of these factors into account, it breaks down like this:
>If you have a credit score of at least 620
>You have a down payment equal to a minimum of 3%
>Or if you want to avoid the PMI have a down payment of 20%
>If your debt to income ratio is low
>And you want more flexibility in your payment options
Then a conventional loan provider is a right way to go for you
>If, however, you have a lower credit score
>If you don’t have a lot for a down payment
>And/or your debt to credit ratio is high
Then an FHA loan is going to be the right way for you to go
I hope this article has helped you decide which loan option is the best one for you. At times the process of purchasing a home can seem overwhelming and confusing. By breaking down each step of the process into small doable ‘bites’ it will make the entire experience much less stressful and help you make the best decisions possible for your specific situation. For a complete guide on first time home buyers please refer to:
https://www.investopedia.com/updates/first-time-home-buyer/
It's estimated that 1 in 5 Americans have mistakes on their personal credit report. Because lenders depend so heavily on these reports in making vital decisions about your mortgage it behooves you to take a moment and make sure yours is correct. Finding and fixing any errors in your credit report can quickly and dramatically increase your credit score which in turn can get you a larger loan, a lower interest rate, and potentially save you many thousands of dollars over the life of your mortgage. To learn how to check your credit report and easily correct any errors you find, please go to:
https://www.credit.com/adv/credit_repair/how-to-fix-errors-on-credit-reports.html
To learn quick and easy tips on how to build your credit which will make a huge difference in how much money mortgage providers will lend you as well as giving you lower interest rates and the best offers you can get, please refer to the following:
https://www.experian.com/blogs/ask-experian/credit-education/improving-credit/building-credit/