FHA Loans vs. Conventional Loans: What You Need to Know

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If you’re new to the world of home loans, or it has been awhile since you’ve gone through the loan process, the terms FHA and conventional loans may sound foreign or confusing. 

At NeighborWorks Orange County (NWOC), we’re here to help guide you, making the entire home-buying process more accessible and achievable. 

So here are the major differences between FHA and conventional loans. 

FHA loans 

FHA loans are a product of the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development (HUD). That’s a really long way saying that FHA loans are government-backed loans. 

The Federal Housing Administration designed these loans with less strict guidelines in order to help families with low-to-moderate incomes better qualify for homeownership. FHA loans can go to applicants with lower credit scores. The down payments are lower that on conventional loans. And the approval process is more forgiving when it comes to time elapsed since a foreclosure or bankruptcy. 

FHA loans allow individuals or families who do not qualify for conventional loans to still qualify for a mortgage. 

In order to make this a reality, the Federal Housing Administration backs these loans. This means that it is assuming the risk with the loan, not the lender. There are a few tradeoffs though. For starters, all FHA loans are required to have mortgage insurance the entire life of the loan. Since these are higher risk loans, the insurance helps balance the risk. 

This protects the FHA against foreclosure or bankruptcy. 

Secondly, there are limits to the amount you can borrow, as well as the type of property you can borrow for. The limits vary by region, but in most regions you will find the “max borrow” loan amount to be less for FHA than conventional loans. Due to the high cost of living, both loans have a maximum of $625,500 for a single-family residence in Orange County. 

FHA loans can only be applied to a home you are going to live in, referred to as an owner-occupied home. This eliminates the ability to apply FHA loans to rental properties, investment properties, second homes, vacation rentals and other acquisitions.    

While there are many advantages for using an FHA loan, for qualified individuals, a conventional mortgage loan may offer a lower monthly payment. However, affordability between an FHA and conventional loan will depend heavily on the mortgage insurance requirement, and how that affects the final mortgage payment. 

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FHA requirements at a glance:

  • 3.5% down payment
  • Credit score as low as 500*
  • Lower interest rate
  • Debt-to-income ratio not limited to 40%
  • Shorter timeframe elapsed since foreclosure (3 years)or bankruptcy (2 years)
  • Streamlined refinance 
  • Mortgage insurance required for the life of the loan

*There is no universal guideline for credit scores. The minimum score will vary by lender based on the overlays the bank imposes on top of the FHA guidelines. 

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Conventional loans

Conventional loans are your typical mortgage loans offered by lenders. Because they don’t have special government backing, they have stricter guidelines for qualifying. They will be backed by either Fannie Mae or Freddie Mac.

If you have good credit and 5% or more for a down payment, then this will be the best option for you.

Even though you will likely pay a higher interest rate, most of the time the monthly payment for a conventional loan will be lower because of the impact of the mortgage insurance amount. Additionally, you can typically borrow more than an FHA loan. You will also have more flexibility in the type of property you can apply the loan to.

Conventional loan requirements at a glance:

  • 5% down payment
  • Credit score620 and above
  • Higher interest rate
  • 40% debt-to-income ratio
  • Longer timeframe elapsed since foreclosure (7 years) or bankruptcy (4 years)
  • Traditional refinance
  • Mortgage insurance only required until balance exceeds 80% loan to value ratio (i.e., you pay off more than 20% of the loan)
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Conclusion

If you are looking to make home ownership a reality, we would like to invite you to attend our NWOC Homebuyer Workshop. No matter your age, or if you have purchased a home before, this class is for you!

It will walk you through all aspects of purchasing a home, as well as help you determine the best option for you. Together, we will work through your credit, mortgage applications, home selection, and more.

After going through our class, you can be confident in both your decision to buy a home and in selecting which financing option makes the most sense for your family.