You've spent months on real estate websites and toured dozens of properties. You've finally found the right house in the right location for the right price and your offer has been accepted.
Now you have to select the method to finance your purchase, and for most first-time buyers there are two main options – an FHA or a conventional mortgage.
Which is better will depend on your individual circumstances. Both have their advantages.
An FHA loan is guaranteed by the Federal Housing Administration, part of the Department of Housing and Urban Development (HUD). If you qualify for an FHA mortgage, the U.S. government guarantees to the lender that the loan will be repaid.
The loan has some advantages and disadvantages for the borrower. The first is that it is easier to qualify for an FHA loan than it is a conventional mortgage.
Because it is a program to encourage homeownership, and the government stands behind the loan, a borrower may qualify with less than perfect credit. While overall lending requirements are much tighter in the wake of the housing crash, FHA requirements are a bit less tight.
For example, a lender looks at a borrower's debt-to-income ratio – what you owe vs. how much money you make. FHA gives you more leeway than conventional loans, meaning if you are early in your career and are still paying on some student loans, an FHA loan may allow you to buy more house than a conventional loan would.
You can purchase a home with an FHA loan without putting 20% down, which is less of an advantage these days because there are many conventional mortgage programs with similar low down payments.
An FHA loan requires as little as 3.5% as a down payment but there are now conventional loans with as little as 3% down.
Lower interest rates
When it comes to interest rates, the advantage usually goes to FHA. FHA loans almost always have lower interest rates than conventional loans, but the rate spread will differ state to state.
If you choose to put less than 20% down you will be required to pay mortgage insurance, whether it is an FHA or conventional loan. Mortgage insurance protects the lender from loss in case the borrower defaults.
Here, the advantage you get with a lower interest rate on an FHA mortgage is wiped out by the slightly higher rate you will pay for mortgage insurance. These insurance costs are based on a percentage of the loan and for FHA mortgage insurance, the percentage is slightly higher.
But in a decided advantage for a conventional loan, you can appeal to the lender to discontinue the mortgage insurance requirement once you have achieved 25% equity in the home. With an FHA loan, the mortgage insurance requirement is permanent for the life of the loan.
Because of mortgage insurance, a conventional loan payment might turn out to be lower than an FHA payment, even though it has a lower interest rate.
If you are just beginning your home search, you should discuss the FHA vs. conventional options with a mortgage officer during the pre-approval process so you will know exactly how much you will be able to pay for a home.