FHA or Conventional?
For many borrowers, there is a lack of knowledge when to use FHA or conventional loans. Often the lender decides for the borrower at the time of application. The lender might decide to put a borrower in the program generating the highest commission. It may or may not go well; the borrower may be in the wrong loan program. Or the borrower should not even be applying for a loan in the first place. Remember, by law the lender cannot try to dissuade you from a loan application, even if the lender knows you will be denied and it might cost you a lot of time and money to learn that experience. Winning Mortgage, Winning Home provides your guide.
Here are some decision points on which loan program a borrower may wish to use.
If your credit score is under 500, don’t try to get a home loan from a lender for either an FHA or conventional loan. You won’t qualify. Another option might be seller financing which usually entails agreeing to pay an inflated purchase price and a high rate of interest. Think of this as the equivalent of a used car “we tote the note” sales lot. The seller expects to collect a number of payments, take the car back and sell it to someone else later. You effectively rent, not own. Getting clear title and ownership can be a problem.
Low Credit Score Borrowers
If your score is between 500 and 580, FHA is about the only option. However, credit unions set their own requirements and may be an alternative. Many target helping credit impaired borrowers. No matter which option you choose, it will be very expensive. Renting is likely a better option until your spending habits, income and credit improve. At this level FHA programs require a 10% down payment. They also require a DTI of less than 43% and mortgage insurance monthly plus an upfront mortgage insurance payment> You must prove a valid social security number, steady income and employment. If your credit is under 580, are you likely to have a 10% down payment in the bank? Probably not, but it can happen. FHA has a somewhat competitive interest rate, but you’re stuck with mortgage insurance for the life of the loan.
If your score is above 580, an FHA loan with only a 3.5% down payment is available. This also requires a DTI of less than 43%, mortgage insurance monthly plus an upfront mortgage insurance payment, valid social security number, steady income and proof of employment. Again, FHA has a somewhat competitive interest rate, but you’re stuck with mortgage insurance for the life of the loan.
Some people actually have no credit score. Having no credit cards and not borrowing money might lead to this result. Having no credit is better than having bad credit!
FHA is NOT Your Lender
The FHA mortgage program you likely would use is a 203 (b) program. The FHA uses the numbering for the sections in the law that govern the program. FHA will not be making you the loan directly. FHA only guarantees the payment of principal and interest to the actual lender. There are other loan programs 203(k)-rehab/renovation loans, Title I loans-mobile homes/manufactured housing, and HECM-reverse mortgage. A few other specialized programs exist but they don’t exist for purchasing homes.
Rules on down payments with FHA mean the borrower must prove the source of the down payment. The lender, the seller and other interested parties to the transaction are prohibited from providing any down payment assistance. However, a seller may provide up to 6% of the purchase price to the buyer to go towards closing costs. Since money can move around, cash strapped borrowers many times go this route. The warning is that the buyer generally over pays by 6% more for the home in order for the seller to make that contribution. That risks an appraisal not being high enough for the loan and a waste of time and (non-refundable) money.
The lender will also be on the lookout for anything unusual in the borrower’s cash situation. Another loan taken out, a fake “gift” from a relative, a large unaccounted for deposit in the bank. If a lender is able to provide sufficient justification, the DTI ratio may be able to go as high as 50%. However, anyone with a DTI of 50% is asking for a default. This is one reason FHA mortgages are 3 times as likely to default as conventional mortgages. Again, the effect acts like being a renter for a large number of these borrowers, but with the end being foreclosure or bankruptcy and bad credit. It is better to wait to improve your situation.
Conventional Loans
Once a credit score level of 620 is reached, more options emerge for the borrower. At this point, a loan officer correctly asks the question FHA or conventional. Fannie Mae and Freddie Mac (conventional mortgages) become possible. For the most part, these loans don’t have LTVs over 95%. Although in some instances LTV may go up to 97%. At this LTV level though, Fannie Mae and Freddie Mac tack on many, many charges for risk. Mortgage insurance premiums peak with this high of an LTV, so the cost factor should be weighed. Until the borrower has a credit score of 640 or 660 or more, FHA may be the better option.
Above the 660 level, FHA rarely offers optimal mortgage. But every borrower’s situation differs. The deciding factor many times comes down to how long the home will be owned. Because of the combinations of upfront closing costs, interest rates, and private mortgage insurance, the answer becomes more bespoke. In almost any situation where the LTV comes in at 80% or less, FHA should not be considered.
Other Types of Loans
VA loans can go to 100% LTV and have other advantages. As a veteran, make sure you are talking with a VA expert as a Mortgage Loan Officer. The VA has no official credit score requirement for borrowers. However, VA also does not make loans directly, only guarantee them. Lenders generally set a minimum score anywhere from 580 to 660. This may be the best loan for veterans with lower credit scores and low levels of funds available for a down payment. Higher credit worthy veterans will likely find conventional mortgages are the best option. Because of the time to make a VA loan and the special appraisal requirements, these loans frequently fall to the bottom of consideration if a seller has multiple offers from which to choose.
Buying a rural home and have limited income? USDA loans may be the best option. But they have a limit on how much borrowers can earn relative to the area median income.
First time buyer? Refinancing? Have kids? Need to refinance for college? Pick up a copy of Winning Mortgage, Winning Home for more insights.