FHA or Conventional Mortgage - Which is Better (& Why)?

FHA or Conventional...this is often the question.  The purpose of this article is to help you (and/or your Clients) articulate the pros & cons of each from an objective perspective.

FHA - Stands for Federal Housing Administration with guidelines handed down from the Department of Housing & Urban Development (HUD).  In other words, any Mortgage Lender who originates an FHA loan is beholden to the guidelines of HUD.

Pros of FHA Loans:

• Metophorically speaking, in order to be approved for ANY mortgage loan, you need to "fit in the box" of approval guidelines.  With FHA, "the box" is larger.  In other words, the underwriting (approval) guidelines are more lenient...especially in terms of credit scores and/or debt-to-income ratios (which measure your proposed cash flow).
• Furthermore, the interest rates for FHA are often lower than Conventional
• Also, Lender's can often offer larger "rebate pricing" through higher interest rates to credit some/all of your Non-Recurring Closing Costs (NRCC's) and/or your Recurring Costs (RC's).  To get a better understanding of how "rebate pricing" can be used to offset some/all of your NRCC's and/or RC's to reduce the amount of money you need to bring to the table when buying a home, CLICK HERE.
  • To gain a better understanding of what NRCC's and RC's are, and how they contribute to the "Funds to Close" when buying a home, CLICK HERE
• If you have an existing FHA mortgage and interest rates drop, you may qualify for an FHA Streamline Refinance (where the Lender pays all of your closing costs, you drop your "payments" by at least 7.5%, and don't need to provide income documentation and/or have an appraisal on your home to qualify)
• FHA loans have an aggressive 5/1 ARM which allows a lower interest rate for qualifying purposes (for those Borrowers who are trying to get into a larger priced home than Conventional will alllow)
• Unlike Conventional loans which access Private Mortgage Insurance (PMI) from an outside source (for down payments less than 20%)  FHA loans are self-insured. What this means is that if you fit into the box of FHA, the Mortgage Insurance is automatically approved (unlike Conventional)
• In many cases, a credit score of 580 can still get an FHA loan (where Conventional typically requires a 620 score). NOTE: With enough "compensating factors" FHA will consider Borrowers with scores down to 500, unlike Conventional.

Cons of FHA Loans:

• With FHA, you pay a 1.750% Up Front Mortgage Insurance Premium, which is pricey.  To understand how to calculate FHA mortgage insurance, CLICK HERE
• With FHA, you also pay Monthly Mortgage Insurance (MMI). The MMI is a sticky subject, as HUD changed the MMI guidelines in a nasty way.  CLICK HERE to better understand the significantly higher costs Borrowers pay over the life of the loan for all FHA loans (with low down payments) acquired after June 3, 2013. If you are weighing FHA vs Conventional, you really should understand how UFMIP and MMI impact the cost of your loan.
• If the property is a Condominium, the Condominium Complex must be FHA approved.  As many Condominium Complexes are not FHA approved, this dynamic limits the available properties a Buyer can access if they are using an FHA loan.
• In a Community Property State, the debts of the Non-Purchasing Spouse (NPS) are used to calculate Debt-to-Income (DTI) ratios, even if the NPS is not on the actual loan. This underwriting guideline has ruined several deals from a DTI perspective. NOTE: the debts from the NPS are not calculated into the DTI on a Conventional loan.
• Cannot be used for Investment (aka Non-Owner Occupied) loans

Conventional Loans (aka Conforming Loans) will conform/adapt to the standards of Fannie Mae and/or Freddie Mac.  Therefore any Lender who originates a Conventional (Conforming) loan is beholden to the standards of "Fannie" and/or "Freddie".  Those standards can be lumped into 3 distinct categories:

1. Approval Guidelines - No matter how much your Loan Officer wants to help you, if you do not meet Fannie/Freddie underwriting guidelines, you will not be able to acquire a Conventional Loan.
2. Documentation Requirements - No matter what Lender asks for what specific documentation up front, all Lenders are likley to have the same documentation in their file at the end of the loan (as the loan must pass a post-closing audit to be saleable in the Secondary Market under Fannie/Freddie guidelines).
3. Pricing Adjustments - Not everyone gets the same mortgage quote! While the quote has nothing to do with characteristics such as race, religion, gender, marital status, age, etc., Fannie/Freddie has created pricing adjustments for factors such as credit score, loan-to-value (LTV), occupancy type, property type, loan amount, and more.

Pros of Conventional (aka Conforming) Loans:

• Down payments can be as low as 3% with Conventional (FHA requires 3.5%). NOTE: If you can muster up 5%, your rate quote will be much better than the 3% down.
• No UFMIP (saves thousands of dollars in acquisition costs)
• Private Mortgage Insurance (PMI) can be removed at a later date when property equity is sufficient (which can save tens of thousands of dollars over the life of the loan versus FHA)
• Condominiums do not have to be FHA approved (allows more of a selection).  NOTE: the condominium must still be a "warrantable condo" (as pass the scrutiny of a Homeowners Association (HOA) Certification form. Items that can make a condominium non-warrantable include (but are not limited to) pending litigation, low owner occupancy ratio guidelines (Investment/Non-Owner Occupied only), high "owner concentration" (1 person/entity owning more than 20% of the units), budget/reserve issues, and more.
• When the Loan to Value (LTV) is above 80% (i.e. less than 20% payment on a purchase, or less than 20% equity on a refinance), Private Mortgage Insurance (PMI) is required.  With high credit scores, PMI is often much less expensive on a Conventional Loan than MMI is on an FHA loan.
• Can be used for Non-Owner Occupied (Investment property) loans (unlike FHA, which cannot). NOTE: while 20% down payments can typically access these loans, you will see a much better rate quote at 25% down (especially if this investment property is a Condominium).

Cons of Conventional (aka Conforming Loans):

• Interest rates are typically higher on Conventional (aka Conforming) loans when compared to FHA
• The disparity on interest rates is further magnified for lower credit scores (especially under 660)
• Credit score of 620 is typically required for Conventional loans (where FHA can often accommodate a 580 score...or lower with compensating factors)
• Typically does not allow Debt-to-Income (DTI) ratios as high as FHA (which can limit the amount of the approval)
• On higher LTV's (less down payment, equity), the PMI company can sometimes block an approval on Conventional loans (where this would not be a factor on an FHA loan)

As with most loan decisions, it is highly recommended that you work with a trusted, experienced, ethical and accountable Loan Officer to determine the best course of action when choosing a loan for yourself (and/or your Client).  I can help if/when desired.  Please feel free to reach out to me with questions and/or scenarios.