What is the Difference Between FHA and Conventional Loan?

Two story country home with a wrap around porchWelcome aboard the journey to understanding 'What is the Difference Between FHA and Conventional Loans?' Strap in as we delve into this crucial topic that could save you thousands of dollars and countless hours spent on financial puzzles. 

Whether you're a first-time homebuyer or an experienced investor looking to diversify your portfolio, this knowledge will equip you with invaluable insights to make informed decisions about your subsequent property acquisition.

Overview of Conventional Loans and FHA Loans

  • Conventional loans typically have lower interest rates and down payment requirements than FHA loans for borrowers with good credit.
  • FHA loans allow down payments as low as 3.5% and have more flexible credit standards, making them preferable for many first-time homebuyers.
  • Conventional loans require private mortgage insurance if you put less than 20% down. FHA loans require upfront MIP plus ongoing MIP for the life of the loan.
  • Conventional conforming loan limits in 2023 will be $726,200, compared to around $420,680 for FHA loans on average.
  • Work with a mortgage lender to compare rates and costs to determine if an FHA or conventional loan better fits your financial situation and home-buying goals.

Features of Conventional Loans

A conventional loan is a type of mortgage not backed by the government. The most typical traditional loans are conforming loans, which satisfy the funding requirements for purchase by government-sponsored companies Fannie Mae or Freddie Mac.

Some key features of conventional loans:

  • Typically, it requires a down payment of at least 5-20%.
  • Private lenders, like banks and credit unions, offer conventional loans.
  • Require private mortgage insurance (PMI) if the down payment is less than 20%.
  • Usually, they have lower monthly mortgage insurance payments than FHA.
  • Have flexible eligibility requirements, with some options for lower credit scores.

Conventional loans come in various terms, with better than the 30-year fixed rate being the most popular. You also have the option of 15- or 20-year repayment terms.

Advantages and Disadvantages of Conventional Loans

Pros of conventional loans:

  • Typically, they have lower interest rates than FHA loans.
  • The minimum down payment with good credit can be 3-5%.
  • Don't require an upfront mortgage insurance premium.
  • More lenient debt-to-income ratio (DTI) qualifications
  • PMI can be removed once 20% equity is reached.

Cons of conventional loans:

  • Require higher credit scores than FHA loans.
  • Require private mortgage insurance if the down payment is under 20%.
  • Have conforming loan limits set each year ($726,200 for 2023).
  • Mortgage insurance may be required for the entire loan repayment period.

Qualifying for a Conventional Loan

While eligibility can vary slightly between lenders, here are some standard requirements to qualify for a conventional loan:

  • Credit score: Most conventional loans require a minimum credit score 620, but many lenders look for at least 660+ for the best rates.
  • Down payment: typically, between 5-20% is required. The higher your down payment, the better mortgage rates you can qualify for.
  • Debt-to-income ratio: Your monthly debt payments, including the new mortgage, usually cannot exceed 45% of your gross monthly income.
  • Loan amount: For conforming conventional loans in 2023, the maximum amount you can borrow is $726,200. Higher loan amounts may be considered jumbo loans.

As you can see, conventional loans offer more flexibility than FHA loans when qualifying with lower credit scores and down payments. But you'll likely need excellent credit to get the very best terms.

Features of FHA Loans

The Federal Housing Administration (FHA) insures mortgages with government backing. Their most notable feature is that they allow buyers to put down as little as 3.5% while making flexible financing available to borrowers who may not qualify for conventional loans.

Here's an overview of crucial details on FHA loans:

  • Require just a 3.5% down payment for qualified borrowers.
  • Government-insured, so it's easier to qualify with lower credit scores.
  • Offer fixed interest rates and long loan terms of up to 30 years.
  • Require both upfront and annual mortgage insurance (MIP).
  • Have lower conforming loan limits set by the county, averaging $420,680?

FHA loans are funded by private lenders but insured by the FHA, which is part of the U.S. Department of Housing and Urban Development (HUD). This insurance protects lenders while assisting buyers with less-than-perfect credit or the ability to make a minimal down payment.

Advantages and Disadvantages of FHA Loans

Pros of FHA loans:

  • Low 3.5% down payment requirement
  • More flexible credit score requirements (usually 580+)
  • Available for first-time homebuyers
  • A smaller down payment allows buyers to keep more savings.

Cons of FHA loans:

  • Require upfront and annual mortgage insurance premiums.
  • Maximum loan amounts are lower than conventional loans.
  • Requires mortgage insurance for the life of the loan
  • Slightly higher interest rates than conventional loans

The upfront mortgage insurance premium and ongoing MIP can make FHA loans more expensive. However, they provide home financing options to buyers who may not qualify through conventional lending standards.

Qualifying for an FHA Loan

FHA home loans have the following eligibility requirements:

  • Credit score: Most lenders look for at least 580 to qualify for the best terms. The minimum can be 500–540.
  • Down payment: An FHA loan requires just 3.5% down. This can help first-time homebuyers.
  • Debt-to-income ratio: Your total monthly debt payments, including the new mortgage, typically should not exceed 43% of your gross monthly income.
  • Loan amount: The maximum FHA loan amount varies by county. The conforming limit nationwide averages $420,680 but can go higher in pricier markets.

FHA loans offer more flexible qualifying guidelines overall, making them a good option if you have past credit issues or limited savings for a down payment.

Comparison of FHA and Conventional Loans

Now that you understand the key features of FHA and conventional loans, let's directly compare them across some essential factors:

Down payments: Conventional loans typically require 5-20% down to get the best terms. FHA allows just 3.5% down, making its minimal requirement significantly beneficial.

Mortgage insurance: Conventional loans require private insurance if less than 20% is put down. FHA loans require an upfront MIP of 1.75% of the loan amount plus an ongoing annual MIP of 0.45% to 1.05% of the loan amount.

Interest rates: Conventional rates are generally 0.25 to 0.5 percentage points lower than FHA loan rates for borrowers with good credit. The difference gets smaller the lower your credit score is.

Credit score requirements: Conventional loans generally require a 620 FICO score or higher. FHA looks for at least 580 for approval but may accept scores in the 500s.

As you can see, conventional loans can offer better rates for borrowers with good credit, while FHA loans provide more lenient eligibility requirements.

Choosing Between FHA and Conventional Loans

Determining which mortgage option makes the most financial sense depends mainly on your specific situation as a borrower. Here are some examples where FHA vs. conventional loans may be a better fit:

First-time homebuyers: First-timers often benefit from the lower 3.5% down payment and more flexible credit standards of an FHA loan. This allows them to get approved and afford a home sooner.

Lower credit scores: Borrowers under 620 likely have difficulty qualifying for an FHA loan. Conventional loans usually require higher scores for the best terms.

Smaller down payments: FHA loans shine if you want to buy sooner by putting less money down and keeping more cash savings after closing.

Conforming loan amounts: For loan amounts over $420,680, a conventional loan would be required since FHA loans have lower limits. Jumbo, conventional loans can go higher.

Strong credit and finances: If you have a long credit history, scores above 720, a 20%+ down payment, and want the lowest rate, a conventional loan is likely your best bet.

Considerations When Deciding Between FHA and Conventional Loans

If you're still undecided about whether an FHA or conventional loan is better once you've reviewed their fundamental differences, keep these tips in mind:

  • Get preapproved to see the rates and terms you qualify for with each loan type.
  • Compare costs, including upfront mortgage insurance and ongoing PMI and MIP payments. Conventional loans can offer lower monthly premiums.
  • Before applying, meet both options' minimum down payment and credit requirements.
  • Consider interest rates. Conventional loans often have lower rates for buyers with 720 or higher credit scores.
  • Weigh the benefits of putting less money down with an FHA loan vs. getting a lower rate with a conventional loan.
  • Ask your mortgage lender for an overall cost comparison to help determine the most affordable option.
  • Look at estimated PMI and MIP costs over the life of the loan to see potential savings with a conventional loan.

Bottom Line

In conclusion, FHA and conventional loans serve different needs and situations. FHA loans are generally easier to qualify for and offer smaller down payments, making them a popular choice for first-time homebuyers or those with less-than-stellar credit.

Conversely, conventional loans require higher credit scores but can offer more favorable terms and flexibility. Ultimately, the right loan depends on your unique financial situation, credit score, and home-buying goals. It's always recommended to consult with a trusted mortgage advisor or lender who can guide you through the process and help you make the best decision based on your circumstances.