Buying a house is the largest financial commitment most of us make, and the process can be intimidating. It involves making a series of decisions — typically about unfamiliar matters — that will have a financial impact (for good or ill) for years to come.
Among other things, you must choose whether to apply for a loan insured through the private mortgage market or one insured through the U.S. government’s Federal Housing Administration. Or to put it in common parlance, whether to get a “conventional” mortgage or an FHA mortgage. (The government also backs lesser-used VA and USDA loans.)
The conventional-vs-FHA decision will make a difference in 1) whether you qualify for the loan, 2) costs at closing, 3) the down payment required, 4) where the down payment can come from, 5) the size of ongoing monthly payments, and 6) options available when re-selling the property.
The FHA expands homeownership
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, it was common for mortgage loans to be limited to 50% of a property’s value and for repayment schedules to be spread over periods of only 3-to-5 years.
The introduction of FHA mortgage insurance greatly expanded home ownership by giving lenders confidence to lend money to riskier borrowers. (The lenders knew the insurance, guaranteed by the U.S. government, would protect them against loan defaults.) The FHA also gradually re-shaped the mortgage marketplace by extending the length of loans and regulating interest rates.
Today, FHA-insured loans account for about 20% of all mortgage originations, according to the mortgage software company Ellie Mae. Most FHA borrowers are people whose low credit scores prevent them from qualifying for a conventional loan, or first-time buyers with limited credit histories and without much money for a down payment.
While a conventional-loan borrower needs a FICO credit score of at least 620 to qualify, the minimum score for most FHA-insured loans is 580. (It can even be as low as 500 if the buyer is able to put 10% down.) Lenders also tolerate a higher debt-to-income ratio for FHA applicants, sometimes allowing overall debt payments (mortgage, credit cards, etc.) to exceed 50% of income.
Further, FHA lenders take a more lenient approach to previous bankruptcies and foreclosures. To qualify for an FHA-insured loan, only two years must have passed since a Chapter 7 bankruptcy and three years since a foreclosure. (For a conventional loan, the wait times are four years and seven years, respectively.)
Of course, it’s the FHA-backed insurance that makes lenders willing to take a chance on higher-risk applicants and buyers with short credit histories. Although the FHA acts as the insurer, the cost of the insurance premiums is borne by borrowers.
FHA borrowers pay a mortgage insurance premium (MIP) as part of their monthly payments, just as most buyers with conventional loans must pay private mortgage insurance (PMI). But FHA borrowers face an additional insurance cost. At closing, an FHA borrower must pay (or roll into the loan) an upfront premium equal to 1.75% of the loan amount. In addition, while conventional-loan PMI payments can be discontinued when a borrower reaches an equity level of 80%, FHA insurance premiums continue for the life of the loan. (An exception is made for FHA borrowers who make a down payment of at least 10%.)
The insurance costs borne by FHA borrowers typically make FHA loans more expensive than comparable conventional loans over time (depending on a number of other factors, including total closing costs and fees).
One other key difference between FHA loans and conventional loans is that FHA guidelines allow — if the borrower’s credit score is 620 or above — for an entire down payment to be a gift from a family member, employer, or charitable organization. (A lender will require a “gift letter,” signed by the donor, verifying that the money is a gift and not a loan.) With conventional loans, only a portion of the down payment may be from a gift (unless the buyer is putting 20% down). [Update and correction: See Making Mortgages More “Affordable” for Millennials.]
The FHA’s greater flexibility regarding gifts makes FHA loans attractive in cases where parents (or other relatives) want to help a young family buy their first house by giving them money for a down payment.
The low down-payment required for an FHA-insured loan — only 3.5% of the purchase price, rather than the 5%-to-20% typically required for a conventional loan — was once the most prominent selling point for FHA mortgages. But that low down-payment advantage no longer exists, having been eclipsed by options in the conventional market.
A decade or so ago, lenders in the conventional marketplace were offering “100% financing” (no-money-down) loans. Although that option evaporated with the bursting of the housing bubble, lenders have resumed offering mortgages with high loan-to-value ratios — not quite “100% financing,” but close. Loans requiring only 3% down (i.e., 97% financing) are common today, slightly undercutting the 3.5% down-payment requirement on FHA-insured loans.
Another area where there isn’t much difference anymore between FHA and conventional loans is in interest rates. For years, FHA-insured loans were at slightly lower interest rates than conventional mortgages. Now that variance is minimal — or even non-existent. Indeed, FHA rates sometimes are fractionally higher than conventional rates.
Unique buying and selling pros and cons
When it comes to selling a property, an owner with an FHA-insured mortgage has an advantage. Unlike most conventional mortgages, FHA loans are “assumable,” meaning a buyer (with lender approval) can “take over” an existing loan under the original terms. When interest rates are rising, assumable mortgages become increasingly attractive to buyers because the rate on an assumable loan may be better than a rate available for a new loan.
That advantage, however, must be balanced against a significant downside when trying to buy a property using an FHA-insured loan. In a competitive-offer situation, many home sellers will prefer an offer from a buyer using a conventional loan (or paying cash!) over one from a buyer who will use an FHA mortgage. Since FHA buyers tend to have higher-risk profiles, a seller may be concerned that an FHA buyer could run into problems with a loan approval.
Sellers also know that FHA appraisals are more stringent than those for conventional loans. An FHA appraisal not only gauges market value, it requires a thorough inspection of the property to ensure conformity with a range of health and safety standards set by the U.S. Department of Housing and Urban Development.
Ready, or not?
Given other lower-cost, less-regulated options via the conventional-loan marketplace, FHA-insured loans really don’t offer much to today’s homebuyer — except the ability to use a gift for the total down-payment amount.
Anyone considering an FHA loan solely because of a low credit score would be better off to focus his or her immediate efforts on improving that score (by paying off debt and paying current bills on time) and saving for a larger down payment. Doing those two things will help streamline the eventual purchase of a house with a conventional mortgage, resulting in years of lower insurance costs and monthly payments.