Conventional Loan or FHA, Which Is Better?
From a guidelines standpoint there are many relatively minor differences between the Conventional loan and an FHA mortgage, but there are three very specific scenarios that only FHA will accept.Since 2008 FHA has been the predominant loan choice for home buyers wanting to put as little down as possible. The 5% down payment required of Conventional loans was often an obstacle and the FHA loan almost always had the lower payment and thus was the obvious choice. But the re-emergence of the Conventional loan 3% down program and recent increases to FHA’s mortgage insurance premiums has made comparing the two loan programs important.
FHA gives favorable treatment to situations in which you add a close relative to your application to help qualify if your income does not meet the guidelines. Mistakenly described as “co-signing” a co-borrower is 100% responsible for the new mortgage payment. However, the Conventional loan program does not give you the full benefit of your co-borrower’s income. FHA does. For example, if your income is $2,000 per month and your co-borrower’s income is $2,000 per month, FHA analyzes your application with $4,000 per month of income. They also consider all the debt of your co-borrower. The industry calls this “blended debt ratios.” The Conventional loan program won't give you the full benefit of that extra income for qualifying. For this reason an FHA loan is almost always used when a parent or family member is co-borrowing with the applicant whose income does not meet guidelines.
The second significant scenario that favors FHA is when an applicant’s debt payments are over 43% of their gross income. The typical Conventional loan will cap the debt ratio to about 45% but there is no such limit with an FHA loan and I've seen them go as high as 55% - not that spending that much is a good idea but in some cases it does make sense. Maybe there is a car loan with a $300 payment that will be paid off next year or a second job that you haven’t had long enough and aren't able to use the income for qualifying. That difference in debt ratio has a huge impact on the loan amount you can qualify for. For a quick example, if your combined income was $80,000 a year, an extra 7% in debt ratio would allow you to increase the home you qualify for by about $70,000. And maybe more – that was just a rough calculation. In most neighborhoods that’s a pretty significant price increase.
For most first time home buyers the biggest obstacle to homeownership is saving up enough money for the down payment. Often times there are family members who are willing to help you by gifting some or all of the down payment and closing costs. The Conventional loan program allows you to use a gift, but only after you have used at least 3% of your own money. If you were purchasing a $200,000 home that means you would need to have at least $6,000 of your own money. The FHA loan program allows 100% of your cash needs to be in the form of a gift from a close relative. In addition, a Conventional loan is going to require that you have two months of cash “reserves” left in your bank account after closing escrow. That means that in addition to your 3% down payment, plus the closing costs, you now need an additional $2,000 to $3,000 left in your account to meet the “reserve” requirement. FHA has no such requirement.
There are many qualifying differences between the two loan programs but these are the ones that we see almost every month in our practice. But FHA’s insurance cost has increased so significantly that you need to make sure you are have the information on both programs so you can determine which program is best for you.
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