FHA loans are designed to help borrowers who cannot qualify for conventional loans, generally because they have weak credit. The FHA loan, in existence since 1934, works great for this purpose, but may not be your best option, based on circumstances. Let’s explore.
Who Makes FHA Loans?
Most home buyers are aware that FHA loans are “government” loans, but many believe this to mean that they are made by the government. They are not. FHA loans are made by FHA-approved mortgage lenders, and then insured by Housing and Urban Development (HUD) so the lender is protected from losing money.
This means that you can get an FHA loan from almost any lender. No lender can claim that it is “the” FHA lender in town (although some will try.) You can always shop for the best deal when shopping for an FHA loan, and almost any mortgage lender or broker can help you.
What are the Benefits of FHA Loans Relative to Conforming Loans?
Many potential home buyers have been told that FHA loans allow you to make a lower down payment, but that’s not true. FHA requires a minimum down payment of 3.5 percent, while conforming loans (those made by lenders intended for sale to Fannie Mae or Freddie Mac) require only 3 percent down.
The main benefit of an FHA loan is that you can have some credit issues and still get financing when you would be declined for conforming financing. Credit issues might include a low credit score (for whatever reason), or specific credit events, such as bankruptcy or foreclosure.
The other benefit of FHA loans is that interest rates are lower because the lender is protected from losses, and monthly mortgage insurance rates are lower because they are underwritten by the federal government, although this benefit is somewhat offset – more on that later.
What are the Differences in Requirements?
As we discussed above, FHA loans require a (very slightly) higher down payment than conforming loans. The debt-to-income ratio is also slightly more stringent. Conforming loans allow a debt-to-income ratio of 45 percent, while FHA allows a maximum of 43 percent.
Debt-to-income ratio describes your total housing payment, including principal, interest, taxes, insurance, homeowner dues and mortgage insurance, plus all monthly payments on credit cards and loans, divided by your gross income. In other words, it’s the percentage of your gross salary that is committed each month to housing and other debt.
Conforming loans have a lower-end credit score cutoff of 580, while FHA loans allow a score as low as 500.
As noted above, FHA loans are more flexible regarding credit history, but there are requirements.
For instance, conforming loans have a lower-end credit score cutoff of 580, while FHA loans allow a score as low as 500, although below 580 may require a higher down payment. If you have a Chapter 7 bankruptcy, you must wait four years to qualify for a conforming loan, but FHA loans require only two years. Chapter 13 bankruptcies require two years for a conforming loan, and there is no waiting period at all for an FHA loan. (In fact, you can get one while still in bankruptcy!)
If you have a foreclosure, you must wait seven years for a conforming loan, but only thee years for an FHA loan.
Loan Differences Based on the Property
FHA loans are only available for your primary residence, while conforming loans can be made on second homes and investment properties.
FHA loans require that the property be protected from obvious potential damage, in livable condition and safe. For this reason, appraisers have to be specially trained to perform an FHA appraisal, and they are taught to note things such as broken windows, which could allow water damage, or inadequate stair rails, which could be a safety hazard. All fixtures and appliances have to be functional at the time of the appraisal as well.
What are the Differences in Costs?
FHA loans are often heavily sold as being less expensive than conforming loans, and sometimes they are. But not always. FHA loans require mortgage insurance regardless of the size of your down payment. Conforming loans require mortgage insurance only if you put less than 20 percent down.
FHA loans also require an up-front mortgage insurance premium of 1.75 percent of the loan amount; this can be financed, but it is a one-time fee that you can never recover. In addition, the monthly premiums, although lower, are forever. You cannot remove them for the life of the loan, unless you refinance into a conventional loan.
Which is Better: FHA vs. Conforming
If you can qualify for a conforming loan, it is almost always better to take one and skip an FHA loan. If you can’t qualify and are determined to buy a home, FHA loans make a purchase possible when your only option with a conforming loan would be to wait out your credit event.