If you're thinking about buying a home and need to borrow money to do it, you'll need to figure out what mortgage loan program will work for you. Residential mortgage loans generally fall under one of two umbrellas: conventional loans and Federal Housing Administration loans.
Which one you choose will depend upon your financial situation and your credit rating, and there are pros and cons to both. A conventional loan is harder to get if you have a lower credit score and no money to put down, but an FHA loan might be feasible.
Sussing out the difference between FHA and conventional loans is a twofold inquiry, as there are two major variables: credit rating and down payment. Conventional mortgage loans are generally available to people with good credit and the ability to make a sizeable down payment, while FHA loans are an option if your credit is less than stellar and you don't have much liquid cash to put down on the house.
What Is a Mortgage Loan?
A "mortgage" and a "loan" are actually separate things. When a bank lends money to be paid back with interest, the bank has given a loan. If the loan is for the purchase of real estate, the borrower gives the bank a mortgage, which is a security interest in the real estate, also known as a lien. The mortgage protects the lender by insuring that, one way or another, the loan will be paid.
Most commonly for consumers, this means that if you buy a house and take out a loan to pay for it, you give the bank a mortgage on the house as security. If you sell the house, you have to pay the mortgage in full, and if you stop paying the loan payments, the bank can foreclose on the property and sell it.
Business loans can also be secured by mortgages, either in commercial real estate or residential.
Types of Mortgage Loans
Mortgages can be divided into two large groups: commercial mortgages and residential mortgages. Residential mortgages have different rules and regulations than commercial mortgages.
Borrowers who want a residential mortgage can seek a conventional mortgage, or they may have the option of applying for an FHA mortgage (or a Veterans Affairs mortgage, if the borrower is military or former military). If the price of the house is quite high, the borrower may need a jumbo loan. Most Americans, however, take out conventional loans, FHA loans or VA loans.
FHA Loans: Government Guaranteed
FHA loans and VA loans are guaranteed by government agencies (the Federal Housing Administration and Veterans Affairs, respectively). The government agrees that, if a borrower on one of these loans defaults, the government will pay the lender a portion of the balance due.
FHA Loan Lending Limits
Anyone can apply for an FHA loan, while only veterans, active military, active reservists and surviving spouses of any of these can apply for VA loans. FHA loans are subject to lending limits, however; the government will not approve an FHA loan over a certain amount, which varies depending on your area.
The largest FHA loan available for a single-family home as of March 2019 is $726,525, and that limit applies to high cost-of-living areas like New York City and San Francisco. In some areas, the cap on FHA lending is as low as $314,827.
Requirements for an FHA Loan
The requirements for an FHA loan are vast and change regularly. Generally, however:
- The loan must be for an amount less than the loan limit for your area.
- You must put down at least 3.5 percent.
- Your credit score should be at least in the 500s (if your score is less than 580, you'll need a 10 percent down payment).
- Your debt-to-income ratio should be 50 percent or less.
- You must be free of any past due federal debts, such as past due income taxes or prior defaulted FHA mortgages.
- You must have at least two established credit accounts.
- You must be able to provide proof of your source of funds for the down payment, even if it's a gift.
You'll need to provide a lot of documentation to apply for the loan, and the lender itself may have more requirements that you must follow. Individual lenders are permitted to set a higher bar on certain requirements; just because the government agrees to guarantee the loan doesn't mean the bank will agree to loan the money.
Debt to Income Ratio
Your debt to income ratio is determined by calculating your monthly debt payments compared to your monthly income (before taxes). Most lenders have debt to income ratio requirements, and to qualify for the FHA program, you'll need a DTI of 50 percent or less.
For example, if you make $50,000 per year, your gross income every month is $4,166.67 ($50,000 per year divided by 12 months). Say you have monthly debt payments of $1,900, as follows:
- A car payment of $500.
- Minimum monthly credit card payments of $600.
- Student loan payments of $800.
Your DTI in this case would be about 46 percent ($1,900 in debt divided by $4,166.67 in income). Therefore, you would pass that hurdle for obtaining an FHA loan. However, if your student loan payments are $1,200, your monthly debt payments total $2,300, which is more than half of your gross income for the month. Your DTI would be 55 percent, and you might not qualify.
Mortgage Insurance Premiums
FHA loans require the borrower to pay mortgage insurance premiums, which are added to the monthly payment. All FHA borrowers must pay MIP, regardless of the size of the down payment, although the bigger the down payment, the lower the MIP (and the less time you have to pay it). The MIP collected on all FHA loans goes into a large fund that the government uses to pay banks when other borrowers default on their loans and the guaranty is called in.
Conventional Loans: Non-FHA Loans
A conventional loan is any non-FHA loan and non-VA loan, which means that it is simply an agreement between a lender and a borrower, two private parties, without any government guaranty. Conventional loans typically require a 20 percent down payment and a credit score of at least 680. You can get a conventional loan without a 20 percent down payment; however, you'll have to pay private mortgage insurance, which adds extra money to your payment every month, until you pay the debt down.
Private Mortgage Insurance
Private mortgage insurance is similar to MIP but is for conventional loans. PMI is only paid on conventional loans, however, when the borrower puts down less than 20 percent. If the down payment is below 20 percent, the borrower must pay the PMI until he pays down the mortgage enough to widen the gap between the loan balance and the property value (decreasing the loan to value ratio, or LTV).
For example, if you buy a house for $100,000 and put down 20 percent, your down payment is $20,000 and your loan is $80,000. Your LTV ratio is 80 percent. If you only put down 10 percent, your LTV is 90 percent. With a conventional loan, you would need to pay PMI until the balance on the mortgage is paid down to 80 percent or lower.
- FHA Loan vs. Conventional Loan: A Detailed Comparison | New American Funding
- Nolo: What's the Difference Between a Conventional, FHA, and VA Loan?
- U.S. Department of Housing & Urban Development: National Servicing Center
- U.S. Department of Housing & Urban Development: Guidance for Homeowners
- U.S. Department of Housing & Urban Development: FHA Mortgage Limits
- NerdWallet: FHA Loan Requirements for 2019