FHA or Conventional Mortgage: Which is better for you?
The dreaded 20% down payment has made many a renter worry that they’ll never be able to buy a home of their own. Saving up one-fifth of the cost of an entire house can take years, especially while you’re paying rent, utilities and a million other expenses.
There are advantages to waiting until you have 20% to put down. But in some cases, buying with a smaller down payment may be in your best interest. Fortunately, conventional loans are becoming more readily available with a smaller down payment, and the Federal Housing Administration, or FHA, backs mortgages for qualifying buyers with down payments as low 3.5%. Let’s look at the options.
Conventional vs. FHA
Because some lenders offer both conventional and FHA loans, homebuyers are often confused about who exactly is lending them money. In both cases, the financial institution is the lender. The difference is that FHA mortgages are insured by the government. The FHA does this to encourage lenders to issue more mortgages to qualified buyers for whom a conventional loan is out of reach.
The size of the loan matters, too. FHA loans must be under a certain dollar amount, which varies by county. Conventional loans offered by lenders like Bright Star Credit Union also have to come in under a cap, and anything higher is considered a jumbo mortgage.
Paying the smallest down payment possible makes sense, right? Not necessarily. For one thing, a larger down payment provides some insulation against market fluctuations. If your down payment is quite small, a downturn in the real estate market in the first few years might leave you owing more than your home is worth. That can make it hard to sell the house without taking a loss if you need to move.
Larger down payments also reduce the total amount you’re borrowing. As a result, a bigger down payment will mean you’re paying interest on a smaller loan balance. Both your monthly payments and the long-term costs of carrying the loan will be smaller if you pay a greater portion of the home’s price up front.
But smaller down payments make home ownership accessible to many people who otherwise wouldn’t be able to buy a house or condo, or would have to wait years longer to get there.
Many lenders offer conventional loans with down payments below 20%, but the smaller the down payment, the higher the buyers’ credit score needs to be — and the higher the interest rate that they’re likely to face. But the down payment that FHA borrowers have to pony up also depends on the strength of their credit, so the differences between the two types of loans may not be as significant as some people think.
If you put down less than the recommended 20% for a conventional loan, your lender will most likely require you to pay for private mortgage insurance, or PMI, on top of your monthly mortgage bill. Your smaller down payment makes you a riskier bet for the lender. The insurance helps the lender recoup more money if you default on the loan.
Now for the bad news. With FHA loans, you have to pay an up-front premium just to close the deal. You must also keep on paying monthly mortgage insurance premiums until the loan is paid off or refinanced. This is a major drawback to FHA loans.
Qualifying for a loan
Whether you’re applying for a conventional loan or an FHA loan, you have to prove that you can afford the required monthly payments. Your lender will require proof of income and will want to see documentation of all your major assets and debts. The lender will also check your credit score, but don’t despair if your credit is less than perfect. The FHA has a minimum credit score requirement of 500, while most lenders require a credit score of at least 580.
How to choose
There are as many types of loans as there are types of buyers. The right decision will depend on your circumstances. If your down payment is on the small side and your credit score is okay but not great, an FHA loan might be the best choice. A conventional loan may be a better bet if you bring either a substantial down payment or good to great credit to the table.
If you’re unsure which route to take, sit down with your lender and look at the options. You’ll be picking up the keys in no time.
Virginia C. McGuire, NerdWallet