Until recently, borrowers with down payment money representing less than 5% of a property's purchase price were limited to FHA loans. While Fannie Mae and many lenders offered financing beyond 95%, the 5% down payment threshold was imposed by mortgage insurance providers that had scaled back their coverage in California. (Any mortgage exceeding 80% of a property's value requires mortgage insurance.) In a bid of confidence for California's housing market, several mortgage insurance providers have recently increased their coverage to 97% for conventional loans.
For the right borrowers, conventional financing to 97% offers certain advantages over FHA loans. Conventional financing allows for just 3% down versus the FHA's 3.5% requirement. The loans tend to be a bit easier to work through the process and loan costs are generally lower than with FHA loans, which typically carry higher processing fees and include an upfront mortgage insurance premium of 1% of the loan amount. The appraisal process is also somewhat less stringent for conventional financing, allowing slightly more latitude in property choice. But conventional loans are more demanding with regard to a borrower's credentials. To qualify, the debt-to-income ratio cannot 41% and credit scores must be 740 or higher.
Conventional financing to 97% is also held to the true conforming loan limit of $417,000. Above this amount, conventional financing is available to $729,750, however borrowers must then have 10% down payment money. By contrast, the FHA allows for a down payment of 3.5% on loans as high as $729,750. But the FHA's seemingly greater consideration does come at a cost. In addition to the upfront mortgage insurance premium of 1%, and typically higher underwriting and processing costs, FHA mortgage insurance often carries a higher monthly payment. Depending on loan size, mortgage insurance payments can easily run several hundred dollars per month.
FHA borrowers are also locked into longer mortgage insurance periods than are those with conventional financing. FHA loans carrying a term of 15 years or more require mortgage insurance for the first 5 years of the loan. The mortgage insurance can be removed after 5 years have elapsed and there is 22% equity in the property, though the borrower must often petition for its removal. By contrast, with conventional financing, mortgage insurance is automatically removed once the loan-to-value ratio reaches 78% of the original purchase price. The borrower can also definitively remove mortgage insurance sooner by providing an appraisal showing 20% equity in their property.
FHA loans still provide great options for borrowers with limited down payment money and less credit worthy applications. For borrowers with stronger earnings and FICO scores, newly enhanced conventional financing options may well provide the better loan.