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What are the differences between an FHA home loan and a conventional loan?
When you are looking at the different loans available to purchase or refinance, it can be confusing. Over the past year there have been many changes in the underwriting guidelines for all mortgages. FHA has become a very popular choice for many home buyers. Lets take a look at the basic differences between an FHA loan and a conventional loan.
FHA stands for Federal Housing Administration. FHA insures loans that are made by approved FHA lenders, they do not lend directly to borrowers. FHA provides lenders with insurance in case a borrower defaults on their loan.
Fannie Mae and Freddie Mac are government sponsored enterprises (GSE). Their mission is to provide stability and liquidity to the U.S housing and mortgage markets. These GSEs also do not lend directly to borrowers, but they help to ensure that the banks and mortgage companies have funds to lend at affordable rates. These types of loans are typically conventional loans.
The FHA underwriting guidelines are generally more liberal than on a conventional loan. The minimum down payment required by FHA is 3.5%. All of the down payment can be a gift from a family member. The seller is allowed to pay up to 6% of the purchase price towards the buyers closing costs. To be eligible for the 6% from the seller, it must be negotiated in the purchase contract. The minimum credit score that most lenders will allow on an FHA loan is 580.
At this time, the minimum down payment on a conventional loan is 5% – 10%. Due to the lack of private mortgage insurance available, most lenders are requiring that the borrower have a minimum credit score of 720 for a loan to value of 90% – 95%. The seller can pay up to 3% of the purchase price toward the buyers closing costs. However, they can only pay the non-recurring costs. They are not allowed to pay the recurring costs such as taxes, insurance or pre-paid interest. On an FHA loan, they can pay both recurring and non-recurring costs.
One of the other benefits of an FHA loan is that they will allow a non-occupant co-borrower to co-sign on the loan. The income of both the borrower and co-borrower will be combined and used for qualifying. On a conventional loan, the owner occupant must qualify at 35%/43% ratios unless higher ratios are approved by the Automated Underwriting System.
Another difference between conventional and FHA loans is regarding private mortgage insurance. FHA mortgage insurance is required on all 30 year FHA home loans regardless of the loan to value. FHA has a monthly mortgage insurance premium and an upfront mortgage insurance premium. Even though it is called an upfront mortgage insurance premium, it is usually financed into the new loan. On average, the upfront premium is 1.75% of the loan amount. Once you have paid on the monthly mortgage insurance premium for a minimum of 5 years and the loan to value is 78% or below, you can get rid of the monthly mortgage insurance. Speak to your current lender for requirements to remove the PMI.
Conventional home loans also require private mortgage insurance; however, they only have a monthly mortgage insurance premium. They do not require the upfront MIP. Also, conventional loans usually only require mortgage insurance on loan to values that are over 80%. You can have the mortgage insurance removed from your conventional loan once you have paid for 5 years and the loan to value is 80% or below. Check with your current lender for specific documentation needed to have your PMI insurance removed.
Above is just a few of the differences between conventional and FHA home loans. For more information or to contact me directly, please visit
The Importance of Mortgage Loan Insurance
Mortgage Loan Insurance is intended to protect the lender from default on the part of the borrower, plain and simple. However, the Canada Mortgage and Housing Corporation (CMHC) designed mortgage loan insurance for more than just protecting the banks. The CMHC wanted homeowners to have a greater ability to enter the housing market, at an earlier time and with better success. After all, more privately owned housing means more jobs, more consumer activity, more money being spent and so on. If there are more jobs and more spending, then the economy benefits. In short, the risk to lenders has been removed, leaving them in a better position to offer lower interest rates and smaller payments.
When the CMHC laid out their plan for mortgage loan insurance (MLI), it included the stipulation that if the buyer had less than 20% of the purchase price as a down payment, the insurance was required. Before the advent of MLI, The Canadian Bank Act prohibited federally regulated lending institutions from lending to those with less than that 20%. Now the banks can finance up to 95% of the purchase price, provided MLI is purchased. The change meant so many more people who had previously given up on owning a home, now had hope.
For those who already own a home, MLI provides options for those wanting to renovate, refinance or move to another home. CMHC MLI’s are portable from an existing home to a newly purchased one, and sometimes without having to pay the initial premium on the new home. Additionally, the self-employed who are seeking to finance the purchase of a new home are now able to do so without providing traditional forms of proof of income. Even those who are new to Canada are eligible. Existing homeowners who wish to incorporate energy efficient elements into their home (NRCan energy assessment rating must rise by at least five points) are entitled to an extended amortization period without a surcharge and with a ten percent insurance premium rebate. There are even further benefits for borrowers purchasing a second home or income property.
Now that we know the importance of MLI, how does it translate into numbers? Well, for starters it depends on a few calculations. Your lender will do them for you, but if you want an idea ahead of time then begin with calculating the Gross Debt Service (GDS). The GDS estimates the most expenses you can afford each month, more specifically the expenses related to running the home. To qualify for an MLI, the total GDS should not be more than 32% of your gross household income. Next is calculating your Total Debt Service (TDS), which estimates the most debt load your income will support. The TDS should not be more than 40% of your gross monthly household income. Then use an online mortgage calculator to enter the information along with your total monthly income along with other factors, and you will be provided with the maximum allowable mortgage you will qualify for.
The MLI premium rate will then be calculated as a percentage of the total loan with the size of the down payment taken into account. For example, if you require the lender to finance 80% of the cost of the home then your premium will be 1% of the total loan. If your purchase requires 95% financing on the part of the lender, the premium will be 2.75% of the total loan amount. Thus, the lower the amount financed, the lower the insurance premium.
In June of 2011 the CMHC reported their findings of recent survey which asked 3512 mortgage buyers about their goals in paying off their debt. A whopping 39% said they had purposefully set their payments higher than the suggested amount so they could pay off the debt faster. A further 20% reported making a lump sum payment since the date their mortgage took effect. The summary statement offered by the CMHC was that Canadian homebuyers have “a high level of financial literacy”. The statistics offered by the corporation is certainly a good sign, and any proud Canadian homeowner should give them self a pat on the back.
Furthermore, the harder homeowners work to pay their mortgage down, the more equity they build in their home. Clearly the opportunity to purchase sooner than what was previously possible (through the installation of the MLI), homeowners have taken the chance to go further than even the lender anticipated. As of 2009, the CMHC reported that Canadian homeowners’ equity position sits at an average of 74% while their American counterparts were at 43%. The importance of the MLI is certainly clear now, isn’t it?