FHA vs. Conventional Loans

When it comes to buying a home, choosing the right mortgage is a crucial step in your journey. Two of the most common types of loans available to homebuyers are FHA loans and conventional loans. Each has its own set of benefits and considerations, and the right choice for you will depend on your financial situation, credit history, and homeownership goals. In this guide, we'll break down the key differences between FHA and conventional loans, including their pros and cons, eligibility requirements, and what makes them unique. Whether you're a first-time homebuyer or looking to refinance, understanding these loan options will help you make a more informed decision.

FHA vs. Conventional Loans: What You Need to Know

Buying a home is typically the biggest financial commitment most people will ever make. To help finance this investment, most homebuyers rely on a mortgage. The type of mortgage you choose can have a significant impact on your interest rate, loan terms, qualification requirements, and the home you can afford. Two of the most popular mortgage options are FHA loans and conventional loans.

FHA Loans are backed by the Federal Housing Administration (FHA) and are offered by approved lenders. These loans are typically easier to qualify for than conventional loans, with lower down payment requirements. However, they come with a catch: you’ll be required to pay mortgage insurance premiums (MIPs) for at least 11 years, or potentially for the entire length of your loan.

In contrast, Conventional Loans are not insured or guaranteed by any government agency. These loans usually have stricter lending standards and higher down payment requirements than FHA loans. However, if you put down less than 20%, you’ll need private mortgage insurance (PMI). The good news is, once your loan balance drops to 80% of the home’s original value, you can request to have PMI removed.

Key Differences

While both FHA and conventional loans help you finance your home purchase, they differ in important ways. Here’s a breakdown of the key differences:

Credit Scores

• FHA Loans: You can qualify with a credit score as low as 500, though a score of 580 is generally preferred. Many FHA-approved lenders require a score of at least 580 for the best terms. A lower score may result in higher down payment and debt-to-income ratio requirements, and could push you into a subprime loan, leading to a higher annual percentage rate (APR) than you’d get with a 580 score or a conventional loan.
• Conventional Loans: These loans typically require higher credit scores, often 620 or higher, and may have stricter standards for down payments and debt-to-income ratios. However, once your credit score and financial profile meet the qualifications, conventional loans can offer competitive rates and more flexibility.

Minimum Down Payments

• FHA Loans: You’ll need a 3.5% down payment if your credit score is 580 or higher. If your credit score is between 500 and 579, the down payment requirement increases to 10%. FHA loans can only be used to purchase a primary residence.
• Conventional Loans: First-time homebuyers can qualify with a down payment as low as 3% of the purchase price. However, to avoid paying mortgage insurance, you’ll need to put down at least 20%. If you’re not a first-time buyer or you’re buying in a specific situation (such as a second home or multi-family property), down payment requirements increase:

1. 5% for non-first-time buyers earning less than 80% of the area’s median income

2. 10% for a second home

3. 15% for a multi-family property

Debt-to-Income (DTI) Ratios

Your debt-to-income (DTI) ratio is an important factor for lenders. It measures the percentage of your gross monthly income that goes toward paying your debts, including:

• Mortgage or rent payments
• Credit card payments
• Student loans, auto loans, and other recurring debt
• Other fixed costs like HOA fees or alimony

To calculate your DTI, add up all of your monthly debts and divide that total by your gross monthly income. Lenders generally prefer a lower DTI, as it indicates better financial stability.

• With an FHA loan, your DTI can’t exceed 45% if your credit score is below 580.
• Both FHA and conventional loans typically require a DTI of 50% or less.

Mortgage Insurance

Mortgage insurance protects the lender if you default on your loan. It's not the same as homeowners insurance, which protects you.

• FHA Loans: Borrowers are required to pay mortgage insurance premiums (MIPs) for the life of the loan. There’s an upfront premium that can be rolled into the loan, along with monthly premiums. If your down payment is 10% or more, you’ll pay MIPs for 11 years. For down payments of less than 10%, you’ll pay MIPs for the full duration of the loan.
• Conventional Loans: Borrowers who put down less than 20% are required to pay private mortgage insurance (PMI). The great news is, you can ask your lender to cancel PMI once your loan balance drops to 80% of the original value of the home. PMI will automatically be removed when the balance reaches 78%.

IMPORTANT: Starting in May 2023, upfront fees for Fannie Mae and Freddie Mac loans changed. Homebuyers with higher credit scores (740 or above) will face higher fees, while those with lower credit scores (below 640) will benefit from reduced fees. Additionally, your down payment size impacts these fees. A larger down payment means lower fees, though your credit score still plays a role. For more details, visit Fannie Mae’s Loan-Level Price Adjustments page. 

Loan Limits

Both FHA and conventional loans come with limits on how much you can borrow. For 2022:

• FHA Loans: The loan limits vary based on the market. In low-cost areas, the FHA loan limit is $420,680, while in higher-priced markets, it can go up to $970,800.
• Conventional Loans: These are subject to limits set by the Federal Housing Finance Agency (FHFA). For 2022, the standard limit is $647,200 in most parts of the U.S.

More About FHA Loans

FHA loans are federally insured and offered by FHA-approved lenders, which include banks, credit unions, and other financial institutions. These loans are designed to help borrowers with limited savings or lower credit scores achieve homeownership.

FHA loans can be used to purchase or refinance a variety of properties, such as:

• Single-family homes
• Multifamily homes (up to four units)
• Condominiums
• Certain manufactured and mobile homes

There are also FHA loan programs for new construction and home renovations.

Because these loans are federally insured, lenders can offer more favorable terms, including lower interest rates, which makes it easier for many borrowers to qualify compared to conventional loans. You can borrow up to 96.5% of the home’s value with an FHA loan, meaning a down payment requirement of just 3.5% for those with a credit score of 580 or higher. If your credit score is below 580, you may still qualify, but you’ll likely need to make a minimum down payment of 10%. Many lenders require a credit score between 620 and 640 for approval.

IMPORTANT: FHA loans may come with additional closing costs that are not typically required by conventional loans.

More About Conventional Loans

Conventional loans are mortgages not backed by any government agency, and they are offered by private lenders such as banks, credit unions, and other financial institutions. Since they are not insured by the federal government, conventional loans present a higher risk for lenders.

Because of this, lenders usually require strong financial profiles from applicants to qualify. Typically, borrowers must have excellent credit scores (often at least 680) and no significant blemishes on their credit report.

Down payment requirements for conventional loans can range from 3% to 40%, depending on the specific mortgage product.

Interest rates for conventional loans can vary based on factors such as your down payment amount, the mortgage product you choose, and prevailing market conditions. Most conventional loans have fixed interest rates, meaning the rate stays the same throughout the loan’s life. This allows you to refinance if interest rates change and you want to take advantage of better rates.

Conventional loans can be further divided into two categories:

• Conforming loans: These loans follow the guidelines set by Fannie Mae and Freddie Mac, the two government-sponsored entities that regulate most conventional loans.
• Nonconforming loans: These do not meet the guidelines set by Fannie Mae and Freddie Mac.

FHA Loan vs. Conventional Loan

FACT: For a conventional loan, PMI can be canceled once a borrower pays down enough of the mortgage’s principal.

Pros and Cons of FHA Loans

Pros and Cons of Conventional Loans

Other Government-Backed Loans

FHA loans aren’t the only type of government-backed loans available. There are two additional options:

• VA Loans: Backed by the U.S. Department of Veterans Affairs, these loans are available to qualified military members, veterans, their spouses, and other eligible beneficiaries. VA loans typically don’t require a down payment and don’t charge mortgage insurance.
• USDA Loans: Offered by the U.S. Department of Agriculture, these loans are designed for low- to moderate-income buyers in rural areas and also don’t require a down payment. There is generally more flexibility with credit score requirements.

Frequently Asked Questions:

1. What Is a Federal Housing Administration (FHA) Loan?

An FHA loan is a government-backed mortgage insured by the Federal Housing Administration. These loans are designed for borrowers who may have lower credit scores or limited funds for a down payment. FHA loans require a lower credit score and down payment compared to conventional loans, making them accessible to a broader range of homebuyers.

2. What is a Conventional Loan?

A conventional loan is a mortgage not secured by the government. These loans are typically offered to borrowers with strong financial profiles, established credit, and the ability to make a higher down payment.

3. What Credit Scores Are Needed for FHA and Conventional Loans?

• To qualify for a conventional loan, you typically need a credit score of 680 or higher.
• For FHA loans, borrowers can qualify with a credit score as low as 580. If your score is lower than 580, you can still qualify, but you'll need to make a minimum down payment of 10%.

Conclusion

Choosing between an FHA loan and a conventional loan depends largely on your financial situation. If you have a lower credit score, a higher debt-to-income ratio, or limited savings for a down payment, an FHA loan may be the better option. However, if your finances are in good shape and you can qualify for favorable terms, a conventional loan may offer more flexibility and fewer long-term costs.