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Cover story: Circumstances decide choice of loan

- - Thursday, November 15, 2012

Whether you are a first-time buyer, a repeat buyer or a homeowner interested in refinancing, you'll need to choose between conventional financing and an FHA-insured loan.

Contrary to what many think, FHA-insured loans are available to all borrowers, not just first-time buyers. These government-insured loans do not have income limitations, either. Every potential mortgage borrower should consult with a reliable mortgage lender to explore the pros and cons of various loan programs, but aspects of FHA loans make them appealing for some borrowers.

"Typically, if a borrower has a little more cash and can make a down payment of at least 5 percent and still have some cash reserves, a conventional loan will be a better fit," said Patrick Cunningham, vice president of Home Savings and Trust Mortgage in Reston. "Usually, a conventional loan will be a little cheaper in terms of monthly payments."

Scott Toler, president and CEO of the Credit Union Mortgage Association in Fairfax, said borrowers will make the cheapest monthly mortgage payments if they can make a down payment of 20 percent or more and can qualify for a conventional home loan because they won't have to pay private mortgage insurance (PMI).

Borrowers who make a down payment of less than 20 percent or have less than 20 percent in home equity must pay private mortgage insurance (PMI) for a conventional loan. All FHA borrowers must pay annual mortgage insurance premiums for at least five years, as well as an upfront mortgage insurance premium. Mortgage insurance payments for borrowers depend on their individual circumstances.

"The biggest reason people choose an FHA loan over a conventional loan is that you only have to make a down payment of 3.5 percent on FHA loans," said Gregg Busch, vice president of First Savings Mortgage Corp. in McLean. "However, conventional loans are now available to borrowers with a down payment of 3 percent if you have good credit."

Many conventional lenders require a down payment of 5 percent or more. The rules about the source of down-payment money differ between FHA and conventional loans.

"FHA guidelines allow your down-payment funds to come entirely from a gift," Mr. Cunningham said. "Buyers who are getting money from their parents or grandparents will often choose FHA financing because of that rule."

Mr. Cunningham said the down-payment rules for conventional loans depend on the size of the down payment. If you are making a down payment of 5 percent, all of the funds must be your own. If you are making a down payment of 10 percent, 5 percent of the funds can be gift money. If you are making a down payment of 20 percent or more, all of the funds can be from a gift, he said.

In addition to needing cash for a down payment and closing costs, borrowers who choose conventional financing typically need to demonstrate that they have cash reserves to cover emergencies.

"FHA loans don't have a specific guideline for cash reserves, but most conventional loans require at least two months or more of mortgage payments in the bank," Mr. Cunningham said.

FHA loans are appealing to borrowers with less cash and also are a good fit for borrowers with less-than-perfect credit.

"Conventional loans usually require a credit score of at least 680, but most lenders will approve an FHA loan for borrowers with a credit score as low as 640," Mr. Busch said. "Sometimes they'll go as low as 620 if the borrower has other compensating factors, such as a good income, a strong job history and their own funds for the down payment."

Conventional loans have risk-based pricing, which means the interest rates are higher for borrowers with a credit score lower than 740. FHA loans generally don't require a higher interest rate for borrowers with a low credit score, often resulting in slightly lower interest rates than conventional loans for borrowers with low credit scores, Mr. Cunningham said.

Mr. Busch said FHA loans allow borrowers to have a debt-to-income ratio as high as 50 percent in some cases, while the ratio for conventional loans typically is capped at 42 percent, especially for borrowers who make a low down payment.

Borrowers need cash for closing costs in addition to their down payment and cash reserves.

"The closing costs are about the same for both types of mortgages, but the difference in loan costs comes in with the amount of the down payment/mortgage insurance required by the borrower," Mr. Toler said. "This can vary widely."

For FHA loans, an upfront mortgage insurance payment of 1.75 percent of the loan amount is required for all borrowers. This premium can be wrapped into the loan itself. In addition, borrowers must pay annual mortgage insurance as part of their monthly mortgage payments. Mr. Busch said those payments must be made for at least five years, even if the homeowner's loan-to-value is less than 80 percent.

"Private mortgage insurance is more flexible," Mr. Cunningham said. "You can pay the premiums upfront with your closing costs, have your lender pay the premiums while you pay a slightly higher interest rate or pay them monthly. You can eliminate PMI faster than FHA mortgage insurance, too."

PMI premiums vary according to your credit score, your loan-to-value and even your home's location. Mr. Cunningham said PMI premiums usually are less expensive than FHA mortgage insurance premiums. A lender can compare these two loan programs based on individual circumstances to see which mortgage will generate lower monthly mortgage payments.

Borrowers who cannot qualify on their own for a mortgage may want to ask someone to co-sign on their home loan.

"FHA rules allow a non-occupying co-signer, such as a parent or grandparent, to be on the loan," Mr. Toler said. "Conventional loans do not allow anyone to co-sign a mortgage unless that person is living in the home."

The maximum allowable loan for conventional financing is $625,500, but Mr. Busch said borrowers must make a down payment of at least 10 percent to be approved for a conventional loan of more than $417,000.

FHA loan limits vary by housing market and are capped at $729,500 in the Washington metropolitan area. Buyers can borrow up to that limit with a down payment of just 3.5 percent in this housing market, so high-income borrowers with less cash may want to consider the benefits of an FHA mortgage.

Refinancing homeowners generally prefer conventional mortgages so they can avoid paying FHA mortgage insurance premiums, Mr. Busch said. However, conventional lenders generally require home equity of at least 5 percent to 10 percent in order to refinance, while FHA refinancing is possible with as little as 2.5 percent in equity.

Mortgage lenders typically use automated underwriting systems, so borrowers can try to qualify first for a conventional loan and then can consider FHA financing if they are rejected for a conventional loan. If, however, you know your credit score is less than 680 or 700, you have limited cash resources for down payment and reserves, and your debt-to-income ratio is high, an FHA loan may be a better fit in spite of the requirement to pay higher mortgage insurance premiums.