Mortgages

FHA vs. Conventional Loans

When purchasing a home, it’s important to consider your loan options. Two of the most popular loans are conventional loans and FHA loans, with both having key strengths and weaknesses.

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Most people rely on a home loan to purchase a house, but several different loan options exist. Two of the most common loan options, especially for first-time homebuyers, are conventional loans and FHA loans, which are mortgages backed by the Federal Housing Administration.

What Is an FHA Loan?

FHA loans are designed for people who otherwise wouldn’t qualify for financing on a home. The FHA encourages lenders to make these FHA loans by protecting them in case borrowers default. Conventional loans do not have this type of government protection if the homebuyer stops paying their mortgage.

To qualify for an FHA loan, you need to have a credit score of at least 500, and the home has to be your primary residence. This means that it is not an investment property or vacation home. Additionally, you will need to pay mortgage insurance premiums throughout the life of the loan.

Traditionally, FHA loans were for people who didn’t have great credit or a lot of cash available for a large down payment.

What Is a Conventional Loan?

A conventional loan is the most common type of mortgage. Because there’s no protection for the lender, the qualifying standards are much higher, meaning the borrower needs a higher credit score and their debt-to-income ratio (DTI) is more important.

Conventional loans don’t have restrictions like FHA loans, so you can use them to buy an investment property and vacation home. Conventional loans can be less expensive in the long-run, so qualifying individuals usually opt for this type of loan.

Potential homebuyers with a credit score over 620 who have enough cash for a down payment of 3% or more are good candidates for a conventional loan.

Critical Differences Between FHA and Conventional Loans

FHA and conventional mortgage lenders review an individual’s credit, income, employment history, and financial situation before determining if they will offer a home loan and what type of loan they qualify for. The following table provides a good idea of what the loan requirements are.

FeatureFHA LoanConventional Loan
Minimum Down Payment3.5%3%
Minimum Credit Score500620
Loan Limit$420,680 for a single-family home in most parts of the country$647,200 for a single-family home in most parts of the country
DTI Ratio43% (sometimes 50%)45% (sometimes 50%)
Appraisal RequirementRequiredTypically required
Mortgage InsuranceRequiredRequired if the down payment is less than 20%

Down Payment Requirements

A down payment is the amount of money a homebuyer pays at closing when the home is officially purchased. Usually, a lump sum amount that is a percentage of the purchase price.

FHA Loan

There are two possible down payment requirements for people looking to get an FHA loan. A credit score of 580 or higher will only require a down payment of 3.5%, while a credit score between 500 and 579 requires a 10% down payment.

Conventional Loan

Down payments for conventional loans can be confusing because there’s more flexibility than an FHA loan. In some cases, 3% is the minimum if you have a 660 credit score and do not make over 80% of the area median income. Otherwise, the typical down payment is 5%, but the borrower can pay as much as they want toward the purchase price.

Please note that with most conventional loans, if the borrower puts less than 20% down on the purchase, they will be required to take out Private Mortgage Insurance (PMI) until they’ve reached the equivalent of 20% down on the value of the home.

Credit Score Requirements

Credit scores play a significant role in determining which type of home loan is available to borrowers. This score is considered an indicator of fiscal responsibility; people with better credit histories have higher scores.

FHA Loan

One of the primary reasons for FHA loans is that they provide people with lower credit scores the opportunity to own a home. A score of 500 or above is required to qualify for an FHA loan. A credit score of 580 or higher drops the required down payment from 10% to 3.5%.

Conventional Loan

Most conventional loans require a credit score of at least 620. Some lenders require even higher scores. The good news is that a higher credit score often leads to a lower interest rate, saving the buyer a lot of money over the loan’s lifetime.

Loan Limits

A loan limit is the maximum amount of money someone can borrow toward a single-family home purchase. Loan limits are not universal. They vary by location and what the overall housing market is doing.

FHA Loan

The current loan limit for most locations in 2022 is $420,608 for an FHA loan. Therefore, after the down payment, the remaining balance or the amount requested for a loan cannot exceed this amount.

There are high-cost areas where that amount would not be enough to purchase a single-family home, and those areas have higher loan limits that can rise to $970,800.

Conventional Loan

For 2022, the Federal Housing Finance Agency (FHFA) announced loan limits for conforming conventional loans with a base of $647,200. The ceiling for high-cost properties is the same as that of FHA loans, $970,800.

This means that conforming conventional home loans cannot exceed $647,200 for most areas and $970,800 for high-cost areas.

Debt-to-income

A debt-to-income ratio is determined by looking at a potential homebuyer’s monthly income and monthly expenses. The ratio is determined by dividing total debt by gross income.

FHA Loan

FHA loan debt-to-income requirements set a suggested rate of 43%, but 50% and higher can be approved if certain requirements are met. To get a higher DTI approval, the borrower will have to explain the high percentage of debt and any gaps or fluctuations in employment history or income.

This is one area where an FHA loan can work in favor of the borrower, giving them more flexibility so they can purchase a home.

Conventional Loan

Conventional loans are a bit more stringent when it comes to debt-to-income. A DTI of 45% and sometimes up to 50% are required for these loans. Any percentage higher than that will likely disqualify the borrower from the loan.

Appraisal Requirements

A home appraisal is the calculated opinion of a licensed professional on the home’s market value. It should not be confused with an inspection, which explains the home’s condition. The appraisal compares the home’s asking price with comparable homes in the area that have sold, market trends, square footage, and other vital factors to ensure that the lender isn’t lending out more money than the property is worth.

FHA Loan

FHA loans require a more in-depth appraisal to verify that the home value is correct and that the home itself is sturdy and safe. FHA-certified appraisers will review that steps are safe, railings are intact, decks have no missing boards, gutters are working, the roof has life left, the crawlspace humidity levels are correct, and many other features.

Conventional Loan

Most conventional home mortgages require an appraisal as an added layer of protection for the lender since they do not have federal protection if the borrower defaults.

In some conventional loan situations, an appraisal isn’t necessary. If the loan amount is less than $250,000 and the loan is a refi or another extension of credit, then some lenders will waive the appraisal or do a desktop or drive-by appraisal.

Mortgage Insurance

Mortgage insurance is designed to protect the lender if the borrower stops making payments. This is where a big difference between FHA and conventional loans becomes evident.

FHA Loan

FHA loans require two different types of mortgage insurance. An upfront mortgage insurance premium is 1.75% of the total loan amount, which is paid for when the home is purchased. For example, if the loan is for $200,000, the upfront mortgage insurance is $3,500. This amount can be rolled into the mortgage.

The second type is a mortgage insurance premium (MIP) which is an annual charge that is then divided by 12 and split evenly over the year and turned into monthly payments. The loan amount determines this payment amount. The MIP is paid throughout the life of the loan or removed after 11 years if you put down at least 10%. MIP can also be removed once you have enough equity to refinance your loan.

Conventional Loan

Conventional home loans might require private mortgage insurance (PMI), which ranges between 0.15% and 1.95% of the total loan amount, with variations based on credit scores and down payment amounts.

If the borrower pays a minimum of 20% when purchasing the home, they skip this insurance entirely. Also, if the borrower can prove they have at least 20% equity in their home, they can then have the PMI removed.

Interest Rates

Interest rates on home loans fluctuate regularly and can have significant variances from one year to the next. They’re also dependent on the length and type of loan. A mortgage interest rate is a percent of the loan paid to the lender. Think of it as the cost of borrowing for a mortgage.

FHA Loan

Usually, FHA loans have an interest rate that’s a little bit lower than a conventional mortgage, which adds up over the life of the loan. Adding mortgage insurance to your loan balance will raise the amount you’re paying to borrow money.

Conventional Loan

Interest rates are not cut and dry. The advertised rate is not always offered because additional fees and credit rates play a huge role in the rate available to lenders. It’s best to shop around different types of lenders to see what rates they offer.

Deciding Between FHA and Conventional Loans

The key factors that go into choosing between an FHA loan or a conventional loan are an individual’s credit score and inability to qualify for a traditional loan.

Anyone with a credit score below 620 will find it almost impossible to qualify for a conventional loan. This factor alone is a big reason that an FHA loan is an excellent option for many first-time buyers.

Conventional loans are the main option for people looking for investment properties or purchasing anything other than a primary residence. Other than that, a traditional loan is more attractive for people with higher credit scores, who can then receive discounts on their interest rates, and people who can afford a down payment of 20% or more so they can avoid all additional insurance fees on their mortgage.

Alternatives to FHA or Conventional Loans

While FHA loans and conventional mortgages are the most common home financing options, they’re not the only ways to purchase a home.

USDA Loans

The U.S. Department of Agriculture backs a USDA loan. It is designed to offer loans to low- to moderate-income homebuyers who find a home to buy in a USDA-designated rural area. To qualify for a USDA home loan, the house needs to exist in an eligible rural area, be a single-family home, and be the borrower’s primary residence. Some income limitations do apply.

By promoting homeownership in rural areas, the USDA is promoting thriving communities and improving the quality of life in rural America.

VA Loans

VA home loans are offered by the U.S. Department of Veterans Affairs and offered to eligible military borrowers with no down payment and no mortgage insurance. VA loans are available to qualifying servicemembers, veterans, and surviving spouses. Some programs help after the home purchase if repairs or adaptations are necessary.

VA loans come from banks and mortgage companies, but the VA facilitates these mortgages by guaranteeing a portion of the loan, which makes the loan more appealing to the lender.

The main benefits of a VA loan to the borrower are that the VA requires no down payment, low-interest rates, limited closing costs, and no PMI, and this is not a one-time benefit.