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When people choose the home loan that will finance their real estate purchase, they usually want to know if they’ll have to pay for mortgage insurance, make a deposit, or stay in the home for a specific length of time. Another critical concern people have in their minds is the loan rates.
When you get a mortgage, this automatically means that you will be paying more than your house is worth. Closing costs include taxes, property fees, origination fees, and sometimes broker fees, in case you hire a mortgage advisor. Some of these fees included at closing are optional. But once you start making monthly payments, there’s an actual charge you have no other option but to pay for interest.
Many people might want to avoid getting FHA loans because they can sometimes get more expensive than a conventional loan. If you’re already living with bad credit, paying for a more expensive mortgage seems counterintuitive.
In this article, we’ll help you decide whether you should choose a conventional or an FHA loan in 2021.
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The first thing you have to know about FHA loans is that almost anyone can get them.
Federal Housing Administration loans are government-insured mortgages. This means lenders are usually more confident to hand these loans out because the government has their back if you stop making monthly payments. This provides them with enough reason to approve borrowers with lower credit scores.
FHA Loan Requirements
To qualify for an FHA loan, you only need a minimum credit score of 500.
According to Experian, this is the minimum credit score of 99% of American consumers. Only 1% of people aren’t eligible for FHA loans, and these represent the most extreme scenarios.
With FHA, even if you’ve had a bankruptcy or you’ve had a foreclosure, you are still welcome to apply after a certain period has passed. You don’t have to be a first-time homebuyer either, although this program is usually promoted to people who have never bought houses.
You have to make sure that you are willing to make a down payment, and you can stay in the house for at least a year after you close the loan.
As inclusive as it may be, though, it can often get to the bottom of peoples’ list of options.
FHA loan limits vary per county, but in general, they are a lot lower than conventional or VA loan limits.
If borrowers can qualify for a VA or USDA loan, these often make better choices. This is because these other government-backed loans do not require down payments. The FHA does. If you want to get an FHA loan and have a credit score below 580, you need to be ready with at least 10% of your home’s worth. With 580, the belt is a little looser because you are only obligated to deposit 3.5 percent. However, pay any amount below 10%, and you’ll be saddled with charges for the life of your loan.
FHA vs. Conventional
Due to the unique qualities of the FHA loan compared to other government-backed loan products, FHA loans are usually pitted against conventional loans.
In the beginning, there were only these conventional loans, which today are your standard Fannie Mae and Freddie Mac mortgages. Government-backed mortgages only came along in 1934, with the formation of the Federal Housing Administration. As a result, government agencies only started offering USDA loans and VA loans many decades later.
The main difference between the two is their credit score requirements. FHA borrowers are usually those who are unable to qualify for conventional mortgages.
Mortgages are privately funded; the lender’s main priority is to protect their investment. So if you’re getting conventional loans, you need to prepare yourself for a much higher credit score requirement. Typically, lenders will ask for a 620 credit score at least, but due to COVID-19, they have gotten a lot stricter. So it might be more common today for lenders to ask for a credit score of at least 670.
On the other hand, FHA mortgage lenders are expected to approve borrowers with poor credit scores as low as 500, provided they exhibit the necessary ability-to-repay qualities. Moreover, since these borrowers are riskier than conventional loan borrowers, they are obligated to pay a nonnegotiable FHA mortgage insurance.
Conventional loans also ask for private mortgage insurance (PMI). However, for these mortgages, there is a way of going around this requirement. If you can pay at least 20% of your home’s purchase price initially, you don’t have to pay for PMI altogether. You only pay for PMI if you pay less than 20 percent, and you only do so until you reach 20% home equity.
Upfront Mortgage Insurance Premium
For FHA loans, it’s a lot harder to get out of paying for mortgage insurance premiums (MIP). You have to pay for it in two ways.
The first one is the upfront mortgage insurance premium. You have to pay for this one no matter if you deposit 20, 10, or 3.5 percent of your home’s worth. The second one is the annual mortgage insurance premium—this one you pay for together with your monthly mortgage payment.
For conventional loans, you pay for PMI depending on how long before you reach 20% home equity. On the other hand, you have to pay for the FHA monthly MIP for a minimum of eleven years, provided you spend at least a 10% down payment at closing. Since you are only required to put 3.5% money down if you have a credit score of 580 or better, some people end up having to pay for MIP for the whole life of their loan. If you have a 30-year mortgage, this is no small amount.
So naturally, if you have a credit score good enough to get a conventional loan, choosing this route makes a lot more sense. Like FHA loans, you can buy a home anywhere in the country if you go conventional. Unlike FHA loans, though, you can use the house for any purpose you want, whether residential or rental. For FHA, you are only allowed to apply if you use the mortgage for a primary residence. If agents of the Department of Housing and Urban Development can prove that you failed to meet this requirement, you can land in jail for fraud.
As of 2021, the upfront MIP rate for FHA loans is 1.75% of your loan amount. For conventional mortgages, the PMI rate can vary per year and according to the total value of your loan. It’s a little complicated to compare the two because what matters is not how high or how low a rate you end up getting. Time decides the difference between how low or how high of a rate you need to pay.
If you get a higher rate and you only need to pay for it for three years, this can be a lot cheaper than a low rate you only need to pay for thirty.
FHA Loan Rates
Aside from FHA mortgage insurance, you also won’t be able to avoid interest payments.
All mortgages have interest rates, and the FHA loan is no exception. But the most significant factor that will affect your interest rate is what type of loan you will choose.
Adjustable-Rate vs. Fixed-Rate Mortgages
You can categorize mortgages according to whether the government backs them, and you can also describe mortgages according to how often the interest rate changes. A mortgage can either have an adjustable rate or a fixed interest rate.
Interest rates change almost all the time. Therefore, these numbers are heavily affected by our economy, the demand, and the decisions made by the Federal Reserve.
Right now, we are still experiencing some of the lowest mortgage rates ever. Last year, the Federal Reserve cut the interest rates to induce people to buy houses in the wake of the COVID-19 pandemic. The housing market plays a crucial role in the national economy, so the hope is that if we can get the housing industry back up, everything else will follow.
In 2021, though, the supply of houses is still low, so while the interest rate may be a little quieter today, home prices are the complete opposite. In addition, we have a seller’s market, so people often have to pay more than what sellers ask. These are some factors you may want to take into account if you’re on the fence about getting a mortgage this year.
Now, if you do want to lock in today’s rates, especially if you’re getting a 20-year or 30-year home loan, what you’ll want to get is a fixed-rate mortgage. Since the interest is set, you are protected if the rate starts rising again, and you get to enjoy this for the whole life of the loan.
On the other hand, an adjustable-rate mortgage (ARM) is ideal if you believe there is a chance that rates can go even lower. If you get this kind, initially, you get a fixed interest rate, but eventually, the rate changes according to the flow of the economy. So your payment amount may look a little bit different every month.
You usually get an ARM when you think that interest rates are a little bit high. Once rates start to settle down and you want to lock in the newer interest rate, you can then look into refinancing your mortgage. Note that a refinance means a new mortgage. There will be closing costs again, and it’s up to you to decide if the savings in interest will be worth it.
FHA Mortgage Rates
Ultimately, the interest rate charged on mortgages varies, whether you’re getting an FHA or a conventional loan. In general, though, we can describe FHA interest rates as a lot lower than traditional mortgage interest. But, again, this is due to the government’s backing.
It all boils down to risk.
A company lends you money so that you can buy a house. In return, they earn from you through the interest you pay. However, mortgages are still debts, and the lender is technically making a gamble via this transaction. Although there is mortgage insurance, this is still a tiny percentage of the loan amount you borrowed. If there is a higher chance you will walk out on your loan, the lender will give you a higher interest rate.
However, with FHA loans, the scenario is a little different. You may be considered a risky borrower, especially if your credit score is below 580, but if the lender approves you under this government loan program, they can always raise a claim if you default.
Compared to a conventional loan, lenders may find more assurance in an FHA loan. So, in turn, FHA mortgage rates can afford to be more competitive.
On the other hand, if two borrowers are getting money under the same program, this is where their credit score decides who receives the higher interest rate. So no matter what kind of mortgage you are getting, if you have a higher credit score, you get the lower interest rate of the program.
For many people, the MIP of FHA loans can be a huge letdown.
Sure, you can pay a low 3.5% down payment, but insurance is included in your monthly mortgage payments forever if you choose this option. However, this is only really a bummer if you intend to keep your 30-year fixed loan.
There is always a chance that you can refinance your FHA loan within eleven years after you close it. And if you can do so, it will have been no different had you chosen to pay 10% at the beginning.
If you start with a credit score of 580, this only has a 40-point difference with a 620 credit score. This higher score is very achievable after a year of paying down your FHA loan. You have to ensure that you’re paying your other bills on time and you’re earning more income than before.
Now, say you have a higher credit score that is good enough for a conventional loan, we suggest shopping around the nation’s largest mortgage lenders. Unfortunately, many people make the mistake of not comparing offers from different companies. Don’t add to this statistic.
Take your application to as many lenders as you think you need. Check if their conventional and FHA loan rates can compete with each other.
FHA or Conventional?
If you can find a mortgage lender who can give you a conventional offer lower than an FHA scenario, this can be your best option, especially if you can pay at least 20% money down. If you can’t, it’s up to you to decide if the interest rate is reason enough to justify paying for PMI until it is removed from your monthly payments.
If you have a lower credit score and you can only apply for an FHA loan, it’s good to know that today’s FHA mortgage rates are some of the lowest we’ll ever see. Regardless of how much money you can pay initially, make a refinance your aim for the future.
This way, you can get the most out of your mortgage loan. Best of luck!