When choosing a home loan, one of the first mortgage decisions that needs to be made is between a conventional or a government loan. To find the perfect loan for you out of all available mortgage solutions, let’s review the basics of these two types of loans.
Conventional loans refer to loans not backed by any government agency. These make up the majority of loans issued to borrowers. They are harder to qualify for than other loans, making them a good choice for borrowers with good credit, a low debt-to-income ratio, and the ability to make a down payment of 20% or more. The minimum credit score necessary to qualify for a conventional loan is 620 and the debt-to-income ratio must be no higher than 50%, although ideally much lower to qualify for the best rates.
Borrowers who are unable to make a down payment of 20% can still qualify, however. A down payment of as little as 3% is acceptable, but requires the borrower to pay for private mortgage insurance. The private mortgage insurance, or PMI, will be added on to the monthly loan payment. Once equity in the home reaches 20%, the insurance can be discontinued.
An alternative to borrower paid PMI is lender paid private mortgage insurance (LPMI). This requires the borrower to make a one time payment at the start of the loan, or to accept a higher interest rate in exchange for the lender paying the mortgage insurance.
Government Insured Loans
The two main types of government loans available to borrowers are FHA loans and VA loans. These loans are backed in full or in part by a federal agency.
An FHA loan is backed by the Federal Housing Administration. Rather than loaning money directly, the FHA insures approved lenders against mortgage default. There are special guidelines for these loans that protect the borrower and lender alike. These loans are only available for those purchasing a primary residence, they cannot be used for second homes or investment properties.
The standards for borrowers are more flexible and are ideal for those who have difficulty qualifying for a conventional loan. Borrowers with lower credit scores will have an easier time getting approved for an FHA loan since the minimum credit score required is 580, compared with 620 for conventional loans.
These loans are also ideal for those with a higher debt-to-income (DTI) ratio. If a borrower is creditworthy in other areas, such as having a higher credit score or being able to afford a larger down payment, a high DTI may not be an obstacle to approval.
A lower down payment is one reason many borrowers look to FHA loans. With a minimum down payment of only 3.5%, these loans are attractive to those unable to make a large down payment. Loans with a down payment of less than 20% are subject to mortgage insurance premium (MIP), which is paid by the borrower. This applies to the life of the loan if the down payment is less than 10% of the loan value. If the down payment is over 10%, the insurance premiums only apply to the first 11 years of the loan.
These loans are available for veterans and U.S. service members. In the same way that FHA loans are insured by the FHA, VA loans are those backed by the U.S. Department of Veteran Affairs. Qualified lenders are insured by the VA in case a borrower defaults on their mortgage. This allows the lender to take on more risk than they would otherwise. Both the lender and the borrower must meet certain criteria to be eligible for the program.
VA loans don’t require a borrower to put down a down payment at all. Instead, the VA requires funding fee, which is added to the principle of the loan or is paid by the seller. This funding fee ranges from 1.25 to 3.3 percent of the total loan value. Closing costs for a VA loan may be paid by either the buyer or the seller.
With VA loans, the VA does not guarantee the entire loan. The VA has limits on the amount of liability it can assume. Even though the VA may only back part of the loan, lenders are usually willing to assume the risk for the remaining balance.
Which Loan is Best for You?
In order to determine the correct choice of loan for you, you need to take an honest look at your own financial circumstances. How is your credit? If you don’t know your credit score, find out. How much debt are you carrying? Consider student loans, car loans, credit cards and any other personal lines of credit. All of these will affect your debt-to-income ratio, an important factor in what kind of loan and rates you will qualify for. How much are you able to afford for the down payment on your new home?
Generally speaking, those with poor credit and a high DTI may find an FHA loan is their best option. Those with better credit, a low DTI, and the ability to put down a large down payment have their choice of conventional loans.
There is a lot of information to consider when applying for a home loan, and it can feel overwhelming. Everyone’s individual financial situation is unique. A mortgage specialist with The Busch Team of First Savings Mortgage can help you sort through the pros and cons of each type of loan to find the perfect one for you.