Many first time homebuyers are aware of the low down payment an FHA loan permits but they are often unaware of the costs. An FHA loan is a loan that is insured by the federal government to protect the lender against loss. A lender who makes a conventional loan does not have this protection. Below are a few of the major ways FHA loans and conventional loans differ.
The minimum down payment required for an FHA loan is 3.5%, while it is 5% for a conventional loan. That down payment can come as a gift from a family member per FHA, while conventional underwriting guidelines require that the 5% be from the borrower’s own funds. With an FHA loan, someone can purchase a home without having any of their own money at risk.
Generally, interest rates are lower on FHA loans compared to conventional loans and they do not change based on credit score. This is due to the government’s involvement in the program. Someone with a 700 credit score will get the same rate on an FHA loan as someone with a 640 credit score. That is not the case for a conventional loan. Interest rates for conventional loans are determined based on a number of factors, one of the biggest being risk. Someone with a 640 credit score is “riskier” than someone with a 700 score. The interest rate and credit score are inversely related with conventional loans. The higher the credit score, the lower the interest rate.
This is where the costs of an FHA loan far exceed those of a conventional loan. For a conventional loan, mortgage insurance is only required for down payments of less than 20% and again a risk based model is used to determine the premium. Those with lower credit scores putting the minimum 5% down will have a higher premium than someone with a higher credit score putting down 10%. Like interest rates, the mortgage insurance for an FHA loan does not change based on credit score. It is based on the loan term and down payment. FHA also requires an Up Front Mortgage Insurance Premium (UFMIP) of 1.75% of the purchase price. This UFMIP may be financed into the loan amount. For a conventional mortgage, the mortgage insurance is required by law to be cancelled once the loan balance is 78% of the original purchase price. If someone made extra payments to pay down their balance in a short period of time to get rid of the mortgage insurance this would work for a conventional loan. FHA requires a borrower to pay a minimum of eleven years of mortgage insurance regardless of the loan-to-value. If the loan term is greater than fifteen years and the down payment is less than 10%, mortgage insurance is required for the entire term of the loan.
To obtain an FHA loan for the purchase of a condo, the condo project must be on the FHA-Approved Condo List. FHA requires the review of an association’s financials as well as review of other factors like owner-occupancy and construction quality to approve a project. If a project is not on the FHA-Approved Condo List, then an FHA loan cannot be used to purchase the property. This can limit the available choices.
FHA loans have greater long term costs than conventional loans but they can often be the only way someone can purchase a home because they are less stringent on down payment and credit score requirements. FHA was created in 1934 with the intent to increase the size of the market for homes by regulating the interest rate and term of the mortgages it insures. The agency has undoubtedly contributed to expanding the base of people who can purchase a home with arguable benefits.
Please feel free to contact me at (312) 285-6644 with any questions you might have. And if you are a neighbor in Bowmanville, please say hello!
Heather McRae is a residential mortgage lender. She was first introduced to the real estate industry in 2001. Heather lends throughout the State of Illinois and specializes in condos within the City of Chicago. She is a proud resident of Lincoln Square’s Bowmanville neighborhood.