Many people do not understand what a Federal Housing Authority (FHA) loan is or the
difference between a FHA loan and a Conventional loan. Here are some basic details
on FHA loans to help you understand what you’re getting if you decide to go with this
option. Let’s start off with what an FHA Loan is and what it isn’t.
It is a mortgage that is insured by the FHA, and, not a loan that is issued by or serviced
by the federal government. The government is not giving you the loan. A FHA loan
provides the bank with additional security that the loan will be repaid. Only FHA
approved banks can provide the loans.
There are additional fees associated with FHA loans that do not apply to Conventional
Mortgages; these additional fees are assessed on every FHA loan and cannot be waived.
In order to fund the program, each customer pays an upfront funding fee called Upfront
Mortgage Insurance Premium. The current cost of this is 2.25% of the loan amount.
Additionally, there is a 0.5% annual charge paid as a monthly Mortgage Insurance. The
monthly Mortgage Insurance must be paid for a minimum of five years. After the five
year term, the monthly premium can be dropped if the loan to value ratio has reached
78% or better.
So, if there are additional fees on an FHA loan why would anyone ever want one? Good
First, FHA loans are more forgiving when it comes to a blemished credit history. The
minimum credit score for an FHA loan is 620. As long as your payments are current and
your score is equal to or greater than the minimum required, your credit should pass.
Next, your debt to income ratio matters. This is how much debt you have versus how
much money you make. There are two calculations used: Front End ratio and Back
End ratio. The front end ratio is your housing payment. This includes the mortgage
principal and interest as well as taxes and insurance, commonly referred to as PITI. On a
Conventional mortgage, your front end ratio should be under 28% of your gross income.
With an FHA mortgage, you front end can be higher, around 29%. The back end ratio
is calculated using all of your recurring payments including the mortgage (PITI). A
Conventional loan typically limits a home owner’s back end ratio to 36%, while an FHA
loan will accept 41%.
Another important difference between a FHA and Conventional loan is the cash out limit.
Under Conventional loans, you are limited to 80% of your homes value. With FHA, the
limit increases to 85%. The extra 5% can be used to pay off credit cards, student loans or