Should I Get an FHA or Conventional Loan?

It is necessary to begin with some simple definitions, which will demonstrate one of the most glaring differences between these two ways to finance a home:

Differences Between FHA and Conventional Home Loans

An FHA loan is insured by the Federal Housing Administration. This organization is controlled by the Department of Housing and Urban Development (HUD) an office of the federal government. Prospective homebuyers and homeowners can apply for these home loans with any mortgage lender which is approved to originate FHA loans.

A conventional loan is void of any repayment guarantee by  a government  office. For the most part, these loans  use  private mortgage insurance (PMI), to safeguard against payment default by the borrower for loan amounts in excess of 80% of the property value.  Therefore, if the lender gives a borrower a 95% loan based on the property value, the PMI insures them for the 15-percent.

In California, Nevada, Arizona and other states where the conventional loans are not being repaid and the loan amounts are now more than the value of the property, also known as underwater, conventional loans have taken a step back in favor of FHA loans since they are insured by the government.

Both Conventional and FHA loans have their advantages and disadvantages. It's comes down to selecting the right loan for your particular scenario. Here is a quick list about some of the differences between the two programs

FHA vs Conforming Loan

• FHA credit score guidelines are not as strict as the rules are for a Conventional Loan where it is very credit driven  as borrowers need score above 680. FHAcan be as low as 580.
• FHA requires a smaller down payment for a home
• FHA - 3.5% down
•  Conventional - 5% down

• FHA permits borrowers to use a gifted down payment while conventional does not
• FHA mortgages can be assumed by a subsequent qualified buyer. Conforming mortgages do not have this option for new buyers. This is very advantageous of times of rising interest rates
• FHA loans have  higher debt-to-income ratios up to  55%  while conforming loans (including MI) are capped out at 45%;
• FHA-insured homes must have no inspection issues or defects while homes with conventional loans from Fannie/Freddie may include minor defects.
• FHA mandates mortgage insurance on all loans. Conforming loans have no such requirements.
• FHA mortgage insurance runs for at least 5 years. Conforming mortgage insurance is only necessary until the loan-to-value reaches 78% for the subject property.
• FHA will approve a loan for borrowers with extenuating circumstances who had a bankruptcy discharged 2 years ago. In contrast, Conventional loans demand 4 years, if not more, to be approved for financing

So which is better, an FHA or Conventional Loan?

Borrowers must review everything completely. However, as a rule of thumb:

1.)  For borrowers who have less than 5-percent for a down payment or minimal equity to refinance and less than a 680 credit score,  FHA slides more into favor as the better choice. (FHA Loan)

2.)  For borrowers who can put  5-percent plus, then the applicant should look at each loan side-by-side. In some instances, a mortgage broker or lender will encourage you that an FHA is better or a conforming loan is better, without providing any valid reason why they take that position. When that happens, review the interest rate, all the fees on the good faith estimate, and your full monthly payment. A conventional loan could appear to be reasonably inexpensive, or very costly based on the amount of equity and your credit score. (FHA for credit scores < 680 and Conventional for higher credit scores )

3.)  For borrowers who have 20-percent in equity or in the form of a down payment, now you can confidently dismiss choosing an FHA loan as an option. The reason is because a conforming loan for a homebuyer or homeowner will avoid the mortgage insurance premiums, while an FHA will still require the condition.

Ok, so now you think you made a decision on which type of loan. Well, the only remaining issue is that many real estate agents and even banks selling their foreclosed properties prefer "all-cash" deals, conventional, and then FHA financing when there are multiple offers on a property.  

Banks and realtors think it will simply be easier possibly due to more paperwork and that FHA insured homes cannot have defects or minor issues that a conventional loan will accept.  There used to be a lot more setbacks coupled with  FHA loans years ago, but nowadays they are more or less on an even scale.