The process of buying a house can be intimidating, especially if you’re a first-time buyer. A home purchase requires a series of decisions — often about unfamiliar matters — that will have financial consequences (for better or worse) for years to come. Among other things, you must decide whether to apply for a “conventional” loan insured by the private mortgage market or an FHA loan insured by the U.S. government’s Federal Housing Administration.
The conventional vs. FHA decision will affect:
The required down payment,
potential sources for the down payment,
closing costs,
the size of monthly payments, and
the options available when reselling the property.
The FHA expands home ownership
Congress created the Federal Housing Administration during the Great Depression to make it easier for low- and middle-income Americans to become homeowners. Before the FHA, mortgage loans were typically limited to 50% of a property’s value, and repayment terms were usually 3 to 5 years.
The introduction of FHA mortgage insurance expanded home ownership by giving lenders confidence to lend to riskier borrowers. Lenders knew the insurance, guaranteed by the U.S. government, would protect them against loan defaults by applicants and buyers with limited credit histories. The FHA also gradually reshaped the mortgage market by extending the length of loans and regulating interest rates.
Today, FHA-insured loans account for about one in every five mortgage originations.
Distinguishing factors
Typically, FHA loans attract first-time home buyers or individuals with lower credit scores. While a conventional mortgage generally requires a minimum FICO score of 620, the FHA threshold is considerably lower at 580. Borrowers may even qualify with a score as low as 500, provided they can make a 10% down payment.
FHA applicants are also permitted to have a higher debt-to-income ratio than buyers seeking conventional loans. An FHA-approved lender may allow total debt payments (mortgage, credit cards, etc.) to exceed 50% of income.
Additionally, lenders take a more lenient approach regarding prior bankruptcies and foreclosures for FHA applicants: Only one year must have passed since a Chapter 13 bankruptcy, two years since a Chapter 7, and three years since a foreclosure. (For a conventional loan, the wait times are two, four, and seven years, respectively.)
Although the U.S. government acts as the insurer, FHA borrowers pay for that coverage. In addition to an ongoing insurance premium paid as part of their monthly payment, FHA borrowers are assessed an upfront premium at closing. That upfront premium, which can be paid in cash at closing or rolled into the loan, is 1.75% of the loan amount.
(While buyers with conventional loans may have a monthly insurance premium, they do not pay an upfront premium.)
Interest rates on FHA loans typically are lower than those on conventional loans (by 0.25% to 0.50%). However, the insurance costs borne by borrowers erase part of that advantage. For example, on a 30-year loan, the cost of the upfront insurance premium — if rolled into the loan — would effectively increase a 5.00% rate to an annual percentage rate (APR) of 5.15%.
Additionally, FHA borrowers face a slightly higher down payment requirement. The down payment on an FHA-insured loan must be at least 3.5% of the purchase price, compared with the 3.0% requirement now common for first-time buyers seeking a conventional loan.
One area where FHA borrowers have a clear advantage is in the source of their down payment funds. For an FHA borrower with a credit score of 580 or higher, the entire down payment may be funded by a gift from a family member, employer, labor union, government entity, or charitable organization (documentation will be required to assure the lender that the money is truly a gift and won’t have to be repaid).
Although conventional borrowers may also use gift funds for a down payment, the allowable sources are more limited (family members, godparents, fiancés, and “domestic partners”).
Buying and selling pros and cons
One downside of going the FHA route is that, in a competitive-offer situation, many sellers will prefer an offer from a buyer using a conventional loan. As mentioned earlier, buyers using FHA financing typically have shorter credit histories or higher-risk profiles, so a seller may be concerned that an FHA buyer could have trouble securing loan approval.
Sellers also know that FHA appraisals are more stringent than those for conventional loans, which can lead to delays. An FHA appraisal requires a thorough inspection of the property to ensure it conforms to a range of health and safety standards set by the U.S. Department of Housing and Urban Development.
The disadvantages of being an FHA buyer, however, must be weighed against a potentially significant advantage when it comes time to sell a house with an FHA mortgage. FHA loans are “assumable,” meaning a buyer (with lender approval) can “take over” an existing loan under the original terms. That is not the case with most conventional loans. When interest rates are rising, a property with an assumable FHA mortgage will be attractive to buyers if the rate on the assumable loan is lower than prevailing rates for new loans.
Ready, or not?
Whether an FHA loan or a conventional loan makes more sense depends on your unique situation. That said, those considering an FHA loan solely because of a low credit score likely would be better served by focusing their immediate efforts on improving that score by paying off debt and paying current bills on time, while also building savings for a down payment on a conventional loan.
Doing those things first could later result in years of lower insurance costs and monthly payments.
