What is the Downside of a Conventional Loan?

Torn scrap of paper with the word disadvantage written on itIf you're applying for a home mortgage loan, you'll likely consider conventional and FHA loans. While both allow you to finance a home purchase, traditional loans and FHA loans have critical differences in their requirements and features. This guide examines the pros, cons, and tradeoffs of conventional versus FHA financing to help inform which type may be better for your situation.

Understanding the Differences

Conventional loans require higher credit scores and down payments but feature lower interest rates. FHA loans allow lower credit scores and down payments but charge mortgage insurance premiums for the life of the loan.

Conventional loan limits are higher than FHA's, but FHA offers more flexible qualifying standards. Look at your finances, goals, and timeline to decide which mortgage type better fits your needs. Compare interest rates, costs, loan limits, and eligibility to decide between loan options.

Advantages of Conventional Loans

Mortgages underwritten by conventional loans are available from private banks and lenders like credit unions. They adhere to guidelines set by Fannie Mae and Freddie Mac.

Conventional loans typically require higher credit scores and down payments than government-backed loans but offer lower interest rates in many cases. They are also not constrained by the same loan limits as FHA loans.

Advantages of FHA Loans

The Federal Housing Administration insures mortgage loans under FHA loans. They require lower minimum credit scores and down payments than conventional loans but also have stricter debt-to-income ratio requirements.

FHA mortgages charge an upfront mortgage insurance premium and annual premiums for the life of the loan. However, they offer more flexible qualifying guidelines, making them popular with first-time buyers.

Advantages of Conventional Loans

Some of the top advantages of a conventional mortgage include:

  • No mortgage insurance is required if you make a down payment of 20% or more. This saves on monthly costs.
  • Potentially lower interest rates than FHA, saving money monthly and over the loan term.
  • Higher loan amounts than FHA loans allow for more significant mortgage amounts.
  • There are no strict seller credit limits at closing, as FHA has.
  • Lower monthly costs than FHA in some cases, thanks to more down or no mortgage insurance.

Disadvantages of Conventional Loans

Some potential disadvantages of conventional mortgages include:

  • Typically, it requires a higher minimum down payment of 5-20% and a higher upfront cost.
  • Stricter credit score and debt-to-income requirements than the FHA, making approval more difficult.
  • If there is less than a 20% down payment, monthly private mortgage insurance payments are required, adding to costs until mortgage insurance can be canceled.
  • Potentially more costly refinancing than an FHA streamline refi, for example.
  • First-time homebuyers may have a more challenging time qualifying for a conventional loan if they have limited savings or credit history.

Advantages of FHA Loans

Key advantages of an FHA mortgage include:

  • Low minimum down payment of just 3.5%. This dramatically reduces the upfront cash needed to buy.
  • More flexible credit score requirements. FHA has a minimum credit score of just 500–580.
  • Higher debt-to-income ratios are allowed. FHA permits total debt ratios up to 57%, helping more buyers qualify.
  • Accessible to first-time homebuyers. Lower credit and downpayment requirements increase approvals.
  • Smaller down payments on investment properties. FHA allows 15% down for multi-unit properties versus conventional loans requiring 20–25%.

Disadvantages of FHA Loans

Some potential FHA loan drawbacks are:

  • Mortgage insurance premiums are required for the life of the loan, increasing long-term costs.
  • Maximum loan amounts are lower than conventional loans in most areas.
  • The upfront mortgage insurance premium due at closing adds to upfront costs.
  • Restrictions on seller credits allowed at closing make negotiations harder.
  • Refinancing requires complete documentation and appraisal versus a streamlined FHA refi.
  • Sometimes, monthly payments may be higher than a conventional mortgage when factoring in mortgage insurance premiums.

Choosing Between Conventional and FHA Mortgages

Choosing between a conventional vs. FHA mortgage involves looking at multiple factors:

  • Your current finances: credit score, savings for a down payment, income, existing debts
  • How long do you plan to stay at home? FHA mortgage insurance matters more if you are not selling soon.
  • Whether you can qualify for a conventional loan based on your financial profile
  • If you need the higher loan limits a conventional mortgage provides.

Doing the math for your unique situation will determine if the pros of an FHA loan outweigh the cons, or vice versa, for a conventional mortgage.

Understanding the Difference between Conventional and Government-backed Loans

Conventional loans are not insured or guaranteed by the government. In contrast, government-backed loans such as FHA and VA loans are insured by the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), respectively. Conventional loans generally have stricter requirements and may offer different loan terms and interest rates.

Qualifying for a Conventional Loan with a Lower Credit Score

Getting a conventional loan with a lower credit score is possible, but you may face higher interest rates and stricter requirements. A credit score of at least 620 is typically required for conventional loans.

Final Thoughts

Reviewing the pros, cons, and differences between FHA and conventional mortgages enables borrowers to select the optimal loan type to finance a home purchase based on their unique situation and financial profile.