Conventional Loan vs. FHA: What’s the Difference, and Which One Should You Choose?
Home buyers who are interested in learning about conventional loan vs. FHA loan requirements will want to look at their financial history and other factors before determining the best choice for their needs.
During the home-buying process, the mortgage options can be overwhelmingly confusing. It seems so simple: Go to the bank or apply online, get a preapproval, shop for a home, and then close and move into the new home. What becomes clear at the start of the process, however, is that there are several different types of loans for a home, as well as a variety of programs and plans available to help buyers get on the property ladder. Some of them can be ruled out because they don’t apply to a buyer’s financial situation or circumstances; for instance, a USDA home loan is not an option for buyers who won’t be settling in a rural area. But for many home buyers, the two most obvious options are Federal Housing Administration (FHA) loans and conventional loans. On the surface, these loan programs look very similar, but the details make a big difference in who qualifies and how much money a buyer can save or will spend. Understanding the differences can make it easier for buyers to choose the right loan for their specific circumstances.
So what is a conventional loan? A conventional mortgage loan is what most people think of when they consider taking out a mortgage to buy a home. Housing is expensive, and while the lender will hold the house and property as collateral in case a borrower defaults, there is no guarantee that the lender won’t still lose money in the event a borrower defaults; there’s a lot of money on the line. As a result, lenders prefer to approve borrowers with excellent credit histories, solid down payments, and a positive debt-to-income ratio, because statistically the likelihood of those borrowers defaulting is lower than it is for borrowers who don’t meet those standards. As a rule, most conventional loans require a credit score of 620 or higher to qualify. The standard 20 percent recommended down payment on a house isn’t actually a requirement for a conventional home loan. If, however, borrowers don’t have a 20 percent down payment, they’ll be required to pay a premium for private mortgage insurance (PMI) that will cover the difference if they default, making the total monthly mortgage payment prohibitively expensive for many borrowers. Conventional loan rates tend to be a bit higher than rates for government-backed loans because the risk is on the lender.
The credit and down payment requirements protect lenders. The problem is, in the past those standards were denying homeownership to would-be homeowners. Many people who live paycheck to paycheck do so because rent and insurance are so expensive, and as they continue to put money toward rent each month, they can’t afford to save enough for a significant down payment. They might fall behind by a month or two on a payment and then be unable to overcome the hit to their credit score. Other borrowers may have gone through financial hardship and damaged their credit significantly. Even though they’ve improved their credit, make enough money to easily cover a mortgage payment, and have some money saved, they can’t qualify for a traditional loan because of their credit history. The FHA loan program was designed to help these borrowers. When considering a conventional loan vs. FHA loan, borrowers can determine the best choice for them by taking a few numbers into account.
1. FHA loans, which are backed by the Federal Housing Administration, tend to have qualification requirements that are easier to meet, making homeownership a possibility for more people.
In order to understand FHA vs. conventional loan differences, it’s important for homeowners to ask, “What is an FHA loan?” FHA loans were developed by the Federal Housing Administration upon realizing that some of the requirements for obtaining a conventional mortgage were prohibitive for many would-be home buyers who were designated by lenders as high risk. These borrowers might have a checkered credit history, or a very limited one, or they might be in a position where their rent costs such a substantial percentage of their income that they aren’t able to save enough for a conventional down payment. Traditionally, lenders viewed those borrowers as too risky, because without a sizable down payment, the borrowers had nothing to lose if they defaulted on the loan. The FHA, recognizing that many of those borrowers were fully capable of making their monthly payment each month (and in fact were anxious for the opportunity to do so), developed the FHA loan program. Through this program, the FHA guarantees the loans that lenders offer through the program. FHA loan requirements include lower down payments, lower credit score requirements, and several other easements that make borrowing easier for hopeful home buyers but reduces the risk for lenders by covering their losses should a borrower default. This program helps people who might not otherwise qualify for a traditional loan to break out of the renting cycle and get into a home faster than they would otherwise be able to, helping add stability to the housing market, adding to the economy, and helping people who want to work hard and experience the pride of homeownership to achieve their dream.
2. The credit score minimum requirement for an FHA loan is much lower than that of a conventional loan.
One of the main tips for getting a home loan is to have a good credit score. The industry standard credit score for a conventional loan is 620 or higher. According to FHA loan credit score requirements, loans can be offered to borrowers with scores as low as 500—but there’s a catch. The lower the credit score, the higher the required down payment, so a borrower with a credit score between 500 and 579 would need to have a 10 percent down payment to qualify. With a credit score of 580 or above, FHA borrowers may be able to offer a down payment as low as 3.5 percent of the loan amount. These parameters are the minimums, however—lenders are allowed, within these guidelines, to set their own standards. Some FHA loan lenders will only grant mortgages to borrowers with a credit score of 580 or above. Larger lenders and national banks are more likely to take a risk on borrowers who have lower scores, even for borrowers who are buying a home out of state.
3. The down payment requirement is another main difference between an FHA loan and a conventional loan.
Many borrowers assume that a 20 percent down payment is the gold standard of home buying—and in a way, it is. Borrowers who can put down 20 percent of the purchase price are viewed as safer risks for a lender to take because that 20 percent is free and clear should the lender need to foreclose. However, 20 percent is not actually required for a conventional loan down payment. In fact, traditional loan borrowers with excellent credit scores can make a down payment of significantly less than 20 percent. To cover the difference, borrowers who are permitted to put down less than 20 percent are required to pay for private mortgage insurance (PMI). What is mortgage insurance? It’s a policy that will cover the lender’s losses should the borrower default. A borrower can request to have PMI removed once they reach the 20 percent equity mark, but until then their monthly payments may be significantly higher than anticipated and the buyer may need to lower their home-buying budget.
FHA borrowers are certainly welcome to put down 20 percent if they can; it buys immediate equity, and for borrowers who have the cash saved it’s a great option. But the size of the down payment is, for many otherwise-qualified borrowers, the single greatest obstacle to homeownership. Old credit debt, high rent, and student loan payments, not to mention the out-of-pocket costs for medical treatment, make it difficult for many buyers (those just starting out and those who are older as well) to scrape up enough savings to even approach the 20 percent down payment necessary in a hot market.
4. Mortgage insurance, debt-to-income ratio, and interest rates are just a few other considerations when choosing between an FHA loan and a conventional loan.
Mortgage insurance requirements have changed over the last few years. If a borrower considers the difference between mortgage insurance vs. homeowners insurance, the purpose of mortgage insurance is to protect the lender just like homeowners insurance protects the borrower. With mortgage insurance, if the borrower defaults on the loan, the lender doesn’t lose money. So how much is mortgage insurance, and how is it paid? A lender will review a collection of factors such as loan size, credit score, and loan-to-value ratio (or how much money is taken in a loan compared to the value of the property) to determine rates. The premium for the mortgage insurance is paid either annually or, more commonly, as an addition to each monthly mortgage payment. For a conventional home loan, private mortgage insurance (PMI) is required only if the borrower makes a down payment of less than 20 percent. When the borrower’s equity in the house reaches 22 percent, the PMI is automatically canceled, and their monthly payment will decrease.
FHA loans require a different kind of mortgage insurance. Borrowers who have had previous FHA loans may recall that they, too, had PMI that they could cancel when they reached 20 percent equity, but that rule has changed. All FHA borrowers must now pay a mortgage insurance premium, or MIP. If the borrower initially makes a down payment of 10 percent or more, the MIP can be canceled after 11 years. Borrowers who make a down payment of less than 10 percent will be required to pay a MIP for the life of the loan. MIP is paid in two parts: the first is an up-front mortgage premium, which can be rolled into the closing costs and paid with part of the loan, and is approximately 1.75 percent of the loan amount. The borrower will then pay between 0.45 percent and 1.05 percent of the loan amount each month as part of their monthly mortgage payment. While this doesn’t seem like a huge amount, borrowers will want to remember that it’s for the life of the loan (likely 30 years), so it adds up. The only way to cancel MIP on a loan prior to the 11 year mark (if the down payment was 10 percent or more) or ever (if the down payment was less than 10 percent) is to refinance the FHA loan into a conventional mortgage.
Borrowers have likely heard several confusing real estate terms such as debt-to-income ratio (DTI). This is a calculation that lenders use to determine whether a borrower will be able to make monthly mortgage payments and still be able to afford basics like food, utilities, and the expenses of everyday life. The DTI calculation is not insignificant: While borrowers may initially be confident that they’ll be able to pinch pennies and make ends meet, lenders know that when there’s a choice between feeding a family and making a mortgage payment, dinner usually wins, so the lender wants to make sure that the borrower will have enough money to make it through the month with all obligations met. To do this, lenders use a calculation that begins with the borrower’s pretax income. They total the amount of money that a borrower will spend on all debt, including the mortgage, credit cards, student loans, auto loans, any other loans, and child support, then calculate what percentage of the borrower’s pretax income will be spent on debt. Under conventional loan requirements, lenders prefer that the DTI ratio be no higher than 45 percent of income. Borrowers applying for an FHA loan can have a DTI ratio of up to 57 percent, because the FHA’s backing of the loan reduces the risk to the bank. It’s important for borrowers to remember that the DTI ratio does not include other expenses, such as food, clothing, utilities, entertainment, school fees, or anything other than debt, so while the lender may be willing to offer a loan that will result in a DTI ratio of 57 percent, it’s still a good idea to plug these figures into an FHA loan calculator to determine whether that’s a livable amount of monthly expense.
How do interest rates compare? Interest rates are affected by several factors, including the economy and the prime rate set by the Federal Reserve. Generally, both conventional and FHA lenders use those numbers as a starting point and base their calculations on income, credit score, DTI ratio, the base amount of the loan, the down payment, and the loan-to-value ratio. Remember that for lenders, mortgages are about risk: The lenders want to make money in interest and not lose money through defaults, so they’ll put the numbers together, decide on the risk or potential reward each borrower may be, and set the interest rate for that individual borrower. In general, FHA loans are less risky for the lender because of the federal guarantee, so even though an FHA borrower may be a greater overall risk than a conventional borrower, the FHA guarantee often results in a loan that has a lower interest rate overall.
5. Both FHA and conventional loans have borrowing limits, but the limit is higher for conventional loans.
The total amount of the loan a borrower needs will guide their choice. FHA loan limits are lower than those for conventional loans, so if it’s necessary for a borrower to take out a loan for more than $420,680 (or $970,800 in certain high-priced areas), a conventional loan will be their only available option, as FHA will not grant loans higher than those limits. The limit for most conventional loans is $647,200, which offers more room for buyers to purchase homes that are larger or more expensive. A conventional loan can be conforming or nonconforming. Conforming loans must adhere to certain guidelines in terms of loan size, the borrower’s credit score, and other factors determined by Fannie Mae, Freddie Mac, and other federal agencies. Any loan above the conventional loan limit is considered a jumbo loan, which is nonconforming and therefore processed differently. In this case, neither an FHA nor a conventional loan will be possible. Taking a good look at the market prices of homes in the area a borrower would like to buy in will help them determine their options.
6. FHA and conventional loans have different property standards; an FHA loan appraisal is more stringent, and borrowers must use the FHA loan funds to purchase a primary residence.
There are other distinctions between FHA and conventional loans. If, for example, a borrower is hoping to finance a second home, they’ll have to apply for a conventional home loan: FHA loans can be used only for a primary residence and can’t be used for flipping houses or purchasing rental properties. It is possible to use an FHA loan to purchase a property that has more than one unit (up to four) as long as the owner lives on-site. Some buyers like to use this method for real estate investment because they can rent out the units they aren’t occupying, and the down payment and credit score requirements are still lower than those of a conventional loan.
By contrast, a conventional loan’s restrictions for home usage are slightly less stringent. Buyers have the freedom to use the funds to purchase investment properties where they do not plan on living, or they can purchase a part-time vacation home. The purchased property must still have only four housing units or fewer, but the owner will not be required to reside there.
7. Borrowers can refinance either type of loan, but an FHA streamline refinance may have fewer costs than a conventional loan refinance.
Many homeowners find it advantageous to refinance their mortgage at one point or another, whether they hope to reduce their monthly mortgage payment or switch to a different type of mortgage. If they have an FHA loan, they can apply for an FHA streamline refinance. There are two varieties of streamline refinances: credit qualifying and non-credit qualifying. A credit- qualifying refinance will require a thorough credit, DTI, and income check and most often applies if one of the borrowers is being removed from the mortgage. A non-credit-qualifying refinance is much quicker because the lender reviews only a few factors, such as credit score.
Both types of FHA streamline refinances tend to involve fewer costs and less red tape than a conventional mortgage refinance. In some cases, for instance, it may be possible to forgo a home appraisal. Some lenders may also offer a “no-cost” option, where they will eliminate any up-front closing costs by either implementing a higher interest rate or rolling the costs into the loan. It’s important to note that a mortgage insurance premium will still be required after a streamline refinance—converting to a conventional loan is the only way to eliminate MIP.
8. Whether an FHA loan or a conventional loan is right for you depends on two main factors in your financial profile: your down payment and your credit score.
The two greatest determiners of what kind of loan will be most beneficial for a borrower are the down payment they are able to make and their credit score. These two numbers guide everything else: Credit score determines what kind of down payment they’ll need to make, and the combination of credit score and down payment affect what interest rates will be available, the need for PMI on a conventional loan or MIP on an FHA loan, and the total amount they’ll pay for the home over time.
Filling out an FHA loan application may be the best option for borrowers with a credit score lower than 620. Even with a score higher than 620, an FHA loan can be a great choice for a borrower looking at a smaller down payment. However, borrowers whose credit scores are very high will probably find that a conventional loan is less expensive each month. But there are many variables, so the first thing for a borrower to do when they start comparing mortgage options is to sit down and assess their financial picture: What is their credit score? What is their DTI? How much do they have available for a down payment? Using an FHA or conventional loan calculator to understand these factors will make it more straightforward when the borrower meets with one of the best mortgage lenders to determine what options are best for their needs.