Not many people know the difference between conventional and FHA loans, and up until the recent market turmoil, FHA was a bad word in the housing market. What's the reason? FHA was a little archaic, with no modernized changes in many years, and the complex appraisal process made this program undesirable in a market flooded with no down payment programs.
Well I've got great news for you. I'm going to break down some differences between them. Now I won't be able to mention every single difference here, but I will give you some of the major differences in regards to rates, down payment, mortgage insurance, and underwriting differences.
Conventional loans are offered in many ways ranging from adjustable rates coming in 1,3,5,7,and 10 year hybrid arms, interest only loans, and 10,15,30, and 40 year fixed rate loans. FHA loans are offered in 3,5 yr arms and 15 and 30 yr fixed rate loans.
Some lenders offer different terms but these are the most common offered. Not ever lender will be the same in their product offerings.
So lets get into some of the differences now.
RATES:
Conventional loans in terms of pricing, or rates, have very high risk adjustments for lower credit scores and higher loan to values. Loan to values are calculated on purchases, as the loan amount divided by the purchase price. For example lets use a purchase price of $125,000 and a loan amount of $100,000. The loan to value would be calculated as 100,000/125,000 = 80%.
In this scenario the ltv (or loan to value) is 80% meaning the borrower is putting 20% down. The higher the ltv the higher the pricing. Lets say a borrower has a 650 credit score and they have 10% down, their rate would be considerably higher than someone with a 720 credit score and the same down payment. Conventional loans will also have pricing adjustments for multi-family properties, FHA does not.
MORTGAGE INSURANCE:
Conventional mortgage insurance is issued through private providers such as MGIC, Radian, RMIC, and PMI. These companies have their own guidelines when issuing mortgage insurance on conventional loans. In recent months all of them have gone to minimum credit score requirements and specific underwriting guidelines to mitigate risk. I've seen loans make it all the way to closing and fall apart because mortgage insurance could not be obtained. Mortgage insurance for multi-family properties will vary on conventional loans but will not be impacted on FHA.
Another note on this is unlike conventional loans that use private companies to obtain mortgage insurance, FHA is fully self funded by the upfront and monthly mortgage insurance premiums they collect. When comparing FHA you will see that the upfront costs associated with the loan are a little more expensive. This is because FHA will charge an UFMIP (up front mortgage insurance premium) that is equal to 1.75% (on purchases, streamline refinances are lower) of the base loan amount - I'll explain this in more detail under the down payment section. The monthly mortgage insurance premium will depend on the ltv. It'll will either range from .005% to .0055% of the loan amount. So for a $100,000 dollar loan amount the yearly mortgage insurance would be $500-$550 a year respectively. This is considerably lower than conventional which would range from .0075% - .0099% of the loan amount. Do the math that almost twice as much.
FHA 15 year loans have lower mortgage insurance, and if you put 10% down on a 15 yr loan, there is NO monthly mortgage insurance. This is not the case with Conventional.
Since FHA is fully self-funded, if you are approved for the loan, you're automatically approved for the mortgage insurance. This is not the case with the private mortgage insurance companies.
DOWN PAYMENT:
While as I write this we'll probably be in the process of receiving more changes, this is the most updated information available in regards to down payment. Conventional loans, non jumbo, which are loans above the annual Freddie Mac and Fannie Mae conforming limits, require 5% down payment. If the property is located in a declining market - which would be determined by the appraiser, Freddie or Fannie, or the MI company, you would need an additional 5% down payment. Below is the list of the conforming loan limits for 2009.
General max limits (for single family residences) are $417,000 and high cost areas $625,000.
For Alaska, Guam, Hawaii, and U.S. Virgin Islands, general is $625,000 and high cost is $930,000. For 2, 3, and 4 units these limits are higher. You can visit Fannie Mae's website at www.efanniemae.com for a full chart of loan limits.
For FHA, as of 2008, will be 3% down payment. Starting January 2009 minimum down will be 3.5%. Congress deliberated awhile on what to change the down payment requirements to on FHA loans. Ideas were thrown around for 1.5% or even $0 down. The fear was that FHA would be the new "sub-prime", so they changed it to 3.5%. The idea here is for people to have some skin in the game. If they've invested their hard earned money into the home, they are less likely to walk away from it without exhausting every avenue. FHA loan limits will vary by county and state and will adjust for high cost areas just as Fannie and Freddie do. You can find a detailed list at http://www.hud.gov/pub/chums/file_layouts.html
Now above I spoke about the UFMIP (up front mortgage insurance premium). How this would be calculated is to take the purchase price, in this case we'll use $100,000. You reduce this by the amount of down payment, for this example lets just say you are putting 3% down. This would be a base loan amount of $97,000. You then multiply this by the 1.75%, which equals $1697. This would be added to the base loan amount to get your total loan amount, which would equal $98,697. This is also the number used to calculate your monthly mortgage insurance. This was the additional up front cost I was talking about earlier. Even though you have this on FHA loans, the overall costs after a full analysis could be substantially lower versus using Conventional financing.
UNDERWRITING DIFFERENCES:
I could spend awhile on this section so I'll try to keep it short and sweet. Most lenders use Freddie Mac and Fannie Mae's automated underwriting systems, LP and DU - loan prospector and desktop underwriter - to evaluate loan candidates and shorten the time taken to make an underwriting decision. These systems have built in risk models that evaluate the data submitted and either give an approval or a denial based on that information.
FHA doesn't technically have a minimum credit score requirement, but this doesn't mean that you can get any credit score approved. When talking about having a no minimum credit score requirement, this is concentrating on those who do not have enough credit to pull a credit score. When this is the case, FHA underwriting guidelines will allow you to get what is called non-traditional credit references establishing a credit history with rent payments, utility payments, cell phone, etc. Not having a credit score will not eliminate the borrower from obtaining FHA insured financing. With the private mortgage insurance companies now implementing minimum credit scores for approval, FHA insured financing is the better option for the borrower.
While this isn't nearly all the differences when underwriting these loans, just know that FHA insured financing has more flexible guidelines then conventional loans, so this would be the better option for borrowers who've had credit issues in the past. This would provide them with low cost financing, making the purchase of the home more affordable, which is the goal of the program.
Please keep in mind this is only some of the major differences between the programs and you should still consult a professional when evaluating your options on buying home. This does not mean you shouldn't sit down at the dinner table with a piece of paper and write out ALL of your expenses, to determine if purchasing a home is right for you.
When being qualified for a loan, lenders only use debt reporting on the credit report for qualification purposes so please, do your due diligence and write out how much you have coming in and how much you have going out, taking into consideration things that may come up, before you invest savings, 401k, or other sources of funds into purchasing a new home.
Please be an informed buyer.
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