Conventional Loan vs. FHA: Key Differences
Homeownership may seem out of reach if you’re a low-to-moderate income borrower, but that doesn’t necessarily have to be so.
The Federal Housing Administration is a governmental organization that helps people become homeowners. Unlike conventional loans, an FHA mortgage is backed by the FHA and requires a lower credit score and down payment to qualify. But that’s not the only difference in the conventional loan vs. FHA loan comparison.
Things To Consider Before Applying for a Conventional or FHA Loan
Here’s a quick rundown of the major points you should consider before making your decision:
Type of Property
When contemplating which loan type to go for, think about what kind of property you’re looking to buy. The main difference between an FHA and a conventional loan is that the first can only be used to finance a primary residence, not a rental property.
So, if you’re looking to buy your first home, an FHA loan might be the best option for you. On the other hand, if you’re planning on purchasing a vacation home, a condo, or an investment property, a conventional loan is the way to go.
Credit Score Requirements
Even if you’re not a first-home buyer, an FHA loan might still be the better option for you, especially if you don’t have a stellar credit history. Most lenders require a 620 credit score for a conventional loan, but the FHA allows buyers with a minimum score of 580 to make a 3.5% down payment.
The reason behind more strict lending terms for conventional loans is that the government doesn’t insure these mortgages, so the private lender assumes the risk of the borrower defaulting on the loan.
One of the benefits of an FHA loan vs. conventional ones is that you may obtain it with a credit score as low as 500 - but you’ll have to make a larger down payment. Namely, if your credit score is somewhere between 500 and 579, you may qualify for a loan with a 10% down payment.
A vital factor to consider in the FHA vs. conventional loan debate are the mortgage requirements you’ll have to meet to qualify for each. You’re required to pay for private mortgage insurance on a conventional loan only if you make less than a 20% down payment.
FHA loans have their own version of PMI called mortgage insurance premium. MIP is mandatory regardless of the down payment size.
On top of that, mortgage insurance premiums need to be paid upfront and annually. The upfront MIP in 2023 equals 1.75% of the loan amount, and you’ll have to pay it as your closing costs.
The annual MIP, despite its name, is paid monthly and is a percentage (ranging from 0.45% to 1.05%) of the loan amount based on your down payment and mortgage payment term.
The cost of MIP can be a deciding factor when choosing between a conventional loan vs. FHA-backed loans. You’ll either be required to pay it for 11 years (for a loan-to-value ratio lower than or equal to 90%) or throughout the life of the loan (for a loan-to-value ratio higher than 90%).
Another important factor in the FHA vs. conventional home loan comparison is loan limits for both types of loans. Both conventional and FHA loans have limits that are adjusted every year. In 2023, the baseline limit of an FHA loan for a single-family home increased by $51,000 to reach $472,030. For expensive markets, the upper limit is now $1,089,300.
There are now also "special exception area" that include Alaska, Hawaii, Guam and the US Virgin Islands, where the upper limit for single-family units in 2023 sits at a staggering $1,633,950.
Another significant difference between conventional and FHA loan types is interest rates. Rates for FHA loans are typically lower than those for conventional loans. Lenders who provide conventional loans usually apply a risk-based fee called the loan-level price adjustment to the total cost of the property to neutralize the risks.
However, you may still be able to get a better interest rate on a conventional loan if you have a credit score in the mid-700s or above. Also, mortgage rates depend on the lender and are subject to daily fluctuations.
Another advantage of conventional loan rates vs. FHA is that the majority is fixed, which means that the rate and payments stay the same throughout the life of the loan.
Another thing to consider when calculating the costs of a conventional home loan vs. an FHA-backed one is your debt-to-income ratio. This is the percentage of your monthly income that goes toward paying debts. Conventional mortgages generally have stricter requirements, and one of them is a low DTI ratio.
Lenders typically prefer this number to be below 36% to approve a conventional loan. In some cases, it can be stretched to 47% or even up to 50% if you have a very good credit score.
FHA loans tend to have higher DTI ratios on average than conventional loans, which means that you may have an easier time qualifying for an FHA loan. Still, your ratio can’t exceed 50%, as this is the maximum percentage allowed by the FHA.
Refinancing an FHA Loan
Refinancing an FHA loan into a conventional loan is an option you might want to consider at some point. It can provide you with a number of benefits, including a lower interest rate, a longer loan term, and even lower monthly payments.
There are a few things to reflect on before you decide to refinance, though. First, you’ll need to have built up enough equity in your home. One of the reasons people decide to refinance an FHA loan is to get rid of MPI. If you already own at least 20% of your home, you won't have to pay PMI with a conventional loan.
You'll also need to have a good credit score and a steady income. A good credit score can help you get a lower interest rate, while a steady income ensures that you’ll be able to make your monthly payments on time.
Another option for refinancing an FHA loan is the FHA Streamline Refinance. This financial product is only available to borrowers who already have an FHA loan. The FHA Streamline Refinance doesn’t require a credit check or income verification, and your house doesn’t have to be appraised, which simplifies the application process.
So, is a conventional loan better than FHA? The answer to that question depends on your individual circumstances. Both FHA loan pros and cons stem from the fact this type of loan was primarily designed to help moderate-to-low-income borrowers with less-excellent credit scores purchase their first home.
If you don’t recognize yourself in the description above, i.e. you have more money saved up for a down payment, your credit score is high, or you’re buying a property as a form of investment and plan to rent it, a conventional loan may be a better option for you since you may qualify for a better interest rate.
Besides, with a down payment of over 20%, you can avoid paying private mortgage insurance.
Why would you choose FHA over conventional loans?
Because FHA loans are typically easier to qualify for thanks to the fact the government guarantees these loans, which reduces the risk to the lender. You may be able to get an FHA-backed loan even if you have a high debt-to-income ratio (up to 50%), a poor credit score (as low as 500), and only a modest amount saved up for a down payment (as low as 3% of the purchase price).
What is the downside of a conventional loan?
With a conventional loan, you may have to pay private mortgage insurance (PMI) if you put less than 20% down on the home. Also, they tend to have higher interest rates than government-backed loans like FHA loans. So, you might end up paying more in interest with a conventional loan.
Which is better: FHA or conventional loan?
That depends on your circumstances. If you’re a first-time homebuyer with a low credit score, you might be better off with an FHA loan. But if you’re a homeowner with good credit and equity in your home, you should consider a conventional mortgage.
Do sellers prefer conventional or FHA loans?
Some sellers may prefer a conventional loan vs. FHA loans because FHA loans require the property to go through an FHA appraisal. Additionally, some may view FHA borrowers as “shaky” borrowers, although the statistics on closing success rates indicate this is, in fact, a misconception.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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