Conventional vs. FHA Loans


Now that you have an offer accepted on your dream home, it's time to turn your attention back to the financing that will help you make the purchase a reality.

Time will be of the essence, so you'll want to meet with your mortgage professional right away. There may be several loan programs available to you, depending upon your income, credit and down payment. Here is a brief overview of the two most popular types of mortgage financing available:

Conventional (Fannie Mae and Freddie Mac)

Conventional loans are loans made by private parties and non-government lending institutions without any government insurance or government guarantee against loss for the lender. Conventional loans that conform to the eligibility guidelines for purchase by Fannie Maeor Freddie Mac are considered conforming loans. Fannie Mae and Freddie Mac have maximum loan limits for loans they will purchase, which is adjusted annually.

Conventional loans can be insured or uninsured. Generally, a conventional loan of up to 80% of the property’s value will be made without private mortgage insurance. To compensate for the greater risk when the loan is above 80% of the value, some lenders will charge higher interest rates. However, most require that the loan be insured by a private mortgage insurance company.

Private mortgage insurance (PMI) is an insurance policy issued to provide protection to the mortgage lender in the event of financial loss due to a borrower’s default. In the event of a default, the insurance company will either pay off the loan or let the lender foreclose and pay the lender for much of its losses.

The borrower pays a mortgage insurance premium, either at closing, as a lump sum covering the life of the loan, or by paying the first year’s premium at closing and then paying annual premiums as part of his mortgage payment. The amount of the premium is a percentage of the loan amount based on the borrower’s down payment. The annual premiums and the insurance stop once the loan is paid down to 78% or 80% of the value of the property at the time the loan was taken.

FHA

The Federal Housing Administration (FHA) is a division of HUD. FHA loans are loans meeting FHA program criteria made by approved lenders. FHA insures those lenders against loss in the event of default on those loans. The insurance allows lenders to make loans with more flexible underwriting guidelines. (higher LTV, lower credit scores, etc.)

FHA funds the insurance from a mortgage insurance premium (MIP) charged to the borrower. Most FHA mortgages require payment of an upfront mortgage insurance premium (UFMIP). For most mortgages the premium is 1.75% of the loan amount, payable at closing or added to the loan amount and financed. The UFMIP is nonrefundable (except to the extent that a portion may be applied to the UFMIP of another FHA-insured mortgage within three years).

In addition, most FHA loans require payment of an annual mortgage insurance premium, payable monthly as part of the mortgage payment. This premium is based on the loan program, the loan term and the loan-to-value ratio.

The most popular of the FHA loan programs has been the 203b program. This program helps finance the purchase of a one- to four-unit family home that the borrower intends to occupy as his residence (i.e., move in within 60 days after closing and stay in the property for 12 months), using a 15- or 30-year loan and a cash investment of as little as 3.5% of the lesser of the property value or the purchase price.

Some or all of the cash investment can come from a gift from:

  • an immediate relative.
  • a labor union or employer.
  • a government agency or public entity.
  • a nonprofit charitable organization.

The gift donor, and the source of the gift donor’s funds, may not be a person or entity with an interest in the sale of the property (e.g., the seller, the real estate agent or broker, the builder, or an associated entity). A gift from any of these sources would be considered an inducement to purchase and would have to be deducted from the sales price.

Therefore, a seller could not give the buyer a gift directly or channel funds through a nonprofit charitable organization to assist the buyer in acquiring the funds for his down payment. FHA will allow the seller to contribute up to 6% of the purchase price toward the buyer’s actual closing costs, prepaid taxes and insurance, discount points, buy down fees, mortgage insurance premiums, and other financing concessions, but nothing toward the down payment.

FHA loans are not restricted to first-time homebuyers or those with low- or moderate income. Anyone who can meet the liberal underwriting criteria can obtain a FHA loan. The borrower’s income and employment must be verified and his credit history will be analyzed. FHA also accepts nontraditional mortgage credit reports on borrowers lacking the types of trade references that normally appear on traditional credit reports provided the information is verified and documented. These may be a substitute or a supplement to a traditional credit report.

Such reports include as credit references rental housing payments, utility payments and other bill payments (insurance, child care, phone, auto leases, etc.)

A borrower can qualify for an FHA loan with monthly payments for principal, interest, and property taxes and insurance (PITI) of up to 31% of his gross monthly income and total monthly debt up to 43% of his gross monthly income.

Sources of regular income not subject to federal taxes (e.g., certain types of disability and public assistance payments, social security income and military allowances) and child support income can be grossed up by 25% in calculating the borrower’s income for qualifying purposes. This means the amount of continuing tax savings attributable to that source may be added to the borrower’s gross income. When a borrower does not have to file a federal income tax return, the tax rate used is 25%.

On the other hand, FHA requires that gross rental income be reduced by 25% or a percentage developed by HUD’s jurisdictional HOC (Homeownership Center) for vacancies and maintenance.

Your mortgage lender will be able to help you decide which loan program will work best for you.


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