If you’re looking to buy your first home, you may be considering all the options available to you, whether it’s a conventional mortgage or an FHA loan. So, what’s the difference between one and the other? FHA stands for Federal Housing Administration, which is a government agency within the Department of Housing and Urban Development (HUD) created in 1934 to insure loans issued by banks and private lenders.
Although not initially accessible to minority groups, FHA or government-backed loans were intended to benefit low and middle-income American families looking to purchase their first single-family home. The Fair Housing Act of 1968 finally regulated FHA programs and made them available to all qualifying individuals, regardless of age, race, or financial status. At present, FHA loans can aid first-time or experienced homebuyers looking to build, purchase, or purchase and renovate any private residence, whether a single-family or multifamily property. Again, the main difference between an FHA loan and a conventional mortgage is the fact that the former is insured by the government up to a certain amount or lending limit, which varies by county.
FHA Loan Features and Benefits
FHA loans are characterized by features that make them more accessible to lower and middle-income individuals and families. Since they are regulated by HUD, the requirements to qualify for these types of loans are less stringent than those for conventional loans. Here are some general features of FHA loans:
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Lower down payments – FHA mortgages typically require lower down payments than traditional loans. Applicants can have a minimum of 3.5% of the total value of the home for a down payment if they have a FICO credit score of 580 or higher.
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Lower credit score – Again, applicants with lower-than-average credit scores may qualify for an FHA loan provided they have at least 3.5% for a down payment. Those with a credit score below 580 are still able to apply but will be required to give a down payment of at least 10%.
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Down payments sources – Another caveat is the source from which you obtain the money from the down payment. Banks and private lenders want to make sure the money you’re putting down for closing is indeed your own and not a loan from family or friends. With conventional loans, applicants with less than 20% for closing costs are only allowed to use “gift funds” to cover part of that amount, but not all of it. On the other hand, the full down payment for an FHA can be from gift money alone, as long as the gift can be verified as such. According to HUD Guidelines 4155.1, the gift donor may only be a relative, a close friend—with a “clear and documented interest” in the borrower—, an employer, a labor union, a charitable organization, or a government agency offering a homeownership assistance program.
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Closing costs – Just as with down payments, FHA loan guidelines allow borrowers to use funds from other sources. In this case, home sellers can cover up to 6% of closing costs, but no more. Anything that exceeds that percentage would have to be subtracted from the mortgage amount, meaning the FHA will reduce the property sale price before applying the loan-to-value ratio.
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A higher LTV – The loan-to-value (LTV) ratio refers to the ratio of a loan over the value of the asset being purchased, which is merely another way for lenders to assess the risk they are incurring by lending money to a given borrower. Additionally, this ratio could also affect how much the borrower will pay for the loan. With FHA loans, the maximum LTV will be 96.5%, which is the cost of the home minus the 3.5% down payment for those with a credit score above 580. Those with lower credit scores will be limited to a 90% LTV and a down payment of at least 10%.
In addition to particular lender requirements—which are mostly universal for secured loans and include a having a good credit history, the ability to make timely payments, and cash assets for closing costs—the HUD established other necessary conditions that must be met for an FHA loan to be approved:
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Primary residences only – FHA loans are intended for the purchase of primary homes, meaning loan applicants must have the intention of becoming "owner-occupiers." There are particular circumstances in which borrowers may be granted a loan while maintaining a secondary residence, but said property must not be a vacation home or a house used for recreational purposes. To qualify, the individual must evidence their need for keeping a secondary home due to seasonal employment or an excessively long commute to work. However, they must be able to demonstrate there is a lack of rental housing within a reasonable commuting distance of their workplace.
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FHA-approved lenders and homes – FHA loans can only be obtained from approved lenders, and the home must also be approved by a certified appraiser from the FHA's roster.
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Mortgage Insurance Premiums (MIP) – One major difference between a conventional loan and an FHA loan is that, if the borrower has 20% or more for a down payment, he or she will not be required to purchase private mortgage insurance to get approved. With FHA loans, mortgage insurance is mandatory regardless of the down payment amount. FHA loans require an upfront premium of 1.75% as well as an annual premium to be paid monthly. When private mortgage insurance (PMI) is required for a conventional loan, the new homeowner only has to pay for insurance until their equity in the home reaches 20%, the loan balance reaches 78% of the home’s estimated value, or when the midpoint of the loan’s amortization period is reached. Conversely, FHA loans require ongoing mortgage insurance payments throughout the life of the loan unless the loan’s LTV is less than 78%, in which case the homeowner would only pay insurance premiums for 11 years.
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Debt-to-income ratio – Debt-to-income ratios are put in place to keep borrowers from entering into a loan agreement they cannot uphold. Two debt-to-income ratios are taken into account for FHA loans: front and back-end ratios. The front-end ratio refers to total mortgage payments over income, and it’s obtained by adding the total mortgage amount—including interest, home insurance premiums, etc.—and dividing that figure by the borrower’s gross monthly income. The back-end ratio refers to all monthly debt including mortgage payments as well as revolving and installment debt—e.g., credit cards, student loans, personal loans, etc.—and is obtained by dividing the total of those expenses by the gross monthly income. For FHA loans, the maximum front-end ratio must not exceed 31%, while the back-end ratio must not surpass 43%.
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Debts and credit issues – To qualify for an FHA loan, the applicant must not have current credit issues, meaning they cannot have declared bankruptcy in the past two years or had a foreclosure suit filed against them in the past three.
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Minimum property standards – When you’re approved for a mortgage, the property you intend to purchase will serve as collateral for the loan. In the event you default, the bank or lender will foreclose or sell the property to get back a portion of their investment. That means homes must also meet minimum property standards to be approved by the FHA and the lender. These standards encompass home safety, security, and structural soundness, and will be verified by the appraiser who assesses the property’s condition. Cosmetic defects and minor repairs are not a problem, as this only applies to issues that could adversely affect the health or safety of the home’s residents, such as defective construction, termite damage, or a rotting foundation.
Aside from these general requirements, FHA loan applicants will also be asked to show proof of uninterrupted employment for at least two years, have a valid Social Security number, be a lawful U.S. resident, and be of legal age. Although a conventional loan applicant may be asked to meet similar criteria, they will generally need to have a higher minimum credit score, a down payment of typically 5% or more, and private mortgage insurance if their down payment is less than 20%.
The pros of conventional loans are that their use is not restricted to the purchase of a primary residence, can have lower interest rates, higher loan amounts, and lower minimum property requirements, which could make them easier to close than government-backed loans. Despite having to adhere to strict eligibility guidelines, FHA loans may be more accessible for certain individuals, especially those looking to buy a home with new credit or a lower-than-average credit score. Visit the U.S. Department of Housing and Urban Development for more information on FHA loan programs for new homebuyers.