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FHA vs. Conventional Loans: How to Tell Which Is Better for Your First Home

Couple looking at their new home
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You’re planning to purchase your first home. What a glorious event!

Until it comes time to figure out how you’re going to pay for it.

Well, if you’re a first-time homebuyer looking into mortgages, you’ve probably heard of, or looked into, FHA loans. They’re the second most common type of mortgage (behind conventional), but they’re highly popular for home-buying newbies.

Here’s what to know if you’re shopping around.

What Is an FHA Loan?

An FHA loan is a type of home mortgage insured by the Federal Housing Administration (FHA) and offered by an FHA-approved financial institution.

This insurance gives banks, credit unions and other lenders more leniency to approve mortgages outside conventional loan requirements.

The major advantages of choosing an FHA loan are the easier credit standards and the lower down payment minimums. And if you’ve had any major credit problems like a foreclosure or bankruptcy, you don’t have to wait as long to obtain an FHA loan as you would for other loans.

While your credit score doesn’t need to be as strong for your loan to be approved, the lower your credit score, the higher your required down payment.

FHA Loan Costs

Credit Score Down Payment Required
500-579 10%
580 or higher 3.5%

Your credit score is also a huge factor in determining what you’ll pay in closing costs. Between 2% and 5% of the loan amount is most common, that’s $4,000-$10,000 on a $200,000 loan.

Another perk of the FHA loan is that if you’re not within the required debt-to-income (DTI) range, you can lower yours by blending DTI ratios with a related, non-occupant co-borrower — like your mom, as long as she doesn’t live with you.

Your DTI ratio is your minimum monthly debt payments divided by your monthly income. You can qualify for an FHA loan with a DTI ratio as high as 50%, but you’re more likely to be approved at 43% or less.

But there are some drawbacks, too.

Homes must meet strict structural standards, making most fixer-uppers hard to get approval for. If you’re set on one, look into an FHA 203K loan. The process for approval is lengthier than for a regular FHA loan, but the mortgage includes estimated home improvement costs in the loan amount.

FHA Loan Requirements

Your credit score and down payment aren’t the only requirements for an FHA loan. Like any other mortgage, there’s a long list of requirements, including:

  • Steady income and employment history, usually for the past two years.
  • The property must be the borrower’s primary residence.
  • The property must meet certain minimum standards for appraisal.
  • The appraisal must be done by an FHA-approved appraiser.
  • Your total monthly payment can’t exceed 31% of gross income.

An FHA loan also requires you to pay a mortgage insurance premium (MIP). No matter how big your down payment is, an upfront MIP payment equal to 1.75% of the base loan amount is added at closing. There’s also an annual mortgage insurance premium — similar to PMI on a conventional loan — that varies depending on your down payment.

For example, most people choosing an FHA loan choose a 30-year fixed mortgage with 3.5% down payment. That’ll incur a 0.85% annual MIP for the entire mortgage term, so on a $200,000 loan, annual MIP will start at $136.71 and gradually go down over the term of the loan.

A higher down payment of 5%-10%, on loans of less than $625,000, will incur a lower annual MIP of 0.8% for the entire mortgage term.

FHA Loan vs. Conventional Loan

Conventional loans are by far the most popular type of mortgage, but does that mean they’re better?

That depends on your financial situation.

Say you’re putting down 5% or more on your house. While FHA loans tend to have slightly lower interest rates, conventional loans tend to be less expensive over the life of the loan — because of differences in mortgage insurance premiums.

However, if you don’t have 5% to put down, an FHA loan with 3.5% down will most likely be cheaper than a conventional loan with only 3% down.

  FHA Conventional
Minimum Credit Score 500 for 10% down

580 for 3.5% down

620
Minimum Down Payment 3.5% 3% minimum,

more commonly 5%

Debt-to-Income Ratio
< 43% Up to 50% with ability to add cosigner < 43%
Closing Costs 1%-6% 2%-5%
Private Mortgage Insurance Requires both a 1.75% upfront premium and 0.45%–1.05% annual premiums. Cannot be canceled if downpayment is    <10%. Either a one-time payment or monthly fees from 0.55%–2.25% depending on credit. Can be canceled once 20% in equity is reached.

Some people will say that FHA loans have lower closing costs compared to conventional loans, but it’s actually that real estate agents, mortgage brokers and sellers can pay for the closing costs on the buyer’s behalf, at up to 6% of the new loan amount — double whata conventional loan allows.

Ultimately, you’ll want to talk to a local credit union or trusted mortgage broker to find out which option is best for you and your financial situation.

And remember: No matter which loan you start with, you can always refinance when interest rates drop and make extra principal payments to shorten your loan term. That’s how you’ll save the most money in the long run.

So if home ownership is your dream, go on and get that mortgage.

Jen Smith is a staff writer at The Penny Hoarder. She gives money-saving and debt-payoff tips on Instagram at @savingwithspunk.

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