Disclosure regarding our editorial content standards.
When it comes to purchasing a home, most homebuyers end up choosing between two popular types of home loans: FHA loans and conventional loans. But how do you know which one to get when comparing an FHA loan vs. a conventional loan? FHA loans are typically best for first-time homebuyers, but it’s also good to know all the details so you can make an informed choice.
What is an FHA loan?
An FHA loan is a mortgage loan backed by the Federal Housing Administration (FHA). The FHA was founded in 1932 under The National Housing Act to protect lenders against losses on home loans. The purpose of the organization is to help first-time home buyers and low-to-medium income households get approved for a mortgage.
An FHA loan has less restrictive qualifications than a conventional loan. The FHA insures home loans originated through a bank or another mortgage lender, making the satisfaction, security and benefits of homeownership available to a broader segment of the population.
According to the U.S. Department of Housing and Urban Development (HUD), the FHA has insured more than 46 million homes since 1934, making it one of the largest insurers of mortgages in the world.
What is a conventional loan?
A conventional loan is the most standard type of home loan in the mortgage industry. These loans are funded by private lenders and sold to government-sponsored organizations, like Fannie Mae and Freddie Mac. This means the private lender, rather than the government, is insuring the loan.
As private financial lenders tend to be more risk-averse, a conventional loan is much harder to qualify for than an FHA loan.
Comparing FHA loans and conventional loans
Both FHA loans and conventional loans have advantages and disadvantages. When evaluating which one you should choose, you need to consider all the ways the loans are different. Let’s take a closer look at some of these factors.
Credit scores
The crucial difference here is that an FHA loan doesn’t have as strict credit score requirements. People can get an FHA loan with a score as low as 580, while a conventional loan typically requires a score of at least 620.
But it’s important to understand that it will always be beneficial to have a higher credit score if you’re looking to get a mortgage. Your credit score is one of the heaviest weighted factors when reviewing your mortgage application. A better score can also secure a lower interest rate, which can save you thousands over the life of your loan.
Down payments
A conventional loan typically requires a down payment of between 5 and 20 percent of the purchase price. However, some applicants can be approved for a conventional loan with as little as 3 percent down.
FHA loans are meant to help individuals who can’t qualify for a conventional loan—either because of their credit score or the size of their down payment. As a result, individuals can get an FHA loan with as little as a 3.5 percent down payment.
Debt-to-income ratios
Your debt-to-income ratio is the percentage of your monthly gross income that goes toward paying debts. Because a mortgage will increase your debt payments, the lender wants to ensure you have room to pay for this new loan.
A conventional loan requires a lower debt-to-income ratio. Typically, an applicant on a conventional loan will only be considered at a maximum debt-to-income ratio of 43 percent. However, FHA loans are more lenient with debt-to-income ratios and sometimes even approve people with a debt-to-income ratio of up to 50 percent.
Generally speaking, it’s best to pay down as much of your outstanding debt as possible before getting a mortgage. Having too much debt can jeopardize your ability to pay your mortgage or pay for emergencies that come up.
Loan limits
Both FHA and conventional loans have loan limits that control how much you can borrow at most. Both options will base this limit on various factors, such as where you’re buying. Generally speaking, you can get a higher limit with a conventional loan.
For example, the 2021 maximum loan amount for conventional loans in most areas is $548,250, while the maximum loan amount for FHA loans in most areas is $356,362.
When it comes to FHA loans, applicants in certain expensive areas, like parts of Hawaii, California and New York, can receive much higher limits. For example, the 2021 loan limit for high-cost areas is $822,375. All of these numbers can change annually.
Mortgage insurance
Mortgage insurance protects the lender if a borrower is unable to continue making their mortgage payments.
A big downside of FHA loans is that they require two types of mortgage insurance payments. This is necessary to offset the additional risk a typical FHA borrower carries, such as a low credit score and a smaller down payment.
First, an FHA loan comes with an up-front mortgage insurance premium (UFMIP). This totals 1.75 percent of your loan amount and can be rolled into your loan amount or paid when you close your loan.
Additionally, FHA loan borrowers pay a monthly MIP included in their mortgage payments. This MIP can range between 0.45 and 1.05 percent of your loan amount, broken down into monthly payments across the life of your loan.
If your down payment was less than 10 percent, you pay this MIP for the life of the loan. However, if you had a down payment of 10 percent or higher, you pay the MIP for the first 11 years of your loan before you can have it removed.
Conventional loans also have mortgage insurance, known as Private Mortgage Insurance (PMI). If your down payment was less than 20 percent, you have to pay PMI. However, as soon as you reach 20 percent in equity, you can request that the PMI be removed. In addition, some lenders automatically terminate the PMI when 22 percent equity is reached.
Individuals who have a down payment of 20 percent or higher don’t need to pay PMI.
Property standards
An FHA loan is only given to people purchasing a property that will be their primary residence. Therefore, individuals can’t get an FHA loan for an investment or a secondary property.
On the other hand, conventional loans can be used for all types of property: your residence, an investment or a secondary property. You also can’t use an FHA loan to buy a property, fix it up and flip it within 90 days.
Additionally, an FHA loan and a conventional loan act differently when it comes to property inspections. While conventional loans usually pass home inspections easily—unless there’s a major problem—the same can’t be said for FHA loans. FHA loans have minimum property standards.
For example, if the home’s exterior has peeling paint, the lender may require this to be fixed before the loan is approved. An FHA appraisal wants to see that the property’s value is accurately assessed, the property is safe and it adheres to local code restrictions.
So when should you consider an FHA loan?
FHA loans are an excellent option for those who don’t qualify for conventional loans, such as those with credit scores below 620. Additionally, they may also be a good option for people with slightly higher scores who can’t afford a sizable down payment. FHA loans are often used by first-time homebuyers for these reasons.
But anyone thinking about getting an FHA loan needs to be aware that it will be more expensive than a conventional loan in the long run, thanks to mortgage insurance.
And when should you consider a conventional loan?
Conventional loans are a great choice for those with good credit scores and those who can afford larger down payments, although you shouldn’t assume a small down payment will disqualify you from a conventional loan. Individuals with an excellent credit score and a healthy debt-to-income ratio can be approved for a conventional loan with as little as a 3 percent down payment.
The conventional loan is an easy choice for someone with a 20 percent or more down payment because they can avoid mortgage insurance payments, which will save them a significant amount of money.
Unfortunately, for those with bad credit scores, a conventional loan will be very challenging to qualify for and may not even be an option.
Other mortgage options
While FHA loans and conventional loans are the two most popular loans, they aren’t the only option out there. There are also VA loans, USDA loans and FHA reverse mortgages for seniors, as well as other options. You might want to work with a mortgage broker to identify the best option for you.
No matter what, working to improve your credit score will only help you when you’re buying a home. Remember that having too low a score can eliminate some loan options for you, while on the other hand, a higher credit score, will typically get you lower rates. This can save you a significant amount of money in the long term.
If you don’t know where to start to fix your credit, consider professional credit repair services. CreditRepair.com will help you by evaluating your credit report for inaccurate negative items, filing disputes and providing you with a credit education. Start working on improving your credit today.
