Comparing Conventional and FHA Loans

Are HUD Insured Mortgages Better than Conventional Loans?

Home buyers are often faced with a lot of confusing choices when they are shopping for a loan. There are conventional loans, subprime loans, FHA loans, fixed rate loans, adjustable rate mortgages(ARM), interest only loans and more. Choosing a loan most suited to one's needs can be quite difficult if the borrower is not familiar with all the banking and mortgage lingo.

First-time home buyers are often advised to go for FHA loans. While FHA loans do have a lot of advantages over conventional loans, especially for first-time home buyers, in some instances conventional loans will work just fine. It is always a good thing to compare the advantages and disadvantages of each type of loan before choosing a particular type of loan.

Interest Rates

FHA loans are insured by HUD, which means that in the event of a foreclosure, FHA will take over the loan. Since the loans are insured and hence carry less risk, lenders are often willing to negotiate better interest rates. FHA loan rates are often comparable with that of conventional loans and generally costs no more than one-eighth of a percentage point more than a conventional loan.

Credit Score

Conventional loans depend heavily on the credit score of a person for credit qualification and for determining the interest rates. Lenders of FHA loans are more concerned about the ability of a person to repay his/her loan. For FHA loans credit qualifying criteria for a borrower are not as strict as conventional financing. A person without a credit history or a less than perfect credit history can still qualify for a FHA loan. Borrowers can qualify for a FHA loan two years after a bankruptcy and three years after a foreclosure.

Down Payment

Conventional mortgages require a down payment of at least 5% while a FHA loan requires a minimum down payment of 3.5%. Even that 3.5% can be gifted by a parent, employee or a non-profit organization, which means that you can buy a buy a home with as little as 0% for down payment.

Mortgage Insurance

For conventional loans with less than 20% down payment require private mortgage insurance which must be paid monthly. FHA loan borrowers have to pay an upfront insurance premium which is 1.5% of the loan amount, which is due at closing. There is an additional 0.5% renewal premium paid annually.

The upfront insurance premium (for a $200,000 loan the insurance premium will be $3000) is one of the biggest disadvantages of an FHA loan. Although it is possible to add the premium amount to the loan amount, it is still a considerable amount. Also unlike private mortgage insurance the annual mortgage insurance premium isn't canceled when the home owner's equity reaches 22% of the principal amount.

Prepayment Penalty

Most conventional loans carry a prepayment penalty but FHA loans do not have any prepayment penalty. This feature is especially useful when the home owner needs to sell his home or refinance.

Assumable or Not?

FHA loans are assumable, meaning that the loan can be transferred to the new owner in case the borrower sells his house. If the new owner satisfies the credit standards for the loan he can take over the FHA loan without the additional cost of obtaining a new loan.

Loan Limits

Another disadvantage of FHA loans is that there is a cap on the maximum loan amount. This FHA loan cap is adjusted annually and will vary from region to region. Conventional loans do not carry such loan limits. This was one of the major reasons why FHA loans lost their popularity during the years from 2000 to 2006 when FHA loan limits could not keep up with the soaring home prices. The recent recession and the subsequent slump in the real estate market has once again made FHA loans an attractive option. The current FHA loan limits can be viewed at the HUD site.

For borrowers with excellent credit report and a stable job who also saved enough for down payment, conventional loans are much better than FHA loans but for home buyers who do not have a significant amount for down payment FHA loans may be a better option.