Conventional vs. FHA: Which is the right loan program for you?
FHA vs. conventional loans
- Conventional mortgages meet the guidelines of Fannie Mae and Freddie Mac.
- FHA loans can be easier to get and cheaper in the short term.
- Conventional loans will cost borrowers less than FHA loans over the long term.
Many first-time homebuyers make the mistake of thinking their work begins and ends with finding a perfect home and negotiating a good price. They forget that choosing the right loan product is critically important too.
The right loan can potentially save thousands of dollars in fees.
This choice, though, isn’t always obvious.
For most homebuyers, it comes down to deciding between a conventional loan or a Federal Housing Administration (FHA) loan.
For buyers with little money to put down on a home, the path can often be foggy.
Fannie Mae and Freddie Mac have rolled out low-down payment programs for first-time homebuyers, where the borrower can put as little as 3 percent down on a home. The low-down payment option had been one of the main draws of FHA, which requires just a 3.5 percent down payment for most qualifying borrowers.
In the overall mortgage market, conventional loans that meet the guidelines of Fannie and Freddie are by far the most common type of mortgages. Conventional loans offer the widest array of choices in loan products. A borrower also won’t typically have as many hoops to jump through to get qualified compared with government loan programs. For these reasons, conventional loans are the most popular choice for a homebuyer with strong credit, particularly those borrowers with more money to put down.
“It is nice to run your loan, get [approved], follow the steps and bring home that loan,” said Laura Reichel, senior vice president with home-loan originator Ditech. “You have more work [with FHA] to do in terms of documenting the file and getting the borrower qualified.”
But even if Fannie and Freddie loans are considered the gold standard, are these the clear choice for every borrower?
Not necessarily, originators say.
In the universe of low-down payment loan programs, FHA still offers advantages over the Fannie and Freddie programs, even if the borrower has strong enough credit to qualify for those conventional loan programs.
FHA loans can be easier to obtain
The first advantage of the FHA program is that it has traditionally had more lenient standards, said Scott Schang, a California originator and author of a consumer information blog. The FHA program has historically allowed borrowers to devote more of their incomes to the housing costs. The program also generally accepts lower credit scores.
“I had a borrower who had a 660 credit score, but a couple of his credit cards were only a couple months old,” Schang said. “So while he had great credit scores, he really didn’t have a deep credit history, and I could not get an [approval] with Fannie Mae. I ran an FHA, all day long it will take it [the loan].”
Borrowers can qualify for an FHA loan with a credit score as low as 580 and still put 3.5 percent down. FHA guidelines also allow credit scores as low as 500, so long as the borrower puts at least 10 percent down.
After the housing crash, however, most lenders tightened their standards and won’t go down to the low end of their program guidelines. Many banks, in particular, have opted to apply so-called credit overlays, requiring conventional and FHA borrowers to score higher than the minimum eligibility requirements in the guidelines.
That, however, had begun to change in late 2015. Even as the banks pulled back on lending to borrowers with weaker credit, numerous nonbank lenders were willing to lend to borrowers with less-than-perfect credit.
Reichel said some nonbank lenders, including her own, will approve FHA loans for borrowers with 580 credit scores, so long as the borrower can meet other guidelines.
“We offer some [loans that allow for] lower FICO scores versus most of the banks out there,” Reichel said. “That is another reason why we are seeing some of the volume increase. We are trying to match up with the FHA requirements in terms of the credit box.”
Loan costs vary
Schang said the price of a loan often depends on a person’s credit history. Fannie Mae, for example, had for years raised the upfront costs for borrowers with weaker credit scores. By late 2015, however, Fannie began to cap or eliminate the additional costs it was charging to borrowers with lower credit scores, a move to make its program more competitive with the loan pricing at FHA.
FHA also has made its own moves to be more competitive. In January 2015, the FHA lowered the annual insurance payment for its loans by half a percentage point, which the Obama administration estimated would save the average borrower around $900 a year.
Over the long term, though, Fannie Mae’s loan program is cheaper. One of the biggest downsides of an FHA loan is that the borrower has to carry default insurance for the entire term of the mortgage. With a conventional loan, the borrower can drop the insurance after paying down the balance. Over the life of the most typical 30-year fixed mortgage, an FHA borrower will pay thousands of dollars more in insurance costs than with a conventional loan.
Schang said that this advantage, though, can be deceiving. Although it is true that FHA loans are more costly over the long-term, he said the FHA loans are usually cheaper over the short term. He noted that it often takes several years to pay down a mortgage enough to drop the insurance on conventional loans. Most FHA borrowers sell their homes or refinance into a conventional loan within five to seven years, Schang said, avoiding the long-term insurance costs.
Schang cautioned, though, that every borrower’s situation differs. A consumer won’t know what the best loan option is until he or she sits down with an originator and crunches the numbers.
“It has a lot more to do with what the homeowner’s goals are than what the costs are now,” Schang said. “There are short-term and long-term things to take into consideration.”