Pros and Cons of FHA Loan Vs Conventional

FHA vs. conventional loan graphicThere are pros and cons to both the FHA and conventional loan options, so it is important to weigh the options carefully before choosing which one to pursue. The key pros of the FHA loan option include that it is available to borrowers with poorer credit scores, is backed by the government, and has low down payments. The con of the FHA loan option is that it requires a down payment of 3.5% of the home’s purchase price, which can be a considerable financial burden for some borrowers.

The key pros of the conventional loan option include that it is available to borrowers with better credit scores and has low down payments. The con of the conventional loan option is that it can be more expensive than the FHA loan option, and can have interest rates that are higher than those offered by the private sector.

What Is an FHA Loan?

An FHA loan is a type of mortgage insured by the Federal Housing Administration. The FHA insures mortgages for borrowers who have low credit scores and/or documented financial hardships such as unemployment or disability.

The FHA’s goal is to help as many qualified borrowers as possible obtain mortgage financing. If you have a credit score below 640 and/or can show that you have a good reason (like unemployment) for a lower credit score, you may be approved for an FHA loan.

The FHA loan has a number of benefits that make it a good option for potential homebuyers with low credit scores.

First, the minimum credit score requirement is only 500, however, the down payment with such a low credit score is 10%. This increases the likelihood that you can get an FHA loan.

Second, with a 580 credit and higher, the down payment requirement is 3.5%. This means that you’ll be able to put down less than 10% of the purchase price and still have access to the financial benefits of an FHA loan.

Eligibility for an FHA Loan

FHA loan applicationFHA loans are a great option for borrowers who may not qualify for other types of loans. There are various qualifying restrictions, but the procedure is easy.

FHA loan requirements include a good credit score, a stable job, and enough income to cover the cost of the home.

  • Primary residences only
  • A credit score higher than 580 (500 to 579 require a 10% down payment)
  • No bankruptcies in the last 2 years and no foreclosures in the last 3 years, with re-established good credit
  • A debt-to-income ratio under 43% 
  • Co-borrower/cosigner permitted
  • Seller concession up to 6% of the purchase price
  • No reserve payments required
  • 2-year work history (there are a few exceptions)

FHA Loans Pros and Cons Explained

Pros

  • Low monthly mortgage insurance
  • Lower credit scores allowed
  • Seller concessions up to 6% of the sales price.
  • Co-borrowers and cosigners can help with buyer's qualification.
  • Lower interest rates due to the federal backing

Cons

FHA loans require a funding fee of 1.75% of the loan amount. The charge helps fund FHA loans and reimburses lenders for defaulted mortgages.

The funding fee can be rolled into the loan, paid in cash, or paid by the home seller if agreed to.

The monthly mortgage cost is lower than the convention PMI premium with the minimum down payment, however, the monthly FHA fee (MIP) never goes a way. Even with 20% equity.

There are loan limits with FHA financing. In general, the FHA loan limits are less than conventional mortgages.

2nd homes and 1-4 unit investment properties are not eligible

Higher debt to income ratio

What is a Conventional Loan?

Conventional loan applicationConventional loans are mortgages that are backed by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These two quasi-government agencies do not lend mortgage money directly to the consumer, but work with banks and mortgage companies to provide mortgage funding to their customers. This arrangement provides lenders with near limitless mortgage funding. Lenders who agree to borrow money from Fannie Mae or Freddie Mac must meet the underwriting guidelines of Fannie Mae and Freddie Mac.  

Conventional loans, also known as conforming loans, are those that meet Fannie Mae and Freddie Mac's lending rules.

Eligibility for a Conventional Loan

Conventional/conforming loans are a great option for first time home buyers and repeat home buyers. Conventional loans set a higher standard than FHA loans.

FHA loan requirements include a good credit score, a stable job, and enough income to cover the cost of the home.

  • Primary residences, 2nd homes and 1-4 unit investment properties are eligible
  • A minimum credit score of 620 is required
  • Chapter 7 bankruptcy waiting period is 4 years, with re-established good credit
    Chapter 13 bankruptcy waiting period is 4 years, with re-established good credit from the date you filed your case and 2 years from the date it was dismissed.
  • A debt-to-income ratio under 36% (there is some flexibility with debt ratio 
  • Co-borrower/cosigner permitted
  • Seller concession
    up to 3% of the purchase price with a down payment of 3% to 9%
    6% of the purchase price with a down payment of 10% to 25%
    9% of the purchase price with a down payment greater than 25%
  • Possible reserve payments
  • 2-year work history (there are a few exceptions)
  • Less than 20% down payment requires private mortgage insurance.
  • No up front mortgage insurance premium

Conventional Loans Pros and Cons Explained

Pros

  • No monthly mortgage insurance with a 20% down payment
  • No upfront mortgage insurance
  • If PMI is required, the PMI can fall off at 22% or 20% equity
  • Seller concessions up to 6% of the sales price with a 10% or greater down payment.
  • It is possible to have co-borrowers and co-signers.
  • 2nd homes and 1-4 unit investment properties are eligible
  • Two 3% down payment programs, HomeReady and Conventional 97
  • Higher lending limit for most U.S. counties

Cons

  • Higher interest rates
  • Higher mortgage insurance with smaller down payments
  • Longer wait period for bankruptcy and foreclosure
  • Higher credit score required (620)
  • Lower debt to income ratio

Conventional loan vs. FHA: What’s better?

There is no mortgage that suits all situations. When picking between conventional loans and FHA loans, you must weigh the costs and advantages in light of your own financial situation.

If you have strong or exceptional credit, a conventional loan is often preferable since your mortgage rate and PMI charges will be lowered. However, if your credit score is in the upper 500s or low 600s, an FHA loan may be ideal. FHA is often the cheapest choice for customers with less than perfect credit.

However, they are merely broad principles. And your decision between conventional vs. FHA may be unique. Consider both loan options carefully and pick the one that best fits your needs.

Rotating question markFrequently Asked Questions

Q. Are FHA interest rates higher than conventional?
A. FHA interest rates are usually lower than conventional interest rates, because FHA mortgages are backed by the federal government, while conventional mortgages are not.

Q. Is FHA a conventional loan?
A. No, FHA is not a conventional loan. It is a government-backed loan program that offers more flexible qualifying criteria than traditional loans.

Q. Is FHA better than conventional?
A. There is no simple answer to this question, as it depends on a variety of factors including the individual's financial situation and mortgage eligibility. However, in general, FHA mortgages may be a better option for some borrowers than conventional mortgages, as they typically have lower down payments and interest rates.

Read more questions and answers about conventional loans

Conclusion

FHA loans are mortgages that are guaranteed by the Federal Housing Administration. The Federal Housing Administration guarantees mortgages for applicants with poor credit scores and/or verifiable financial challenges, such as unemployment or disability. FHA loans are an excellent choice for homeowners who may not qualify for other types of loans. Loan limits apply to FHA loans. FHA loan limitations are often lower than conventional mortgage restrictions.

With the lowest down payment, the monthly mortgage cost is less than the PMI premium; nevertheless, the monthly FHA charge (MIP) never disappears. Conforming loans are those that adhere to Fannie Mae and Freddie Mac's lending guidelines. Consider the benefits and drawbacks of each option, then choose the one that best meets your requirements.