FHA v. Conventional

Both FHA and conventional loans have benefits and disadvantages. Below are some reasons to select conventional financing and instances when an FHA loan may be the only or the better option.

Reasons to Go Conventional:

  • Less Expensive. If a borrower can qualify for a conventional loan (i.e. has credit scores higher than 660, can put down at least 5%, has a debt-to-income ratio that is less than 50%, does not have a recent bankruptcy, etc.), a conventional loan will in most cases be the better option because FHA loans are more expensive even though the interest rate on an FHA loan is usually lower than on a conventional loan.

    An FHA loan is usually the more expensive option for the following reasons:

    • A borrower is required to pay an upfront mortgage insurance premium equal to 1.75% of the loan amount. This amount can be financed and added to the loan amount.
    • The monthly mortgage insurance premium on an FHA loan is much higher than the private mortgage insurance premium on a conventional loan. On a 30-year fixed FHA loan to purchase a home where the loan amount is $625,500 or under and the buyer is putting 5% down, the annual mortgage insurance premium is 1.30% of the loan amount.
    • With an FHA loan, the borrower is required to pay monthly mortgage insurance for 11 years or for the entire duration of the loan term depending on the loan to value ratio when the loan was made. If the LTV is 90% or less, the borrower will have to pay mortgage insurance for 11 years and if the LTV is greater than 90%, then mortgage insurance is obligatory for the life of the loan. On the other hand, with a conventional loan, a lender is prohibited from requiring the borrower to pay for mortgage insurance once the LTV reaches 80%.
  • Fewer Required Repairs. A conventional loan may be the better option if the home that you are interested in purchasing is not in good condition. FHA loans have more stringent standards which may require that certain repairs be made before the loan can be approved. Making repairs to a home before escrow closes is problematic for both buyers and sellers. Buyers do not want to spend money on a home that they do not yet own since a number of things could still happen to derail the transaction including the seller backing out or their loan not being approved. For that same reason and also for liability concerns, sellers may not want any improvements or alterations made to their home before escrow closes.
  • Competitive Advantage. Buyers who are seeking FHA financing are usually less desirable to sellers because of the greater potential that the lender will require that certain repairs be made as a condition to funding the loan and because of the sometimes longer processing time. Some sellers may also be concerned that buyers who are seeking FHA financing may have some credit or income issues that may after full underwriting, ultimately prevent them from getting loan approval. All things being equal, sellers would rather sell to a buyer who is seeking conventional financing than FHA financing.
  • Not Eligible for FHA Financing. A conventional loan may be your only option if the home you are purchasing is a second home or investment property as FHA-insured purchase money loans are, subject to limited exceptions, reserved only for owner-occupied primary residences.

Instances When FHA Financing Is the Better or Only Choice:

  • Less than perfect credit. Most conventional loans are underwritten under Fannie Mae guidelines which require a minimum credit score of 620 or higher depending on a number of factors. Lenders can set higher credit standards and many of them do. If you don't qualify for a conventional loan because of your credit scores or credit history, then you may be able to qualify for an FHA loan which has more lenient credit standards. HUD sets minimum standards and guidelines for eligibility but some lenders have additional overlays to the minimum HUD standards which may require a higher credit score than what would otherwise meet HUD's minimum requirement. It is important to check with several lenders as they each may have different lending criteria above and beyond the minimum standards set by HUD.
  • Low cash reserves. You do not have the minimum 5% down payment required by most lenders for a conventional, conforming loan (loan amount is $417,000 or less) or a minimum 10% down payment for a conventional, high balance conforming loan (loan amount great than $417,000 up to $625,500). With an FHA loan, you only need to put down 3.5% and that money can come from a family member, employer or charitable organization as a gift. Other loan programs don't allow this and require that 5% come directly from the borrower's own funds unless the LTV is 80% or less. Although conventional loans are available with only 3% down, that option almost never makes sense over putting 5% down. The interest rate will be higher and mortgage insurance will also be significantly higher when the down payment is only 3%.
  • High debt to income ratio. The highest debt to income ratio under Fannie Mae guidelines for conventional, conforming loans is 45% with flexibility up to 50% if there are strong compensating factors. With FHA loans, the qualifying ratios are more liberal and there is more flexibility to qualify for a loan with a higher debt to income ratio depending on the borrower's overall financial picture and very strong compensating factors.
  • Recent bankruptcy, foreclosure or short sale. If you have a bankruptcy, foreclosure or short sale on your record, you may become eligible for an FHA loan sooner than with a conventional loan.
  • Home in need of great repairs. The home requires significant repairs and is not financeable through a conventional loan without the repairs being made before close of escrow. Most mortgage financing plans provide only permanent financing. That is, the lender will not usually close the loan and release the mortgage proceeds unless the condition and value of the property provides adequate security for the loan. FHA offers the 203(k) rehabilitation loan program and a streamlined version that allows you to borrow money for the acquisition of the home and for making the required repairs and close on the loan before the repairs are made. The portion of the loan that is for rehabilitation costs is placed into a rehabilitation escrow account and the repairs are made after the close of escrow with the lender releasing the funds to pay for the repairs in phases as the repair work is completed.