When FHA May be a Better Loan Than the 5% Down Conventional Loan
When FHA May be a Better Loan than the 5% Down Conventional Loan
As you know, based on our prior dealings, I spend a good deal of time with my customers on pre-purchase, pre-financing mortgage consultation in order to assist you in deciding which is the best loan suited for you. Although not everyone has the ability to finance with a 20% down Conventional mortgage, it generally provides the best terms and the lowest annual percentage rate (APR) that a borrower can obtain for their mortgage financing (in some cases, the VA loan may be better). There are instances however where FHA Loans are superior to 5% down Conventional Loans. If you know of someone getting into the housing market soon that may benefit from this information, please feel free to pass along this brief synopsis.
Underwriting guidelines are much more lenient for FHA loans than Conventional loans. For quite some time, mortgage lenders have been running their borrower’s input data, which is linked to their credit reports through an AUS system. AUS is an acronym for Automated Underwriting System, and it acts as a type of brain or artificial intelligence that has the ability to determine and analyze each mortgage applicant’s risk factor. The AUS system will almost always be more forgiving for an FHA borrower than a Conventional borrower. This can be caused by one or more of the following risk factors: lower credit scores, thin credit, shorter waiting periods after bankruptcies or foreclosures, lack of savings combined with no rental history, gifted money vs. saved money, lack of liquid reserves after closing, time on the job, high debt ratios, etc., etc. Many declined loans that we take over from other lenders and close were initially taken, processed and declined as a Conventional loan when they probably should have been taken as FHA loans, to begin with.
Increased Purchasing Power:
Not only are AUS systems more flexible for approving a borrower for FHA financing compared to Conventional financing, but AUS systems will also generally approve a borrower for a much higher debt ratio. Typically, a 5% down Conventional AUS finding will cap out a borrower around a 45% debt ratio. It would not be unusual for the same borrower to receive an AUS “Approve/Eligible” up to a 57%-58% debt ratio by running it as an FHA scenario. Depending on the borrower’s income, the difference between capping out at a 45% debt ratio, and a 58% debt ratio can make as much of a difference as getting approved between a $225,000 home or a $300,000 home. NOTE: We are not advocating that a home buyer overextend themselves and be strapped to a house payment that would be difficult to afford. There are many instances, however, where there is another income available that the lender is not able to use in qualifying that would make the 58% debt ratio very affordable to the buyer.
Lower Down Payment:
It goes without saying that a 3.5% down payment for an FHA buyer will need less money to purchase than the 5% down Conventional buyer. This 1.5% difference between the two programs accounts for a $3,000 difference in down payment based on a home selling for $200,000. As with eligible conventional borrowers, eligible FHA buyers can apply for MSHDA’s $7,500 down payment assistance to help cover closing costs, pre-paid escrows, and a significant portion of the required 3.50% down payment.
Lower Monthly Payments for Less than Perfect Credit:
Compared to a 5% down conventional loan, the FHA loan will typically provide lower credit buyers with a lower monthly payment. Because conventional loan pricing is much more sensitive to credit scoring, a borrower with lower credit scores should receive much better interest rate offers for FHA loans compared to conventional loans. Additionally, the mortgage insurance rate for FHA loans is the same for everyone, whether they have a 580 credit score, or an 820 credit score. Conventional PMI rates, on the other hand, are based on risk. Therefore a low down payment, lower credit score, Conventional borrower will have a much higher monthly mortgage insurance escrow added as part of their monthly payment compared to that of an FHA buyer. As a Conventional buyer’s credit score increases, their interest rate offers and PMI rates will improve faster relative toa borrower’s FHA interest rate offers. Simply put, an FHA borrower isn’t penalized as much for having lower credit scores.
For an explanation on Mortgage Insurance: PMI & Other Types
I have provided two loan estimate examples using a borrower with a 679 credit score for a 3.5% FHA Loan and a 5% Down Conventional Loan based on a $200,000 sales price:
FHA Loans are easier to Refinance:
This is because FHA does not require income to qualify, nor an appraisal. As long as there is no extra cash-back and the interest rate is going down enough to provide the homeowner a net tangible benefit, that is good enough to satisfy FHA’s streamline refinance guidelines. The FHA streamline refinance closes easily without requiring extra paperwork or hoop jumping.
FHA Loans are Assumable:
Many people may not know this. The assumable feature of an FHA mortgage means that the homeowner can sell their home without having to pay off their mortgage, providing the new buyer taking over the existing mortgage qualifies and is approved to do so. Selling on “formal” assumption gives the homeowner a “Release of Liability” and can provide some real benefits to a Seller. For example, if a Buyer locked in today at a 30 year, 4.75% FHA mortgage, and paid for 5 years before selling, a future qualifying buyer could pay the difference in selling price and existing principal balance, and assume (take over) the existing 4.75% mortgage! Think about the advantage this seller would have with a 4.75%, 25-year remaining term mortgage that stayed with the house if interest rates were to get up into the 6% range, or higher in the future.
It should also be noted that repair requirements on FHA loans ain’t what they used to be. In fact, the majority of our FHA appraisals are “AS IS”, and do not require repairs. FHA appraisal requirements are to satisfy safety and health concerns. Furthermore, FHA appraisers will comp a home the same way they comp a home for a conventional appraisal. There is no difference in the value that the same FHA appraiser would assign to a property if he or she were appraising it as a conventional. Value is value. The FHA loan is not a 2nd class mortgage, and some FHA buyers are more solid buyers than 5% down conventional buyers. There is no dispute in this among experienced and knowledgable loan officers. True, FHA loans are not always the best method of financing, and it is my opinion that a buyer with higher credit scores should choose a 5% down conventional loan over an FHA loan in most cases, but there are still some instances where FHA may be a better fit.