Despite the easing of conventional underwriting standards, market observers consider it easier to obtain an FHA loan than a conventional loan. Conventional lenders tend to disapprove loans if the monthly payment, including principal, interest, taxes and insurance, exceeds 25 to 28 percent of the borrower’s monthly income, depending on the type of loan. The FHA allows up to 29 percent. The FHA also allows a borrower to have a higher total debt burden than most conventional lenders would allow. Total debt payment, including existing debts running for ten months or more, can be as much as 41 percent of income, compared with 36 percent for most conventional loans. Lenders emphasize that these payment-to-income ratios are guidelines, not hard and fast rules. For both FHA and conventional loans, “compensating factors” such as an excellent credit record may be used to justify exceeding the guidelines.
FHA loan policies allow more expansive use of such factors than conventional loans do. Despite the recent ceiling increases, FHA loan maximums remain much lower than the limits on conventional loans, except in areas with high housing costs. For most areas, the maximum FHA loan is $132,000. Dallas has Texas’ highest FHA loan limit at $156,750. By contrast, private mortgage insurance (PMI) on conventional loans is limited to those loans eligible for purchase by Freddie Mac and Fannie Mae, which dictate an upper limit of $275,000. FHA loans have traditionally required a much lower down payment than conventional loans, making them particularly appealing to first-time homebuyers. In the past, borrowers were allowed to wrap closing costs and mortgage insurance premiums into the loan, bringing the loan total to more than 100 percent of the value of the home. In 1998, the FHA introduced a simplified method of calculating maximum loan amount that requires the borrower to make a cash investment at least equal to 3 percent of the value of the home. Part of this cash investment can be payment of closing costs in cash.
The maximum loan-to-value ratio (the amount borrowed compared with the lesser of the appraised value of the home or the sales price) depends on whether the home is located in a high- or low-settlement-cost state. In Texas, a high-settlement- cost state, an FHA loan can cover as much as 97.75 percent of acquisition costs (98.75 percent if the home costs less than $50,000).
As competition for firsttime homebuyers’ business has increased, more and more lenders have begun offering conventional loans with 3 percent down payments (97 percent loan-to-value). Through the support of Fannie Mae and Freddie Mac, lenders have introduced an array of conventional loans designed to appeal to this group. Consequently, borrowers have a much broader selection of loans, and the FHA program is becoming less unique.
While FHA loans generally have lower cash requirements than conventional loans, they may carry a higher interest rate. Recent national rate quotes for FHA fixed-rate loans run about 20 basis points (0.2 percentage points) higher than those for conventional fixed-rate loans. The table compares FHA and conventional loans on a $70,000 home. The FHA loan is calculated at maximum loanto- value and the conventional loan with 3 percent down. Closing costs for the FHA loan in this example are lower because some of the buyer’s closing costs are paid by the seller.
The monthly payment is higher because the up-front mortgage premium is financed into the loan. Both conventional and FHA lenders require an appraisal of the property prior to approving the loan. The FHA, however, now requires appraisers to inspect the homes for specific defects. The agency instituted the inspection program in 1999 to help borrowers steer clear of homes needing significant repair work. The requirement may cause sales to fall through if sellers refuse to make required repairs.
Types of Loans Available
FHA’s selection of loans includes standard fixed-rate loans and adjustable rate mortgages (ARMs). FHA’s ARM has more restrictive payment adjustment caps, meaning the range of percentage rates the loan is subject to is smaller than the range applied to conventional loans. FHA’s annual cap is 1 percent, with a lifetime cap of 5 percent, while the most common conventional ARMs have caps of 2 and 6 percent, respectively. As a result, FHA ARM borrowers are less exposed to interest rate volatility.