If you’re ready to buy a house, congratulations. You’re one step closer to making what’s likely to be the largest single purchase of your life – at least until your family grows larger and you’re forced to upsize to a more spacious abode.
Whether you’re buying a new construction home or an old fixer-upper house, chances are good that you don’t have enough cash to purchase your home outright. You’ll need to finance the purchase with a mortgage loan.
Likewise, if you purchased your home when interest rates were higher, but you don’t have enough cash to pay off your mortgage in full, you might be ready to refinance your purchase loan. That means taking out a new home loan to pay off your existing loan and lock in a lower interest rate that saves you thousands (and perhaps tens or even hundreds of thousands) over the remainder of your loan term.
Types of Home Loans: Conforming and Non-Conforming
Purchase and refinance loans come in many different configurations. Before you make an offer on a home or commit to refinancing your current mortgage, you’ll need to evaluate your options and choose the one that best fits your needs.
Home loans can be divided into two broad categories: conventional and non-conventional. At times, you may see reference to “conforming” and “non-conforming” loans as well. These terms are not synonymous, but they’re sometimes used interchangeably.
Conventional vs. Non-Conventional Loans: Key Differences
The most important distinction between conventional and non-conventional loans is that conventional loans are not issued or backed by a federal government agency. Conversely, non-conventional loans are issued or backed by departments of the executive branch, including the Department of Veteran’s Affairs (VA), the Federal Housing Administration (FHA, part of the Department of Housing and Urban Development), and the Department of Agriculture (USDA).
Conforming Loan Requirements
Most conventional loans are conforming, which means they must conform to loan limits set by the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), two quasi-governmental enterprises that have tremendous influence over the American home lending industry. Fannie Mae and Freddie Mac guarantee loans that conform to these limits, ensuring a liquid secondary market for residential mortgage debt.
Loan Size Limits
To qualify as a conforming loan, the loan’s principal cannot exceed a hard maximum that’s adjusted upward each year to reflect market conditions. In 2017, the limit was approximately $424,000 for single-family homes in the continental U.S. and approximately $625,000 in high-cost areas (including Alaska, Hawaii, and expensive coastal cities such as Seattle and San Francisco).
Non-government-backed loans with larger principals are known as jumbo loans. Jumbo loans aren’t guaranteed by Fannie and Freddie, so the secondary market for them is smaller and riskier.
Eligible Property Types
Eligible property types include one- to four-family detached homes, condominiums, new construction houses in planned developments, co-op housing, and manufactured homes. However, condos, co-op homes, and manufactured homes are subject to some additional restrictions.
Credit and Debt Requirements
In most cases, conforming loans are reserved for borrowers with good to excellent credit. It’s rare for borrowers with FICO scores under 680 to qualify for conforming loans, though lenders have some discretion to make exceptions. Prime rates are reserved for homeowners with excellent credit.
Additionally, most lenders require conforming loan applicants to have debt-to-income (DTI) ratios below 43%. Some lenders are stricter, requiring ratios below 36%. However, in some cases, DTI ratios can rise above 50%, though high-DTI loans’ interest rates are likely to be higher. Your debt-to-income ratio is defined as the proportion (percentage) of your monthly income spent on debt service, including unsecured credit products such as credit cards and secured credit products such as car notes.
In the following sections, we’ll take a deeper dive into the differences between conventional mortgage loans, FHA mortgage loans, and VA mortgage loans.
Conventional Mortgage Loans: Rates, Terms & Parameters
Types of Conventional Loans
Conventional home loans come in several different configurations. Unless otherwise noted, these loan types can be used for purchase or refinance:
- Fixed-Rate: Fixed-rate loans’ interest rates are fixed for the entire loan term. Fixed-rate loan terms range from 10 to 40 years, though 15- and 30-year terms are more common. In most cases, longer-term loans have higher interest rates – for instance, in early 2018, 30-year APRs were nearly 1 percentage point higher than 10-year APRs for borrowers with excellent credit. The best rates are reserved for prime borrowers – those with FICO scores above 740.
- Adjustable-Rate: Adjustable-rate (ARM) loans‘ interest rates remain fixed for a defined initial period. At the end of this period, they adjust upward, and then change annually or twice annually with prevailing interest rates (with LIBOR or another widely accepted standard as the benchmark). Most ARMs have periodic and lifetime interest rate increase caps – typically 1 to 2 percentage points per year and 5 to 6 percentage points over the life of the loan, meaning an ARM with an initial rate of 4% could increase only to 5% or 6% within a single year and 9% to 10% over its entire term. Initial terms can be as short as 1 year and as long as 10 years. All other things being equal, initial ARM APRs are significantly lower than fixed-rate APRs, though they invariably rise above prevailing fixed-rate APRs. Some ARMs are convertible, meaning they can be converted to fixed-rate loans under certain circumstances.
- Interest-Only ARM: Interest-only ARMs are structured like traditional ARMs, with one important difference: During an initial period, the borrower only pays interest on the loan balance. This substantially lowers payments early on, but hampers equity-building and does not reduce the loan’s principal. Following the initial period, the loan amortizes and the borrower is responsible for paying principal and interest. The transition from interest-only to principal-and-interest payments can be jarring, so borrowers must confirm that they can afford future principal-and-interest payments before securing interest-only ARMs. Interest-only ARMs are often suitable for buyers who expect to sell their homes in the short- to medium-term, before principal-and-interest payments kick in and rates adjust upward. However, some ARMs (including interest-only) carry prepayment penalties that apply when they’re paid off in full within a predetermined timeframe.
The down payment is a crucial consideration for buyers seeking purchase loans. Refinance loans don’t require down payments, though they do carry substantial closing costs.
Historically, lenders required at least 20% down on conventional loans, e.g., $40,000 on a $200,000 loan. In recent years, lenders have become less strict. By 2014, many started accepting down payments as low as 3%, e.g., $6,000 on a $200,000 loan.
Low-down-payment conventional loans (down payments under 10% of the purchase price) are known as Conventional 97 loans. Interest rates may be higher on such loans, just as they’re higher for borrowers with sub-prime credit. Keep in mind that many lenders avoid Conventional 97 loans, so they may be harder to find in your area, especially if you have sub-prime credit.
Private Mortgage Insurance (PMI)
Borrowers who put down less than 20% on a conventional loan must pay private mortgage insurance, or PMI. PMI premiums are typically paid monthly. Depending on the loan-to-value (LTV) ratio, annual PMI payments on conventional loans can add up to as much as 1% of the loan principal, with higher LTV ratios producing higher PMI payments.
- Prepaid Property Taxes: Buyers generally need to prepay property taxes that accrue between the closing date and the next property tax due date. Tax rates vary widely by jurisdiction, but buyers should budget at least a few hundred dollars for this item.
- Prepaid Hazard Insurance: Buyers must also prepay their first year’s homeowners insurance premiums, which can range from less than 0.25% to more than 1% of the home’s assessed value.
- Property Survey and Appraisal: Depending on your property type and location, you may need to conduct a survey. In most cases, a relatively perfunctory mortgage survey suffices at a cost of less than $500. You’ll also need to fund a lender-commissioned property appraisal, which confirms that you’re not overpaying for the property and thereby reduces the lender’s exposure to financial loss in foreclosure. Appraisals usually cost less than $500 as well.
- Flood Determinations and Environmental Assessments: Even if the property appears not to be vulnerable to flooding, a flood determination is required to confirm this and verify that flood insurance is not necessary. Flood determinations usually cost $20 to $50. In some regions, other environmental assessments, such as fire hazard assessments, may be required.
- Home Inspection: A home inspection is optional, but highly recommended, as it can uncover potential defects and safety hazards before the transaction becomes official. Thorough inspections’ costs approach $500.
- Title Search and Insurance: A title search verifies that the seller has the right to sell the property to you – that no one else has a valid claim to its title. Title insurance covers the cost of fixing any issues discovered in the search, as well as any issues (including claims on the property) that may arise in the future. Title search costs are usually bound up in title insurance costs, and the whole package typically exceeds $1,000 (one-time, payable at closing).
- Recording and Transfer: These fees cover the cost of recording the sale with the proper authorities (usually a city or county department) and formalizing the transfer with instruments known as “stamps.” Recording and transfer costs typically range from $300 to more than $700.
- Origination Fee: This is a catch-all line item that bundles lesser closing costs together. Costs commonly included in the origination fee include courier fees, escrow charges, document fees, and attorney’s fees. These fees should be clearly laid out in the Good Faith Estimate that you receive during the closing process. Origination fees can vary significantly, but 1% of the purchase price is common.
- Discount Points: This is an optional, though common, means for lenders to increase loan yields above the stated interest rates. Discount points are basically upfront interest payments, with each point corresponding to 1% of the total loan amount and lowering the loan’s rate by as much as 0.25%. Buyers with sufficient cash at closing can reduce their ongoing monthly payments (and improve their household’s cash flow) by paying points.
FHA Mortgage Loans: Ideal for First-Time Homebuyers
FHA mortgage loans are issued by private lenders and guaranteed by the Federal Housing Administration. Designed for first-time homebuyers with limited assets and less-than-perfect credit, FHA purchase loans have historically been a crucial aid for lower-income Americans seeking the benefits of homeownership. With one noteworthy exception, homes purchased or refinanced with FHA loans must be owner-occupied and used as the borrower’s primary residence.
FHA purchase loans can be fixed-rate (the 203b mortgage loan, which applies to one- to four-family detached homes, is the most common) or adjustable-rate (the Section 251 loan applies to one- to four-family detached homes). Both configurations allow a variety of terms, with 15- and 30-year terms being the most common fixed-rate options.
FHA refinance loans, such as the FHA streamline refinance product, allow FHA-endowed homeowners to refinance at lower cost than conventional refinance loans. They’re also available in fixed-rate and adjustable-rate configurations. FHA streamline refinance loans don’t have mortgage insurance (MIP) requirements – a huge financial help for homeowners on tight budgets.
Differences Between FHA and Conventional Loans
FHA loans and conventional loans differ in some important ways:
- Maximum Loan Limits: In most markets, the maximum allowable FHA purchase loan is 115% of the median local sale price (usually calculated at the county level). In the continental U.S., the lowest maximum is $271,050 (in low-cost markets) and the highest maximum is $625,000 (in high-cost markets). In Alaska, Hawaii, and overseas protectorates such as Guam, the maximum is $938,250. These limits are subject to change with prevailing home prices. For reverse mortgages (or HECMs, a popular FHA product), the maximum allowable loan limit is $625,000 everywhere in the continental U.S. and $938,250 in non-continental jurisdictions. Use HUD’s FHA mortgage loan calculator to find your local limits.
- DTI and Housing Ratio: FHA loans permit higher DTI ratios – reliably up to 43%, and sometimes higher. The housing ratio, or the ratio of housing costs to borrower income, can also be higher than the 28% conventional loan standard – up to 31%, in most cases.
- Down Payment: For borrowers with FICO scores at 580 or better, FHA purchase loan down payments can be as low as 3.5% of the purchase price, e.g., $7,000 on a $200,000 house. That’s significantly less than the historic 20% down payment requirement on conventional loans, e.g., $40,000 on a $200,000 house. It’s also less than the 10% down payment cutoff between conventional and Conventional 97 loans, e.g., $20,000 on a $200,000 house.
- Mortgage Insurance: Mortgage insurance is much more expensive on FHA purchase loans and most FHA refinance loans (excluding streamline refinance loans). By statute, borrowers are charged a flat fee of 1.75% of the loan amount at closing, regardless of the loan type, term, or rate. This fee is typically wrapped into the loan, increasing the principal, though it can also be paid out-of-pocket. Going forward, borrowers who begin at 90% LTV or higher (10% or less down) must pay ongoing mortgage insurance premiums until the entire loan is paid off – as high as 1.05% of the loan amount each year, depending on loan term and amount financed. Borrowers who begin at less than 90% LTV must pay ongoing insurance premiums for at least 11 years. By contrast, conventional loan borrowers who begin at 80% LTV or less aren’t required to carry mortgage insurance at all. The only way for most FHA borrowers to cancel their mortgage insurance is through the FHA streamline refinance program.
- Interest Rates: All other things being equal, FHA purchase and refinance loans almost always have lower interest rates than comparable conventional loans. However, interest rate savings may be offset by higher mortgage insurance premiums.
- Credit Requirements: FHA loans have looser underwriting requirements than conventional loans. You can get a 3.5% down FHA purchase loan with a FICO score of 580 or better, and a 10% down FHA loan with a FICO score of 500 or better.
- Seller-Paid Closing Costs: FHA loans allow sellers to pay up to 6% of the purchase price toward closing, e.g., $12,000 on a $200,000 house. That’s a potentially huge benefit in buyers’ markets. Conventional loans cap seller-paid closing costs at 3% of the purchase price, e.g., $6,000 on a $200,000 house.
- Assumption: FHA loans are assumable, meaning they can be transferred from seller to buyer with minimal changes to rates and terms. Though assumptions are subject to FHA approval and lender underwriting, as well as the buyer’s ability to cover the difference (either in cash or through a second mortgage) between the remaining loan balance and the home’s appraised price, they’re huge time- and stress-savers for motivated sellers. Conventional loans generally aren’t assumable.
Types of FHA Loans
In addition to 203b and Section 251 loans for one- to four-family detached houses, FHA loans take several other forms:
- Condominium Loans: Known as Section 234c loans, FHA-insured condominium loans share much in common with 30-year fixed-rate FHA-insured loans for detached homes. However, 30-year fixed is the only FHA-backed financing option for condominium purchases. To qualify, a Section 234c loan must be applied to the purchase of an individual condominium unit within a development with at least five units. Owner-occupancy requirements are looser for Section 234c loans, but the program does require that at least 80% of FHA-insured loans in any given development be made to owner-occupants.
- Secure Refinance Loan: FHA secure refinance loans convert conventional mortgage loans, including loans that have fallen into delinquency due to upward interest rate adjustments on conventional ARMs, into FHA-backed fixed-rate loans. If you’re opting for a cash-out refinance, the upper borrowing limit is 85% LTV. For non-cash-out refinances, the upper limit is 97.75% LTV.
- FHA Streamline Refinance: FHA streamline refinance loans are designed to refinance existing FHA loans with no home appraisal and relatively low closing costs (usually less than 4% of the principal). The program’s requirements are quite lenient on paper – for instance, you can technically refinance a deeply underwater home, and there are no formal income or employment thresholds. However, most lenders require decent credit (FICO at 620 or better) and employment verification. Loans also can’t be seriously delinquent. To qualify, your new loan must drop your monthly payment by at least 5% (for instance, from $1,000 to $950). Some lenders offer the option to wrap closing costs into the loan principal, resulting in a “zero cost” loan, though this results in a higher monthly payment over the life of the loan.
- Home Equity Conversion Mortgages (HECM or Reverse Mortgage): Also known as reverse mortgages, HECM loans help owner-occupant seniors (those aged 62 or older) tap their home equity without selling their homes and moving out. Unusually for a mortgage product, HECMs don’t require monthly payments. Instead, they’re ideal sources of tax-free cash for borrowers with fixed incomes and limited assets. However, due to their significant legal and financial consequences, it’s best not to take out a HECM before consulting an attorney or financial advisor.
- Graduated Payment Loan: Graduated payment loans, or Section 245 loans, initially have very low monthly payments. Over the course of the first 5 to 10 years of the loan’s life, these payments gradually increase at rates between 2% and 7.5% annually. At the end of the step-up period, they plateau and remain constant for the remainder of the term. Graduated payment loans are ideal for borrowers who expect their incomes to rise significantly over time.
- Growing Equity Loan: Known as Section 245a loans, growing equity loans are basically more versatile and financially forgiving versions of graduated payment loans. They’re valid for most types of housing, including co-op units and existing homes slated for renovation or rehabilitation. The annual payment increase is more gradual than the graduated payment option – annual increases are capped at 5%. Terms are shorter as well – 22 years is the max.
Advantages of FHA Loans vs. Conventional Loans
Here’s a recap of the key advantages of FHA loans over conventional loans:
- Looser underwriting (credit score) requirements
- Lower down payment requirements (as low as 3.5% for borrowers with FICO at 580 or better)
- Assumability (can be transferred from seller to buyer with minimal friction)
- Higher seller-paid closing cost allowance
- Lower interest rates
- Looser DTI and housing ratio requirements
Disadvantages of FHA Loans vs. Conventional Loans
And the crucial disadvantages of FHA loans versus conventional loans:
- Upfront mortgage insurance payment 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 streamline refinance
- Lower guaranteed loan limits in low-cost markets (disadvantageous to high-end buyers in those areas)
- Homes must be owner-occupied, primary residences
VA Mortgage Loans: Great for Military Families
Authorized by the Servicemembers Readjustment Act of 1944 (SRA), the VA home loan program helps current and former servicemembers realize the dream of homeownership. Like FHA loans, most VA loans are made by private lenders and backed by the Department of Veterans’ Affairs – they’re not direct loans originated by the VA. Like FHA loans, VA loans can only be used for owner-occupied homes that qualify as the borrowers’ primary residences.
VA loans can fund purchases and refinancing efforts. Like FHA and conventional loans, they’re available in a wide variety of configurations, including 15- and 30-year fixed-rate and various adjustable-rate terms. Interest rates are usually comparable to conventional loans and higher than FHA loans.
VA loan eligibility requirements vary somewhat by branch, date, and duration of service.
As a general rule, active-duty servicemembers are eligible after serving after 180 consecutive days of duty, and sometimes as few as 90 consecutive days of duty. Veterans, including reservists and National Guard members, are eligible after 90 to 180 consecutive days of duty at any point during their careers. Reservists and National Guard personnel who do not see active duty are eligible after six consecutive years of service. Dishonorable discharges are disqualifying.
Check out the VA’s eligibility table for more information on qualification and details on applying for a Certificate of Eligibility (CoE).
Differences Between VA and Conventional Loans
In addition to service eligibility requirements, VA loans and conventional loans differ in some fundamental ways:
- Funding Fee: The biggest and most costly difference between VA loans and conventional loans is the VA funding fee. The VA funding fee is a unique charge that does not apply to conventional or FHA loans. It varies considerably by service branch, loan type, and down payment size, but generally favors first-time homebuyers or refinancers with prior active-duty experience and sub-90% LTV ratios. On purchase and cash-out refinance loans, funding fees typically range from 1.25% to 3.3% of the loan principal, e.g., $2,500 to $6,600 on a $200,000 loan. On no-cash-out refinance loans, they can be as low as 0.50% of the loan principal.
- Maximum Loan Size: VA loans are guaranteed up to $424,100 in most markets, though that cap is subject to change with market conditions. If your lender approves you for a larger loan, you’re free to take it, but the VA won’t assume the excess liability. In higher-cost markets, the VA may guarantee larger loans.
- Down Payment: One of the greatest benefits of a VA loan is the lack of a down payment requirement on smaller loans. If you qualify for a VA loan, you can potentially finance the entire purchase price of your house. However, the no-down-payment benefit has a key practical limitation: it’s usually capped at four times the standard VA entitlement of $36,000 per buyer, or $144,000. Larger loans do require down payments, though not necessarily the 10%-plus down payments commonly required by conventional lenders.
- Mortgage Insurance: VA loans do not require mortgage insurance, even when LTV is greater than 80%.
- Credit Requirements: The VA loan program’s underwriting standards aren’t quite as loose as the FHA program’s. Most lenders require a minimum FICO score of 620 to qualify, though exceptions can be made on a case-by-case basis (for instance, high-income borrowers).
- Closing Costs: By law, lenders aren’t allowed to assess certain types of closing costs on VA loans. These include attorney’s fees, escrow fees, underwriting fees, and document processing charges. In lieu of these itemized charges, lenders can assess origination charges up to 1% of the loan amount.
- Assumption: Like FHA loans, VA loans are assumable with VA approval and buyer qualification.
Types of VA Loans
VA loans come in several different forms:
- Purchase Loan: VA purchase loans require no money down – in other words, the allowable LTV ranges as high as 100%. With some restrictions, they can be used for existing detached homes, built-to-spec (new construction) homes, condominium units, manufactured homes and lots, and purchase-and-renovation projects (similar to an FHA 203k rehabilitation loan).
- Cash-Out Refinance Loan: Like conventional and FHA cash-out refinance loans, VA cash-out refinance loans replace the original loan and provide the borrower with a lump sum that they can use as they see fit. This lump sum can be as large as 100% of the borrower’s equity in the home – for instance, if the borrower owes $100,000 on a house worth $200,000, they can take up to $100,000 in cash. Cash-out refinance loans typically have lower interest rates than the loans they replace. The original (refinanced) loan does not necessarily have to be a VA loan.
- Interest-Rate Reduction Refinance Loan (IRRRL): Also known as the VA Streamline Refinance Loan (or, simply, streamline refinance), IRRRLs are specifically designed to refinance existing VA purchase loans without a second VA loan application. There’s no cash-out option, save for a $6,000 carve-out for energy-efficient home improvement projects.
- Native American Direct Loan Program (NADL): Designed specifically for service members and veterans of Native American origin, NADL loans are made directly by the VA. They’re always configured as fixed-rate, 30-year loans. Per the VA, NADLs can only be used to “finance the purchase, construction, or improvement of homes on Federal Trust Land (reservation land), or to refinance a prior NADL to reduce the interest rate.”
The VA also makes two different types of Adapted Housing Grants, which are non-loan payments for veterans with severe, permanent service-connected disabilities. These grants are designed to fund the construction, purchase, or retrofitting of disability-adapted housing for disabled veterans and their families. They don’t need to be repaid.
Advantages of VA Loans vs. Conventional Loans
Here’s a quick recap of the key advantages of VA loans versus conventional mortgages:
- No down payments required on particular loans
- No mortgage insurance required
- High cash-out refinance loan limits (cash out up to 100% of your equity in the home)
- Low costs on streamline refinance loans
- Restrictions on closing cost types and values
Disadvantages of VA Loans vs. Conventional Loans
And their key 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
If you live in a Census-defined metropolitan area, odds are you’ll qualify for a conventional, VA, or FHA loan. However, if you’re partial to wide open spaces, your best home loan option might be one we’ve only mentioned here in passing: the USDA loan.
Backed by the U.S. Department of Agriculture, USDA loans are designed specifically for first-time buyers looking to settle down outside Census-defined metropolitan areas, where the vast majority of Americans live. For those who qualify, the USDA loan program is incredibly generous – it offers 100% financing (no money down), ultra-low interest rates, and discounted PMI. Before you apply for a conventional loan or one of the more common non-conventional alternatives, do yourself (and your wallet) a favor and look into this elusive, potentially lucrative real estate financing product.
If you want to improve your chances of being approved for a mortgage, see this article: 6 Tips to Get Approved for a Home Mortgage Loan.
Which of the different mortgage loans, FHA, VA, or conventional, is right for you?