FHA vs Conventional Loan

If you’re in the market for a house, it’s a good idea to explore all your mortgage options. While some loans might make sense for your personal situation, others may not. For example, one loan may help you achieve affordable monthly payments, while another one could affect your long-term financial stability due to high interest rates or fees.

As you do your research and shop around, you’ll likely come across FHA loans and conventional loans. To help you decide which one might be a good fit, this article will break down the basics of how they work, along with the pros and cons of each type of loan.

What is an FHA Loan?

An FHA loan is a mortgage issued by banks, credit unions and other lenders that is backed by the Federal Housing Administration (FHA). An FHA loan typically appeals to first-time homebuyers or those with less-than-perfect credit. Since the FHA insures lenders if a borrower defaults on their loan, the requirements for an FHA loan are usually more lenient than those for other types of loans.¹

To take out an FHA loan, you must purchase a primary home, which is a property you’ll live in most of the year. An FHA mortgage also requires a credit score of at least 500 and a debt-to-income (DTI) ratio, or all your monthly debt payments divided by your monthly income, of no more than 43%. If you have a minimum credit score of 580, you may qualify with a 3.5% down payment. However, if your credit score falls between 500 and 580, you’ll need to put at least 10% down.²

Additionally, you’ll be required to meet FHA loan limits, which vary by location and year. The search tool on the Department of Housing and Urban Development’s website can help you determine how much you might be able to borrow with an FHA loan.³

Pros and cons of FHA Loans

Here’s a look at the benefits and drawbacks of FHA loans:

Pros

• Smaller down payment: Depending on your credit score, you may qualify for an FHA loan with a down payment of as little as 3.5% of your property’s purchase price. If you don’t have a lot of cash saved, this type of mortgage can help you buy a home sooner.
• Relaxed credit score requirements: You may be eligible for an FHA loan even if you have less than perfect credit. If your credit score is at least 500, you can still get approved.
• Competitive interest rates: FHA loans tend to offer better interest rates than other mortgage options, since they’re backed by the government.⁴ A lower interest rate might save you thousands of dollars over the life of your mortgage.

Cons

• Mortgage premiums: To take out an FHA loan, you’ll need to pay mortgage insurance premiums (MIPs), which protect the lender if you default on your loan.⁵ An upfront mortgage insurance premium (UFMIP) will be due at loan closing, as well as an annual MIP, which is an ongoing premium that is charged each year and divided into monthly installments that are added to your mortgage payment.⁶
• Property requirements: FHA loans are only available for homes that meet certain safety requirements. You may not qualify for one if your property is a fixer-upper with major structural or safety problems that need significant home improvements.⁷
• Loan limits: With an FHA loan, you can’t borrow more than the loan limits set for your area. Therefore, if you want to buy a more expensive home in a specific location, an FHA loan might not work.

What is a conventional loan?

A conventional loan is a type of mortgage not guaranteed or insured by a government agency. Usually offered by banks, credit unions and other mortgage lenders, a conventional loan might be conforming, which means they adhere to guidelines set by Fannie Mae and Freddy Mac regarding loan limits and credit scores. A conventional loan can also be non-conforming, meaning it doesn’t adhere to any loan limits.⁸

While conforming loans are backed by Fannie Mae or Freddie Mac, the two large companies that guarantee most U.S. mortgages, non-conforming loans are not.⁹ A conventional loan typically requires a credit score of at least 620 and a DTI of no more than 45%.

While you may get approved with a down payment of only 3%, you’ll have to pay private mortgage insurance (PMI) if you put less than 20% down. A conventional loan is usually geared toward home buyers with stronger credit who can afford higher down payments.¹⁰

Pros and cons of conventional loans

Just like FHA loans, conventional loans come with advantages and disadvantages, such as:

Pros

• Lower down payments: You can put down as little as 3% with a conventional loan, compared to an FHA loan, which requires at least 3.5% down.
• Property flexibility: A conventional mortgage may be an option for a primary residence, fixer-upper, second home, vacation home, rental property or mobile home. Conventional loans offer greater flexibility around the type of property you buy.
• Generous loan limits: Loan limits for a conventional loan are higher than limits for FHA loans or other mortgage options. You may use this type of loan to help you spend more on a home or a property in an expensive area.¹¹

Cons

• Higher credit score required: A conventional loan typically requires a credit score of at least 620. If you have less than perfect credit, you might not be eligible.
• PMI in some cases: Unless you make a down payment of 20% or more, you’ll owe PMI until you reach 20% equity (the amount of your home that you own). You can include a PMI in your monthly payment.¹²
• Potential for higher interest rates: Factors like your credit score and income will determine your interest rate with a conventional loan. Depending on your financial situation, you may be offered a higher rate than if you were to go with a government-backed mortgage, like an FHA loan.¹³

What’s the difference between an FHA loan and a conventional loan?

There are some key differences between an FHA loan and a conventional loan to keep in mind. The most noteworthy differences between FHA and conventional mortgages include:

• Credit score criteria: A conventional loan requires stronger credit than an FHA mortgage. While you’ll need a credit score of at least 620 to take out a conventional loan, an FHA loan accepts borrowers with a minimum credit score of 500.
• Down payment requirements: You’ll need to put at least 3.5% down with an FHA loan. For a conventional loan, most lenders look for a down payment of only 3%. However, less than 20% down requires you to have PMI, which could be an additional cost.
• Mortgage insurance requirements: If you opt for an FHA loan, you’ll need to pay an UFMIP and ongoing MIPs, which — if your FHA loan originated after 2013 — will be due for the life of your loan.¹⁴ A conventional mortgage will only require mortgage insurance if you put less than 20% down up front, but you could request to stop paying PMI once you reach 20% down.¹⁵ PMI in a conventional mortgage can be paid upfront or along with your mortgage payments, depending on your preferences and the lender’s options.
• Property options: With an FHA loan, you’ll have to buy a primary home and meet the loan limits in your area. Not only does a conventional loan offer much higher loan limits, but it’s also more flexible and can be an option for all types of properties beyond your primary home.

Which loan is right for you?

Whether you’d be better off with an FHA loan or a conventional loan depends on your credit, budget, financial goals and personal preferences.

If you have less-than-perfect credit or you are working on building your credit and/or haven’t saved up 20% or more for a down payment on your first home, an FHA loan is likely your best bet. An FHA loan could also be good to consider for new construction, since the FHA has stricter property requirements, and a fixer-upper may not pass inspection.

On the other hand, if you have a substantial down payment and strong credit, a conventional loan might be a better fit. A conventional mortgage can also make sense if you plan to buy an expensive home and need a higher loan limit than an FHA will provide, or a non-primary residence, such as a vacation home or rental.

Find the right loan fit

By becoming familiar with FHA and conventional loans, you can make the most informed mortgage decision for your situation. Do your research, weigh the pros and cons and set yourself up for a potentially more seamless home buying experience.

If you’re looking for personalized advice, don’t hesitate to reach out to a lender who can provide you with recommendations based on your unique financial picture.

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Sources

1,2: https://www.bankrate.com/mortgages/what-is-an-fha-loan/#requirements
3. https://entp.hud.gov/idapp/html/hicostlook.cfm
4. https://answers.hud.gov/FHA/s/article/How-can-FHA-help-me-buy-a-home
5. https://www.investopedia.com/mortgage/insurance/qualified-insurance-premium/
6,14 https://www.hud.gov/hud-partners/housing-premium-discountinue
7. https://www.investopedia.com/articles/mortgages-real-estate/11/fha-minimum-property-standards.asp
8,10,11,12: https://www.bankrate.com/mortgages/what-is-a-conventional-loan/
9. https://www.consumerfinance.gov/ask-cfpb/what-are-fannie-mae-and-freddie-mac-en-1959/
12. https://www.bankrate.com/real-estate/20-percent-down-payment-for-house/#private-mortgage-insurance
15. https://www.bankrate.com/mortgages/removing-private-mortgage-insurance/