The two most common home loans in America are the FHA and Conventional Loans. Find out which of these may be best for you based on the pros and cons of each loan program.
Welcome to Part 1 of a two-part video series where I break down the benefits and disadvantages of the FHA Home Loan and Conventional Mortgage Loan programs.
In this video we will focus on the FHA Loan.
The Federal Housing Administration or (FHA) loan is insured by a government agency created by the National Housing Act of 1934. The agency was formed to make home buying more affordable for many people who struggle to save the 5% - 20% down payment required for a conventional loan. The FHA does not lend money, instead it backs qualified lenders in case the borrower defaults on the mortgage. This mortgage insurance provides the security that qualified lenders need in order to take on a riskier loan.
The FHA loan offers many benefits. To start, the loan only requires a low-down payment of 3.5%. The minimum down payment required for most conventional loans starts at 5%. That 1.5% difference may not seem like a lot, but when you consider the average purchase price of a home here in Phoenix at approximately $250,000 that measly 1.5% turns out to be the difference of $3,750. That’s a significant amount of money that can now be used towards other expenses such as the closing costs for the home.
Speaking of closing costs, they can be given as a gift along with up to 100% of the down payment for the house. This allows a family member or an extremely awesome friend to pitch in on the up-front cash requirement needed to buy a house.
FHA Loans are also much easier to get approved for than conventional loans. This goes back to the FHA loans being insured by the government. Because the government is insuring part of the loan lenders can take on additional risk while still providing competitive mortgage interest rates that are often lower than conventional loans.
The most significant of the reduced risk advantages is the ability to reduce the standard conventional loan limit minimum credit score from a 620 down to a 580 for FHA Loans.
Another risks advantage is the FHA is more lenient on maximum debt-to-income ratios with a standard Debt to Income ratio of 45% and can be as high as 50% in some cases. This calculation is the percentage of your monthly income minus monthly obligations and plays a major determining factor in how much you can borrow.
There are even down payment assistance programs and first-time buyer grants you can use for FHA.
Sounds like a great program…So what’s the catch?
The FHA Loan is great, but just like anything it does come with some disadvantages.
To start, the maximum loan limit is only 65% of what you can get with a conventional loan. In Maricopa County the maximum loan limit for a single-family home using an FHA Loan in 2018 is $294,515.
The biggest disadvantage is the Mortgage Insurance required for the LIFE OF THE LOAN. With a Government loan it is referred to as a mortgage insurance premium, or (MIP). The mortgage insurance premium is an annual fee added onto a loan payment to insure the mortgage against foreclosure. This is how the FHA can pay the lender in the event a property is foreclosed on. FHA MIP fee varies but it is typically 0.85% of the loan amount divided into 12 equal monthly payments over each year. Both FHA and Conventional mortgages with less than a 20% down payment require mortgage insurance.
However, there is also an Up-Front Mortgage Insurance Premium when purchasing a house with an FHA Loan currently set at 1.75% of the loan value due at closing. The borrower will then have a mortgage amount of the base loan amount plus the cost of the upfront mortgage insurance premium. For example, a $250,000 FHA loan at 1.75% would yield an Upfront Mortgage Insurance Premium of $4,300 rolled into the $250,000 home loan to bring the total of the loan to $254,300.
Another thing to note is an FHA loan must be used for the purchase of the borrower’s primary residence. You may not use an FHA loan for the purchase of a second home or investment property. Investors seeking to purchase additional properties beyond their primary residence will need to use a conventional loan or pay cash.
The FHA loan also has much stricter guidelines for appraisals and even restricts buyers looking to purchase a condominium to seek only FHA approved complexes.
To conclude, FHA loans are the most popular type of mortgage used by first-time home buyers. They are often the only option for borrowers with high debt-to-income ratios and low credit scores and to get rid of FHA premiums, you must refinance the loan. While conventional loans are cheaper than FHA in the long run, FHA is cheaper up-front because they require a low-down payment.
That brings us to the end of Part 1 of this video series explaining the benefits and disadvantages of the FHA Home Loan.
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