Understanding the differences between Conventional and FHA loans is one of the most important first steps in the process of buying a home.
Each option has its advantages and drawbacks. This brief introduction will help ease the first-time homebuyer into the often confusing and intimidating world of mortgages and home ownership.
Conventional loans are not made or issued by a government entity. There are established guidelines for credit scores, income requirements and minimum down payments. Excellent credit is required for a good interest rate and additional fees are added for lower credit scores. Most conventional mortgages have either fixed or adjustable interest rates and can be conforming or nonconforming. FHA loans are insured by the Federal Housing Administration and are funded by FHA-Approved lenders and banks. The federal government insures loans for FHA-approved lenders in order to reduce their risk of loss if a borrower defaults on their mortgage payments. In theory, this provides the lender the confidence needed to offer lower-income Americans access to a mortgage that the potential homeowner may not have otherwise been able to afford.
The choice between a conventional and FHA loan depends on a number of subjective factors.
The choice between a conventional and FHA loan depends on a number of subjective factors. Both types of loans require a credit check. Conventional mortgages are generally less administratively burdensome to obtain and, because they generally require higher down payments, home equity can accrue more quickly. They are typically a good fit for borrowers with terrific credit that afford higher down payments.
FHA loans are popular with first time home buyers and have a more standardized threshold for the borrower’s credit score. Typically FHA loans are easier to qualify for because it requires a lower down payment and less-than-perfect credit. Borrowers with less than perfect credit, or who have undergone bankruptcy or have been foreclosed upon, may be able to still qualify for an FHA loan.
Also consider the debt-to-income ratio, or DTI. Conventional loans have a varied DTI based on the individual lending institution practices so this is an important factor to consider when shopping around for lenders. FHA loans have a structured limit set nationwide and tend to allow for a higher debt-to-income ratio than conventional loans.
Keep in mind the two values that make up a DTI, the front-end and back-end ratios. The front-end DTI takes into account only housing expenses, where the back-end includes both housing expenses and reoccurring debt payments. A borrower’s debt ratios must be at or under the set DTI when applying for each specific loan. It’s important to come to the table with that information already calculated to make the loan application process as smooth as possible.
There may also be a difference for borrowers who had recently gone through bankruptcy or foreclosure. In 2013, the FHA instituted the “Back to Work” program where a prospective homeowner could qualify for an FHA loan only one year after Chapter 13 or Chapter 7 bankruptcy as well as a foreclosure, provided the homebuyer has satisfied the requirements of the program. With conventional mortgages, those durations are longer and varied between lenders.
As a side note, there is a government-backed VA mortgage program available for veterans. The military loan guaranty program is designed to assist returning service members purchase homes. It is a mortgage loan issued by approved lenders and guaranteed by the federal government.
VA mortgages are unique in that they may require no down payment. However, VA loans are not automatically offered as a no-money-down mortgage. The buyer must have the home appraised by a VA-assigned appraiser so a notice of value can be issued. If that notice of value has a figure lower than the purchase price of the home, the buyer has to make up the difference in cash.
In the end, the first step anyone must take on the road to home ownership is to decide which loan is right for their specific financial situation. All options offered have unique advantages and drawbacks that must be weighed on a case-by-case basis.
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