By Ramsey Judah
This is a question that comes up a lot in home lending. It is very important to know the difference because FHA and conventional loans have different rules for interest rates, appraisals and loan documentation. The reason why we have both started with the Great Depression.
Back in 1929, the market economy in the United States crashed. Most people lost everything: jobs, homes, farms, land, etc. Franklin Delano Roosevelt, or FDR, became president in 1933 and was tasked with finding a way out of this collapse.
He sat with the mega-rich who were taking advantage by buying everything up for pennies on dollars and forced them to agree to pay their fair share in taxes in order to help the people get back on their feet.
Thus, social services were born in order to set a foundation of care of the nation’s masses of poor and homeless. Social services like welfare, government housing, medical care and a multitude of other programs were established to allow the devastated masses to be less devastated.
The FHA Loan is Born
Among these sweeping changes, came the Federal Housing Authority in 1934 which regulated what was coined to be an FHA loan. Banks at the time were nervous to give out loans because they were afraid people wouldn’t be able to pay them back. So the federal government gave the banks a guarantee that the loans would be backed by the US government. So if anything goes wrong, the government will take over the loan.
But the FHA loan would also be regulated by the government which means the banks would have to honor the interest rate the government sets and would have to abide by the rules and regulations it has for the loan.
The Difference of a Conventional Loan
On the other hand, conventional loans come straight from the banks. They have no government-backing and can freely set the interest rates they want. Each bank has a set of loan products, or plans, that have different down payments and qualification requirements. But FHA loans have a nationally standardized 3.5% down payment and interest rate.
Besides the difference in interest rates, appraisals have different guidelines. FHA loans have much stricter guidelines for appraisals that requires full habitability for the home. For instance, if a smoke detector is working but is sitting next to where it needs to be installed, it will most likely fail the FHA appraisal.
Credit scores are also different from each loan. Conventional loans require higher credit scores whereas FHA loans can go below 600. Debt-to-income ratios are also different.
Which Loan Should You Go With?
Which loan you pick should come down to strategy. A good loan officer will figure out what would be the best scenario for you regarding the interest rate, your credit scores, your debt-to-income ratios and what your needs are. If your realtor is good, they will be able to know right off the bat whether the loan you’re getting is a good one as well based on the criteria it has. Loans are like products, each has its benefits and restrictions.