What is a Conventional Mortgage?
A conventional mortgage refers to a loan that is not insured or guaranteed by the federal government and is offered by a bank. This makes it a slightly higher risk for the bank, so the qualifications are stricter than loans that are insured by the federal government. For example, it may require a higher down payment or a lower debt to income ratio. Like other types of mortgages, the interest rate that you pay is determined based on the prime mortgage rate and your credit score.
A conventional, or conforming, mortgage adheres to the guidelines set by Fannie Mae and Freddie Mac. The maximum limit for a conforming loan depends on the county and state in which you live and can be found here: Fannie Mae Loan Limits .
A conventional mortgage could have a fixed rate or a variable interest rate. Fixed-rate mortgages have a set interest rate for the entire length of the mortgage term, which can be between 10 and 30 years. An adjustable-rate mortgage (ARM) has a term of 30 years with a low introductory rate for a fixed period followed by periodic adjustments according to a specific benchmark, typically a specific LIBOR or a T-Bill index. (LIBOR or ICE LIBOR is a benchmark rate that some of the world's leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. The T-Bill index is based on the results of auctions that the U.S. Treasury holds for its Treasury bills, notes and bonds.) If your income and credit qualify and you want to purchase a new home, or merely lower the rate or term of you existing home mortgage, a conventional loan may be what is best for you. Conforming loans require a down payment/equity as little as 3%* for a fixed rate term or 10%* for an Adjustable rate.
Pros and Cons
One point on the pro side of a conventional mortgage loan is that equity builds faster because of the higher down payment expected upfront. A con is that the higher down payment makes it more difficult for some consumers to obtain a conventional loan. With the larger down payment expected on a conventional mortgage loan, as much as 20 percent in many cases, the lender may not require the borrower to have private mortgage insurance (PMI), which can be a plus. Conversely, if the borrower does not have a significant down payment, PMI will likely be required and the borrower must then meet the requirements of a mortgage insurance provider, which is essentially like applying twice for loan approval. Concerning conventional mortgage loans, down payments may need to be authenticated as belonging to the borrower. The down payment must be made with money belonging to the borrower because the saved the money or were gifted it. The down payment cannot be a loan from a third party. A con of conventional loans for borrowers with lower credit scores means higher interest rates and fees often become part of the loan terms. The lender may also demand a higher interest rate if it's allowing the borrower to include part of the closing costs into the loan. Conventional loans may also carry higher interest rates than some government loan programs. Terms and Conditions A plus to conventional loans is that lenders may be more willing to negotiate terms and conditions than with a government-backed loan where the lender must follow standard guidelines. In addition, a conventional loan, on average, is processed faster than a government-backed mortgage such as through FHA. Points on the con side of the argument are that borrowers may be required to pay a nonrefundable fee at the time of applying for the loan and, if approved, the terms of a conventional loan may include a stiff prepayment penalty, meaning the borrower will be subject to this charge if the loan is repaid early. Creditworthiness With a conventional loan, the decision on qualification belongs solely to the lender and there may be fewer restrictions on the applicant's personal financial situation than a government-backed loan. On the con side, a bankruptcy or home foreclosure in the past can significantly decrease a potential borrower's chances of obtaining a conventional loan. Many lenders require a long waiting period in which the consumer will be expected to repair credit. Both a pro and con of a conventional loan are that lenders consider the applicant's debt-to-income ratio, the relation between the amount of money required to meet debt obligations each month such as auto loans and credit card payments and the amount of monthly gross income earned. The lower the debt-to-income ratio, the better terms the borrower may be offered.
What is an FHA Home Loan?
Banks like to feel confident that they will receive those monthly mortgage payments each month. Oftentimes buyers who can’t show a large monthly income, don’t have credit built up to show they are viable, or who have some negative credit scores, can have a hard time convincing banks to loan them the money they need to purchase a home. An FHA loan is a loan that is insured by the Federal Housing Administration. Because the loan is insured, the banks are confident that they’ll receive payment whether it’s from the buyer or from the FHA. An FHA loan is a great option for many buyers. The FHA has one of the lower down payment requirements. Often times, buyers can put as little as 3.5% down. This loan type also has more leniency in allowing buyers to utilize financial gifts from relatives or friends toward their down payment or closing costs. Some loans charge substantial pre-payment penalty fees if a borrower finds the means to pay off the loan early. FHA loans have no pre-payment fee. These loans can also be assumable which means the current homeowner can sell the property to a new buyer and allow that buyer to take over the monthly payments and maintain the interest rate the previous owner was already locked into.For buyers who may not have a perfect credit score, using a FHA loan offers them the opportunity to buy a home much sooner after a bankruptcy or foreclosure than some other loans. Buyers may be able to qualify for a FHA loan as early as two to three years after either of these marks on their credit. With all of these perks, one might wonder why everyone doesn’t use a FHA loan to purchase a home. The major drawback to an FHA loan is that the lender and the federal housing administration requires buyers to pay MIP (mortgage insurance premiums). Because the loan is insured by the FHA, the FHA has set up a fund that buyers pay into to cover the risk they are taking in insuring the loan. This premium is added onto the monthly mortgage payment and cannot be removed until the homeowner can prove that they have accumulated at least 22% equity in the home. Buyers need to take into account this added expense that they will need to be able to cover each month. Buyers should meet with a knowledgeable and reputable mortgage lender to discuss the pros and cons of several loan options to determine the best fit for their situation.