Mortgages

What Is The Difference Between FHA, VA, And Conventional Loans

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 19 minute read

Good for you if you’re finally ready to take the plunge and buy a home. You’re getting closer to making the biggest investment of your life — at least until your family expands and you need a bigger house.

There is a significant probability that you won’t be able to pay cash for your home, whether it’s brand new or an old fixer-upper. Getting a mortgage loan to cover the price is necessary.

Equally, if you bought a property when rates were higher but don’t have the resources to pay off your mortgage in full, you may qualify to refinance your purchase loan. By refinancing into a new mortgage and paying off the old one, you can lock in a lower interest rate and save thousands, if not tens of thousands, over the life of the loan.

Non-Conforming and Conforming Home Loans

Loans for both home purchases and renovations can be tailored to suit a variety of needs. You should carefully consider all of your mortgage refinancing and house purchase choices before settling on one.

There are two main types of mortgage loans conventional and non-conventional. In addition, terms like “conforming” and “non-conforming” loans may appear in your research. While they do not mean the same thing, these words are often used interchangeably.

Key Differences Between Conventional and Non-Conventional Loans

The primary difference between conventional and alternative loans is that conventional loans are neither granted nor guaranteed by the federal government.

Non-conventional loans, on the other hand, are granted or supported by federal government agencies like the Department of Agriculture, the Department of Veterans Affairs, or the Federal Housing Administration (part of the Department of Housing and Urban Development) (USDA).

Prerequisites for Conforming Loans

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), both quasi-governmental corporations with enormous sway in the American home lending market, set loan restrictions that most conventional loans must adhere to. 

Loans that fall within these parameters are backed by Fannie Mae and Freddie Mac, guaranteeing a healthy secondary market for home mortgage debt.

Limits on Loan Size

A loan cannot be considered a conforming loan if its principal amount is greater than the maximum amount that is increased annually to account for inflation. Single-family houses in the lower 48 states had a limit of about $424,000 in 2017, while those on the West Coast and Alaska had a limit of about $625,000 (including Alaska, Hawaii, and expensive coastal cities such as Seattle and San Francisco).

Loans with a principal amount of more than $750,000 that are not guaranteed by the federal government are referred to as jumbo loans. Since Fannie Mae and Freddie Mac do not guarantee jumbo loans, the secondary market for them is more limited and precarious.

Types of Property That Qualify

Single-family attached homes, townhouses, condominiums, single-family detached homes in master-planned communities, cooperative apartments, and mobile homes are all acceptable types of real estate. Additional regulations apply to condos, co-ops, and manufactured homes.

Requirements for Debt and Credit

Conforming loans are often only made to customers with good to excellent credit. Generally speaking, applicants with credit scores below 680 won’t be able to get conforming loans, but lenders always have the option to make exceptions. Only homeowners with the highest credit scores qualify for prime interest rates.

In addition, the debt-to-income (DTI) ratio of those applying for conforming loans is required to be lower than 43%. Some creditors are more stringent and necessitate ratios of 36% or below. It is possible for DTI ratios to go above 50% in some circumstances; however, interest rates on high-DTI loans will likely be higher. 

You have a high debt-to-income ratio if you’re spending more than half of your monthly income on debt service. This includes payments on both unsecured (credit cards) and secured (auto loans).

Here, we’ll explore the distinctions between conventional mortgages, FHA mortgages, and VA mortgages in further detail.

Interest Rates, Fees, and Other Costs for Conventional Mortgages

Loans of a Conventional Nature

There are a wide variety of conventional mortgages available. Except where stated, the following forms of financing can be utilized both for purchases and refinances:

  • Fixed-Rate. When you get a loan with a fixed rate, your interest payment won’t change for the duration of the loan. Loans with fixed rates are available for terms of 10 years to 40 years, with the most frequent being 15 and 30 years. The annual percentage rate (APR) for a 30-year loan in early 2018 was about 1 percentage point more than the APR for a 10-year loan, even for customers with great credit. Prime borrowers, defined as having a FICO credit score of 740 or higher, get access to the market’s most competitive interest rates.
  • Adjustable-Rate. The interest rate on an ARM loan is set at a fixed rate for a certain introductory period. After that time has passed, they will increase and then continue to increase annually or biannually in accordance with market interest rates (with LIBOR or another widely accepted standard as the benchmark). An ARM with an initial rate of 4% could climb to 5% or 6% within a single year and 9% to 10% over its full term due to periodic and lifetime interest rate limitations of typically 1 to 2 percentage points per year and 5 to 6 percentage points over the life of the loan, respectively. There is a wide range of possible initial terms, from one year to ten. ARM annual percentage rates (APRs) at the outset are usually much lower than fixed-rate APRs, but they always end up being higher than the prevalent fixed-rate APRs. Some adjustable-rate mortgages (ARMs) are convertible, meaning that they can be changed into fixed-rate mortgages.
  • The Interest-Only Adjustable Rate Mortgage. Structure-wise, interest-only ARMs are quite similar to standard ARMs; however, there is one major distinction; At the beginning of the loan term, the borrower is simply responsible for paying the interest on the loan. This greatly reduces early payments but prevents equity from being built and does not apply to the principal. After the grace period ends, the borrower is responsible for making monthly payments of principal and interest on the loan. Borrowers should be sure they can afford future principal-and-interest payments before getting interest-only ARMs because the shift from interest-only to principal-and-interest payments can be disruptive. Homebuyers with a short- to medium-term exit strategy may prefer an interest-only adjustable-rate mortgage (ARM) since they can avoid making principal and interest payments until they sell. However, prepayment penalties occur if you pay off any adjustable-rate mortgages (ARMs) early, and this includes interest-only ARMs.

The Down Payment

When applying for a purchase loan, the down payment is an important factor. Loan refinancing doesn’t necessitate a down payment, but it does come with hefty closing charges.

Conventional loans have often needed a 20% down payment, or $40,000 on a $200,000 loan. Lenders’ requirements have loosened up recently. By 2014, many lenders had begun allowing 3% down payments, or $6,000 on a $200,000 loan.

Conventional loans with low down payments Conventional 97 loans are for those with down payments of less than 10% of the buying price. It’s possible that the interest rates on such loans would be similar to those offered to borrowers with sub-prime credit. You should know that Conventional 97 loans are avoided by many banks, so finding one may be difficult, especially if you have poor credit.

The Private Mortgage Insurance (PMI)

To qualify for a traditional loan, borrowers must have a 20% down payment or pay for private mortgage insurance (PMI). Typically, PMI premiums are paid on a monthly basis. In the case of traditional loans, annual PMI payments can amount to as much as 1% of the loan principal, with greater LTV percentages resulting in higher PMI payments.

Closing Expenses

There are many different types of mortgage fees, but even the most typical loans have numerous closing costs. 

Standard examples include:

  • Payable Taxes on Real Estate Purchased in Advance. Typically, buyers are responsible for prepaying any property taxes that will be payable between the closing date and the next scheduled property tax payment date. Buyers should factor in at least a few hundred dollars in taxes, depending on the buyer’s location.
    Risk protection is paid in advance. Additionally, the first year’s worth of homeowners insurance premiums, which can be anywhere from 0.25 percent to more than one percent of the home’s assessed value, must be paid in full at the time of purchase.
  • An Evaluation and Survey of the Premises. It may be necessary to undertake a survey, depending on the nature and location of your property. A simple mortgage survey that doesn’t cost more than $500 usually does the trick. You’ll also have to pay for an assessment of the property that will be ordered by the lender to ensure that they’re not taking a loss in the event of foreclosure and that you’re not trying to get away with an outrageously inflated asking price. The majority of appraisals have a price tag of less than $500.
  • Results of Environmental Studies and Flood Determinations. While it may be obvious that your home is not at risk of flooding, a flood determination is still necessary to confirm this and rule out the need for flood insurance. Price estimates for flood damage typically range between $20 and $50. Fire hazard evaluations and other forms of environmental analysis may be necessary for specific areas.
  • To examine a dwelling. Optional, but highly advised, prior to closing, is having the home inspected to identify any issues or safety risks. The typical price of a comprehensive inspection is around $500.
  • Title Check and Insurance. An examination of the property’s title ensures that the seller has the legal right to sell it to you and that no other parties have any legitimate claims to the land. If problems (such as claims on the property) are found during the search, or if problems (such as those) occur afterward, the costs associated with rectifying them are covered by title insurance. In most cases, the total price of a title search and title insurance will surpass $1,000. (one-time, payable at closing).
  • Putting on tape and sending it somewhere else. This sum accounts for the expenses incurred in filing the sale with the relevant authorities (often a city or county agency) and executing the transfer using stamps. Usually, you may expect to pay anything from $300 up to $700 for recording and transfer.
  • Start-Up Costs. All other, less significant closing expenses are rolled into this one line item. Origination fees typically cover the costs of sending paperwork back and forth between parties, holding an escrow, and hiring an attorney. The Good Faith Estimate you receive at closing needs to detail all of these costs in detail. Origination costs can be very low (sometimes even nothing) or very high (often as much as 5% of the purchase price).
  • Rewards Points are a great way to save money. Lenders can enhance their profits on loans above the advertised interest rates in this customary but not required fashion. A discount point is a prepayment of interest equal to 1% of the loan principal that can reduce the interest rate by 0.25%. In order to lower their monthly payments and so increase their household cash flow, buyers who have a sizable sum of money available at closing can pay points.

For first-time homebuyers, FHA mortgage loans are ideal.

Private mortgage lenders offer FHA loans because they know the government will back them. FHA purchase loans have historically been a key aid for lower-income Americans seeking the benefits of homeownership, as they are specifically designed for first-time homebuyers with limited assets and less-than-perfect credit. With one notable exception, FHA loans can only be utilized for the purchase or refinancing of the main dwelling.

There are two types of FHA purchase loans; fixed-rate loans (the 203b mortgage loan, which applies to one- to four-family detached homes, is the most prevalent) and adjustable-rate loans (the Section 251 loan), both of which apply to one- to four-family detached homes. In both setups, you can choose from a wide range of maturities, the most popular of which are 15 and 30-year fixed rates.

Homeowners who have been awarded the Federal Housing Administration’s mortgage insurance can refinance their loans at a cheaper interest rate by using an FHA refinance loan, such as the FHA streamline refinancing product. They come in both fixed and variable interest rate options. Mortgage insurance premiums (MIPs) are not required on FHA streamline refinancing loans, which is a big saving for homeowners on a limited budget.

FHA and Conventional Loan Differences

There are significant distinctions between FHA and conventional loans:

  • Total Cap on Borrowings. A maximum FHA loan approval amount is 115% of the local median listing price in most areas (usually calculated at the county level). The continental United States has a maximum of $625,000, with a minimum of $271,050 (in low-cost sectors) (in high-cost markets). The limit is $938,250 in the states of Alaska and Hawaii and in overseas protectorates like Guam. These caps could go up or down based on the market value of homes at the time. Maximum loan amounts for reverse mortgages (also known as HECMs, a popular FHA product) are $625,000 within the contiguous United States and $938,250 in all other jurisdictions. See what your county or city allows in terms of an FHA loan by using the tool provided by HUD.
  • Calculating the Housing Expenses and DTI. When applying for an FHA loan, the debt-to-income ratio might be as high as 43%. Housing ratios (the proportion of monthly mortgage payments to monthly gross income) can go as high as 31%, compared to the 28% maximum allowed by conventional lenders.
  • Initially Invested Amount. With an FHA purchase loan, the minimum required down payment is 3.5% of the purchase price (or $7,000 on a $200,000 house) for borrowers with credit scores of 580 or above. That’s a lot lower than the standard 20% down payment needed for conventional loans, or $40,000 for a home that costs $200,000. Also, a 20% down payment on a $200,000 home would be under the 10% threshold for eligibility for a Conventional 97 loan.
  • Mortgage Coverage. The FHA mortgage insurance premium is significantly higher for both FHA purchases and most FHA refinance loans (excluding streamlined refinance loans). Borrowers in all 50 states must pay a one-time, non-negotiable fee at closing equal to 1.75 percent of the loan amount, regardless of the loan’s type, length, or interest rate. This cost is often tacked onto the principle of the loan, however, it can also be paid separately. When financing a home with a loan-to-value ratio of 90% or higher (10% down) and for a duration of 30 years or less, the borrower will be required to pay annual mortgage insurance premiums of up to 1.05% of the loan amount. If a borrower’s initial loan-to-value (LTV) is below 90%, they must maintain insurance coverage for a period of 11 years. For the most part, conventional loan borrowers who start with an LTV of 80% or less are exempt from mortgage insurance. FHA streamlined refinancing is the only option that allows most FHA borrowers to stop paying mortgage insurance.
  • The Interest Rates. For both home purchases and refinances, FHA loans often have lower interest rates than conventional loans of similar terms and conditions. Increases in mortgage insurance costs may cancel out any savings from lower interest rates.
  • Essentials of Credit. As an alternative to conventional loans, FHA loans have more lenient underwriting standards. With a 580 FICO or higher, you qualify for the 3.5% down payment FHA loan for purchases, and with a 500 FICO or higher, you qualify for the 10% down payment FHA loan.
  • The Seller Will Pay All Closing Costs. Seller contributions to closing costs are limited to 6% of the purchase price with an FHA loan, or $12,000 on a $200,000 home. The potential gain there is substantial in buyer’s markets. Seller-paid closing costs on conventional loans cannot exceed three percent of the purchase price, or six thousand dollars on a home that costs $200,000.
  • Assumption. A buyer can take over an existing FHA loan with few alterations to the interest rate or other parameters if the seller has an assumable loan. Assumptions can be a significant time and stress saver for motivated sellers, but they are contingent on FHA clearance and lender underwriting, as well as the buyer’s ability to fund the difference between the outstanding loan balance and the appraised price of the home. There is typically no option to assume a conventional loan.

FHA Loan Categories

FHA loans come in a number of different varieties, including the 203b and Section 251 loans for single-family and multi-family detached homes, and the 203k loan for condominiums.

  • Home Equity Loans for Condos. FHA-insured mortgages for condominiums, also known as Section 234c loans, are very similar to FHA-insured mortgages for single-family homes, including the 30-year fixed-interest rate. There is only one type of FHA-insured loan available for condo purchases, and that is a 30-year fixed. A Section 234c loan can be used to finance the purchase of a single condo in a complex with at least five other units. Section 234c loans have more lenient owner-occupancy standards, although the program still requires that at least 80% of FHA-insured loans in development go to owner-occupants.
  • Loan Refinancing Protection. Delinquent conventional mortgage loans, such as those caused by interest rate increases on conventional adjustable-rate mortgages, can be refinanced into stable, FHA-insured fixed-rate loans through FHA-secured refinance loans. The maximum loan-to-value (LTV) percentage allowed for a cash-out refinance is 85%. The maximum allowed LTV for a refinance that does not include taking cash out is 97.75%.
  • The Federal Housing Administration’s streamlined refinancing program. It is possible to refinance an existing FHA loan with no appraisal and modest closing fees (often less than 4% of the principal) via a program called an FHA to streamline refinance. On paper, the program’s conditions seem extremely lax; for example, you can theoretically refinance a home that is significantly underwater, and there are no hard income or employment caps. While employment verification and a good credit score (FICO 620 or higher) are usually required by lenders, poor credit won’t go you very far. Also, there can’t be any major loan arrears. If the new loan will reduce your monthly payment by at least 5% (say, from $1,000 to $950), then you will be eligible. While this results in a “zero cost” loan, the monthly payment will be higher than it otherwise would be because the closing expenses are included in the loan principle.
  • Alternative Mortgages Using Home Equity (HECM or Reverse Mortgage). Owner-occupants who are 62 or older can use HECM loans, also called reverse mortgages, to access their home equity without having to sell and relocate. Reverse mortgages, or HECMs, are unusual in that they don’t necessitate regular payments. Borrowers with low incomes and few assets can instead benefit greatly from these loans because the money they receive is not subject to taxation. Taking out a HECM is not recommended before consulting an attorney or financial advisor due to the seriousness of the legal and financial ramifications.
  • Progressive Repayment Loan. Section 245 loans, which have graduated payments, have exceptionally low monthly payments in the beginning. In the first 5–10 years of the loan’s term, payments will climb by between 2% and 7.5% each year. They increase initially, but then level off and stay the same for the duration of the contract when the initial ramp-up period ends. Borrowers whose wages are expected to increase substantially over the loan’s lifecycle benefit greatly from graduated payment loans.
  • Increased Equity Loan. Expanding equity loans, also known as Section 245a loans, are essentially more flexible and forgiving variants of graduated payment loans. They apply to many different kinds of dwellings, such as co-ops and pre-existing houses undergoing restoration. When compared to the graduated payment plan, the annual payment growth is more gradual because it is capped at 5%. In addition, the maximum term length is now only 22 years.

Advantages That Make FHA Loans Better Than Conventional Loans

Here is a quick review of why FHA loans are preferable to conventional ones:

  • Relaxed underwriting (credit score) standards
  • We accept as little as a 3.5% down payment from qualified borrowers with credit scores of 580 and above.
  • Assumability (can be passed from seller to buyer with minimal friction) (can be transferred from seller to buyer with minimal friction)
  • Increased seller’s contribution toward closing costs
  • Curb the rate of interest
  • Reductions in the minimum required DTI and housing ratio

Benefits of Conventional Loans Over FHA Loans and Their Drawbacks

Also, conventional loans have many advantages that FHA loans do not:

  • Upfront mortgage insurance payment is required by statute on purchase loans and non-streamline refinance loans (1.75% of loan size)
  • Higher ongoing mortgage insurance premiums (up to 1.05% of loan size annually)
  • Can’t cancel mortgage insurance except through streamlined refinance
  • Lower guaranteed loan limits in low-cost markets (disadvantageous to high-end buyers in those areas)
  • Homes must be owner-occupied, primary residences

Great for Military Families are VA Mortgage Loans.

Veterans of the United States Armed Forces can get a helping hand in becoming homeowners thanks to a program made possible by the Servicemembers Readjustment Act of 1944 (SRA). Most VA loans, like FHA loans, are offered by private lenders but backed by the Department of Veterans Affairs. VA loans, like FHA loans, can only be utilized on properties that will be used as the borrower’s principal residence.

There are two main uses for VA loans financing for purchases and lowering interest rates on existing mortgages. They come in a wide range of options, including fixed-rate 15- and 30-year plans, as well as a number of adjustable-rate options, similar to FHA and conventional mortgages. They often have higher interest rates than FHA loans but are online with conventional loans.

Eligibility Requirements

The time in service, date of application, and branch served all play a role in determining if a borrower is eligible for a VA loan. Members of the armed forces are usually eligible after serving for at least 90 days consecutively, though this number might be as low as 180 days depending on the circumstances. 

Veterans, including those who served in the reserves or National Guard, are eligible after 90 to 180 cumulative days of service. Veterans of six years of continuous service in the reserves or National Guard who have not seen active duty are eligible. A discharge with less than honorable conduct will disqualify you.

For information on who is eligible and how to submit a Certificate of Eligibility application, please refer to the VA’s eligibility table (CoE).

VA Loans and Regular Loans Have Different Features

There are some major differences between VA loans and conventional loans besides the eligibility requirements for military service:

  • Financial Costs. The VA funding charge is the major and most expensive difference between VA loans and conventional loans. The funding fee for a VA loan is a one-off cost that is not associated with FHA or traditional mortgages. First-time homeowners or refinancers with previous active-duty experience and sub-90% LTV ratios tend to fare better, however, this varies widely across military branches, loan types, and down payment sizes. Funding fees for buy and cash-out refinance loans are usually between 1.25 and 3.3 percent of the loan amount ($2,500 and $6,600 on a $200,000 loan, for example). No cash-out refinancing fees might be as low as 0.50% of the loan’s principal.
  • Total Loan Amount Cap. In most areas, VA loans are insured up to $424,100; however, this limit can vary based on local housing prices. The VA won’t take on any additional responsibility for a loan that is larger than what they originally guaranteed, even if the lender agrees to do so. The VA can guarantee greater loans in higher-priced areas.
  • Initially Invested Amount. Smaller VA loans have no down payment requirement, which is one of the lending program’s most appealing features. It is possible to use a VA loan for the full purchase price of a home if you meet the requirements. It’s important to note that there is a hard maximum on how much you may save with the zero-down payment option; typically, it’s $144,000, which is four times the ordinary VA entitlement of $36,000 per buyer. While conventional lenders often need a down payment of 10% or more for larger loans, alternative lenders may accept lower down payments.
  • Mortgage Coverage. When the loan-to-value (LTV) of a VA loan is over 80%, mortgage insurance is not required.
  • Essentials of Credit. Unlike the more lenient guidelines of the FHA loan program, those of the VA loan program is more stringent. In order to qualify with the majority of lenders, a credit score of 620 or above is typically required, for instance, for high-income borrowers.
  • Expenses Related to the Closing Process. Certain forms of closing charges cannot be charged to Veterans Administration borrowers. Legal fees, escrow costs, underwriter premiums, and processing fees all fall under this category. Lenders may levy origination fees of up to 1 percent of the loan amount in place of the above-mentioned fees.
  • Assumption. For those who qualify, VA loans can be assumed by a new buyer, much like FHA loans.

Alternative VA Loans

Veterans Affairs (VA) loans can take many forms:

  • Borrowing for a Purchase. Without having to worry about a down payment, VA purchase loans might have an LTV of up to 100%. They can, within certain parameters, be used for the acquisition and improvement of single-family homes, condominiums, mobile homes, and lots (similar to an FHA 203k rehabilitation loan).
  • Refinancing With Drawn-Out Cash. VA cash-out refinance loans are similar to conventional and FHA cash-out refinance loans in that they pay off the existing loan and give the borrower a lump sum of cash. If the borrower owes $100,000 on a house that is now worth $200,000, for example, they could take as much as $100,000 in cash. In most cases, the interest rate on a cash-out refinance loan will be lower than the rate on the loan it is replacing. It is not necessary for the original (refinanced) loan to have been a VA loan.
  • Refinancing at a Lower Interest Rate (IRRRL). IRRRLs, which are a subset of the VA Streamline Refinance Loan (or just streamline refinance), is made for those who want to refinance their existing VA purchase loan without filling out a new VA loan application. Except for an exemption of up to $6,000 for energy-saving home renovation projects, there is no cash-out option.
  • Loans for Native Americans (NADL). The VA offers NADL loans, which were established to aid service personnel and veterans of Native American descent. Always, these loans are set up with a fixed interest rate for 30 years. When utilized as intended, NADLs can lower the interest rate on an existing loan or be used to finance the purchase, construction, or rehabilitation of dwellings on Federal Trust Land (reserve land).
  • Those veterans with severe, persistent disabilities resulting from their military service are eligible for one of two types of Adapted Housing Grants, which are not loans. Disabled veterans and their families can use these grants to pay for the building, buying, or modifying of a home that is accessible for those with disabilities. They aren’t asking for repayment.

VA Loans Have Advantages Over Conventional Loans

Here is a quick review of the main benefits of VA loans compared to traditional mortgages:

  • No down payments are required on particular loans
  • No mortgage insurance required
  • Assumability
  • High cash-out refinance loan limits cash out up to 100% of your equity in the home
  • Low costs on streamlined refinance loans
  • Restrictions on closing cost types and values

VA Loan Disadvantages Compared to Conventional Loans

Also, there are some major disadvantages.

  • VA funding fee required upfront
  • Restricted to active-duty servicemembers, veterans, and their families
  • Loan size limits that can disadvantage buyers in high-cost markets
  • Homes must be owner-occupied, primary residences

Bottom Line

You have a better chance of getting approved for a conventional, VA, or FHA loan if you live in an urban core, as defined by the Census. But if you prefer open areas, the USDA loan may be the best choice for you.

The United States Department of Agriculture (USDA) guarantees mortgages to first-time purchasers who plan to purchase a home in a rural area as defined by the Census. This is because the majority of Americans reside in urban areas. 

The USDA loan program is extremely helpful for people who qualify, as it provides full financing with no down payment, as well as inexpensive interest rates and reduced private mortgage insurance premiums. 

Do yourself and your pocketbook a favor before applying for a conventional loan or one of the more common non-conventional alternatives and investigate this elusive, possibly lucrative real estate financing product.

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