As someone taking advantage of a rent-to-own home purchase arrangement, there are important decisions you will need to make. For instance, after you finish the rental portion of the contract, you will need to finance the rest of the loan so the home can become your own. That means you’ll have to choose between the many available mortgage options.
Two of the most common ways to finance a rent-to-own home are through a conventional mortgage or an FHA (Federal Housing Administration) loan. Both have benefits and disadvantages – and you may find one is far better for you than the other.
We’ll be looking at each of these loans, what it offers, and why you may or may not want to choose it as your rent-to-own home lending option.
The Difference Between Conventional and FHA Loans
Many people assume an FHA loan is only for a first-time buyer, while a conventional loan is for someone who has experience buying homes or other types of properties.
While this isn’t entirely untrue, it’s also not wholly accurate. An FHA loan is insured by the Federal Housing Administration, while a conventional mortgage has no insurance from an agency under the federal government. However, both loans have advantages for some buyers, and each has its own set of qualification requirements.
Comparing the Pros and Cons of FHA and Conventional Loans
It’s not as simple as saying that a conventional or FHA loan is better in all situations. It all comes down to your specific needs. There are many things that come into play when choosing between these two types of loans. We’ll go into each of those and then explain whether FHA or conventional loans have an edge.
Minimum Down Payment Amount
With an FHA loan, the minimum down payment is 3.5% assuming you are a home buyer with a credit score of 580 or higher. On the other hand, a conventional mortgage’s minimum down payment might be as little as 3%. However, this will only apply in situations where you have an excellent credit score and a large amount of savings.
In the end, an FHA loan is better for someone with average credit and savings, and a conventional loan is ideal for those with a better credit score and savings. Of course, this is only taking the minimum down payment into consideration; there are other factors to keep in mind.
Credit Score
As mentioned, it’s easier to qualify for an FHA loan since you only need a credit score of 580 to get a 3.5% down payment (1). For those with a score between 500 and 579, you can expect to qualify if you can put down at least 10% as a down payment.
With a conventional loan, most lenders will expect a credit score of at least 620. In some cases, an even higher score is needed.
No matter which type of loan you choose, the lender will determine the actual required credit score. While the FHA has a minimum score, a lender may want a higher minimum. A better score will lead to lower interest rates regardless of the loan type.
In most cases, an FHA loan is better than a conventional loan in terms of required credit score.
Debt-to-Income Ratio
Debt-to-income ratio (DTI) is the amount of your pretax monthly income you use on your debts. This includes items like credit card minimum payments, child support, auto loans, student loans, and your mortgage. The higher the DTI is, the more challenging it may be to pay all of your monthly bills.
You can have a DTI of up to 50% for an FHA loan. In theory, the same is possible with a conventional loan. However, this isn’t a common practice. While lenders in some circumstances will accept that DTI, it’s more common to approve those with a DTI of 43% or less.
Mortgage Insurance
Mortgage insurance gives the lender protection if the mortgage isn’t paid. Conventional lenders will want you to pay mortgage insurance for any down payment under 20%. However, FHA loans require mortgage insurance no matter what down payment you provide.
Other things to be aware of are that insurance premiums are the same for FHA loans regardless of credit score. This isn’t the case for a conventional loan. The insurance payments on an FHA loan also last the entire loan period with a down payment of under 10%. This loan insurance can also be removed by refinancing to a conventional loan.
Both loans have pros and cons, but the conventional loan stands out for not requiring mortgage insurance by all people.
Loan Limits
Both FHA and conventional loans have a limit on the amount you can borrow. In addition, maximum loan amounts are set by the county, and this amount can change on an annual basis.
For instance, the FHA loan limit in low-cost areas is $420,860 for 2022, while that rises to $900,800 in more expensive locations. The Federal Housing Finance Agency sets conventional loan limits. As of 2022, the limit is $647,200. Amounts above that are considered jumbo loans.
The better limit depends on where you are buying a home. However, FHA loans have a higher limit in cities with a high cost of living.
Property Standards
The way a property will be used and its condition are also important things to think about when choosing a conventional or FHA loan.
The appraisals for FHA loans are stricter than for conventional loans. The value of the home is assessed, but it must also be inspected for adherence to local code restrictions, soundless construction, and overall safety.
Final Thoughts
When it comes down to it, FHA loans can be taken out by those with lower credit scores, but have higher down payment requirements. The property standards are stricter for qualifying for an FHA loan, and you will often find that FHA mortgage insurance is required throughout the entire loan (2).
With a conventional loan, you may need a higher credit score, but will take advantage of potentially smaller down payments. This is because the property standards are less rigorous, and mortgage insurance is only required with down payments of less than 20%.
Additional Resources
Comparing and Contrasting the Top Mortgage Lenders in the US
(1) – USA.gov
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