Lots of people ask us whether it’s best to get a Conventional mortgage – one that meets the minimum requirements for purchase by Fannie Mae or Freddie Mac – or apply for an FHA loan.
There are advantages and disadvantages to both, so the answer is usually, “It depends!”
The first thing to note is that here in Orange County, many mortgages are “Jumbo” loans, which means that the loan amount is above the conforming limit for conventional mortgages. Underwriting standards for Jumbo mortgages vary by lender but are generally stricter than they are for smaller loans that conform to Fannie Mae and Freddie Mac standards.
If it’s clear you’re going to need a Jumbo loan (over $726,525, the maximum conforming loan amount here in Orange County), and you’re planning on putting up a relatively small down payment, call us.
Otherwise, read on for the key differences between FHA and Conventional mortgages and how they affect Orange County homebuyers.
Years ago, it used to be if you didn’t have 10% to put down on a home, you didn’t have much choice: you had to go with an FHA loan, which only requires a down payment of 3.5 percent. FHA also has more lenient requirements about where you get your down payment. VA loans have a down payment requirement of zero, but not everyone can qualify for a VA loan.
But today, it’s possible for first-time homebuyers (those who haven’t owned a home in three years or longer) to get a conventional loan with as little as 3 percent down, via a Conventional 97 loan. The problem for us in Orange County: Conventional 97 loans are capped at $484,100. That loan amount buys some beautiful homes in other places, but it doesn’t buy much in here, where the average house is selling for roughly twice that.
For those with good credit but limited down payment funds available, we can often put together a piggy-back loan package that enables borrowers to get conventional financing with lower down payments. In some circumstances, the HomeReady program works well, too.
Credit scores make a difference, too. The FHA is generally much friendlier to borrowers with fair-to-middling credit – and FHA lenders will even look at people with terrible credit but no bankruptcies in the last 12 months (24 months for Chapter 7 bankruptcies). The minimum credit score for an FHA loan with 3.5% to 9.99% down is 580. But if you can come up with a down payment of 10% or more, some lenders will consider applicants with FICO scores as low as 500 – though in practice, you have a much better chance of success with FICO scores of 620 or better.
Take a look at these graphics:
Graphics: Ellie Mae
These graphs reflect the percentage of home loans for purchases that were actually approved in January of 2019 – the most recent month available at press time. The data comes from the Ellie Mae Origination Insights Report – one of the most closely-watched reports in the mortgage industry, and reflects thousands of mortgages nationwide.
In the first graph, you can see that you most certainly don’t need a perfect score. Only about 13% of borrowers had scores in the heady 800+ category.
But look at the difference between the distribution for conventional loans and FHA loans, below:
As you can clearly see, people with credit challenges are having much more success with FHA loans than they are with conventional mortgages. The fat part of the FHA bell curve is far to the left of that for conventional mortgages.
For FHA loans, 66 percent approved applicants had FICO scores below 700. For conventional mortgages, that figure was just 18 percent. And more than 30 percent of those approved for FHA loans in January were in the low 600s or below. 1 in 20 had scores in the 500s (the minimum FICO score for the FHA program is 520, though lenders commonly overlay higher standards for their own portfolios).
So if you have a credit score in the low 600s or below, chances are good you’re looking at an FHA loan rather than conventional.
Likewise, people with credit scores above 800 comprise less than 2% of those approved for an FHA mortgage.
What does this tell us? Their behavior tells us two things: Those with excellent credit get better deals, overall, going conventional than with FHA. Many of those 2 percent of FHA mortgage recipients with credit scores of 800 or above probably simply didn’t have the down payment on hand when they applied, or they, too, would have gone conventional.
Why do people with good credit and at least 10 percent in down payment money prefer to go conventional?
1. They get better interest rates, all things considered.
2. They get a better deal on mortgage insurance.
What’s mortgage insurance?
We’re going to do a future blog on this subject very soon, but in a nutshell, primary mortgage insurance, is insurance you buy to protect the lender against default. You don’t get a benefit out of it, other than a lender who is more willing to lend. But the premiums are paid by the borrower. That’s you!
Generally, you need to buy mortgage insurance on any FHA or conventional loan with a loan-to-value ratio (LTV) of 80 percent or greater. That is, if you’re borrowing 80 percent or more of what the property is worth, your LTV is 80 percent or greater, and you’ll have to buy it to get a loan from a traditional lender.
For FHA loans, the amount you pay is called MIP, or mortgage insurance premium. For conventional loans, they call it PMI, or private mortgage insurance.)
Conventional lenders let you cancel mortgage insurance once your LTV gets to 78 percent or below. At 78 percent, the lender thinks their risk is generally covered, because if you default, they can foreclose on the property and cover their loss. They’re actually required to cancel it once you have 78 percent equity in the home, which you can build either by paying down the loan, or via increases in the home’s value.
But with FHA loans applied for since June 3, 2013, if your down payment was less than 10 percent, need to keep paying MIP for the entire life of the loan – that is, until you pay it off entirely, or until you refinance. If you put down 10 percent or more, then your MIP lasts for 11 years, or until you refinance.
These PMI premiums can be substantial: As much as 1.05% of the loan. So it’s a good idea to be rid of it as soon as you can – and that’s a big part of why those with great credit who would have no problem qualifying for either a conventional or FHA loan overwhelmingly choose to go with a conventional mortgage.
While nobody loves paying MIP or PMI, it’s not the end of the world if it helps you get into the home that’s right for you – and building equity in your home right away, which is better than renting.
When house prices are rising – and they usually are – most people pay PMI for just a few years before it’s cancelled, or if they are in an FHA loan, they’re able to refinance out of that loan to rid themselves of the MIP payment.
Don’t let the tail wag the dog: PMI and MIP by themselves should not dissuade you from buying the home that’s right for you!
FHA loans require a “funding fee,” generally between 1% and 3% of the loan amount. This is also generally true of VA and FDA loans. Conventional loans don’t require an up-front funding fee.
The less personal debt you have, the better your chances of qualifying for the best home loans.
For an FHA loan, you’ll usually want your DTI (debt-to-income) ratio to be not more than 31% for housing-related debt, and not more than 43 percent for total debt, though there are exceptions. If you’ve got proven cash reserves, income left over each month after all your expenses are paid (residual income), job security, some additional documentable income not reflected in your effective income, decent credit (at least 580) or a compelling combination of the three, some FHA lenders may lend with a housing-related DTI as high as 40 percent and a total DTI of as high as 50 percent. There have been a few cases of FHA approvals with DTI as high as 57 percent, but those are rare. If you have a very high debt-to-income ratio, although not true in every case, chances are good you’ll need to focus on FHA loans.
On the conventional mortgage side, Fannie Mae recently loosened its debt-to-income requirements for conventional loans. In late 2017, they increased their maximum total DTI requirement from 45 to 50 percent, though those at the higher end of the DTI spectrum will need very good credit scores.
But the best approach is usually to work on reducing personal debt – particularly reducing monthly payments.
Even better, call us at (949) 494-4861, or fill out an online application, and let us go over your individual scenario with you. Even if you’re close to or slightly over the DTI requirements, there may be other factors that can assist you in getting a mortgage. Chances are excellent we have a loan program that suits your needs.