FHA vs. Conventional Loans: What’s Better For You?
If you’re looking to start your homebuying journey, you may be wondering how different loan products compare and which one is right for you. Two of your most popular options will likely be an FHA (Federal Housing Administration) loan or a conventional mortgage.
In this article, you’ll learn everything you need to know about FHA and conventional loans. Continue reading to understand how they differ, what their benefits are, and how you can get started today.
How are FHA and Conventional Mortgage Loans Different?
FHA and conventional mortgage loans have big differences that every borrower should know. Let’s break it down:
- FHA loans are backed by the government. They make homeownership possible by offering more lenient requirements to low-to-moderate-income families who may not qualify for conventional loans.
Poor credit, a low down payment, or a lack of credit history are all reasons why borrowers aren’t able to qualify for conventional mortgage loans. FHA loans, on the other hand, are attainable with a credit score above 580 and a down payment of 3.5 percent of the total purchase price.
- Conventional loans are not insured by the government. They are mostly geared toward borrowers who have higher credit scores with the ability to make a larger down payment. You can get a conventional loan from a private lender such as a bank or credit union.
Most conventional loans require a down payment of three to 20 percent, a credit score of at least 650, and a low debt-to-income ratio.
Check your loan eligibility for free today to determine which loan option works best for you.
FHA vs. Conventional: Key Considerations
If you’re on the fence between an FHA and a conventional loan, keep these important points in mind:
- FHA loans are federally insured, meaning that the government will protect the lender if you default on the loan (are unable to make payments).
- Because of this, lenders are able to offer FHA mortgage loans up to 96.5 percent of a property’s value – resulting in lower down payment requirements.
- Lenders are more willing to lend money at lower interest rates – which results in cheaper monthly payments. Loans that are not backed by the government, on the other hand, present more risk. This applies to conventional mortgages.
- With all of this in mind, the approval odds are higher for FHA loans than conventional mortgages.
If you have any questions, Total Mortgage loan experts are standing by. Find a professional near you for more information.
FHA vs. Conventional Credit Guidelines
Credit is important for all mortgage loans – but in the case of FHA vs. conventional, your credit score will significantly affect your options.
FHA Credit Score Requirements (At Least 580)
Since FHA loans were created specifically for buyers with low and recovering credit scores, they have the lowest credit score requirements available. This makes FHA loans a viable option for first-time homebuyers who haven’t had the chance to build up their credit.
A credit score of 580 or more allows you to make a down payment of just 3.5 percent. If your credit score is between 500 and 579, you’ll need to put down at least 10 percent.
In most cases, homebuyers who have a credit score below 500 won’t be able to qualify. If you’re leaning toward an FHA home loan, it’s worth it to shoot for a credit score of at least 580.
Conventional Credit Score Requirements (At Least 620)
Compared to FHA loans, conventional mortgage credit scores will typically need to be much higher. It’s difficult to guarantee an exact number since requirements vary by lender and can also be contingent upon other financial factors.
A credit score of 620 is generally the lower limit of conventional credit requirements. Remember, though, that credit impacts interest rates.
While you may be able to go as low as 620 if the rest of your loan application is spotless, the best possible rates are reserved for higher credit scores.
If your credit score is under 680, it will probably make more sense for you to opt for an FHA mortgage loan.
Are FHA Loans Better Than Conventional Loans?
The best option for you will depend on your credit score – ideally at least 680 for conventional loans and 580-680 for FHA loans.
FHA loans are easier to qualify for and require a lower down payment, which makes them more affordable for low-income borrowers or those who are actively working to improve their credit.
Interest rates are more competitive for FHA loans, which means a lower interest rate with a lower monthly payment. Plus, having an affordable down payment means you can buy a home sooner rather than later.
In addition to that, conventional loans have stricter lending requirements, making them a harder and more expensive option to qualify for.
Down Payment Requirements for FHA and Conventional Loans
According to Terry Hastings, Manager of Total Mortgage’s Ridgefield branch, borrowers usually assume they need a 10 to 20 percent down payment to buy a home – but that’s not always the case.
“Many are opting to rent because they don’t know that they can buy—and probably pay less than renting,” Terry said. “In reality, you don’t even need to put down 10 percent or even five percent.”
FHA Loan 3.5% Down Payment
With an FHA loan, you can put as little as 3.5 percent down on a house, placing the cost of buying a house more in range with the cost of a security deposit for a new rental.
To do this, you just need to have a credit score of at least 580 and meet all other FHA guidelines.
Conventional Loan 3% Down Payment
With a conventional home loan, you can go as low as three percent with something called a conventional 97 loan. Since a conventional 97 loan is technically a different program than a standard conventional loan, it has a few extra restrictions:
- The loan must be a 30-year fixed-rate loan
- The property must be a one-unit, single-family home, co-op, PUD, or condo.
- The property will be the buyer’s primary residence
- The buyer (or one of the buyers) can’t have owned a house in the last 3 years
- The loan amount is at or under $453,100
Many first-time homebuyers meet these requirements automatically, so they may not present major obstacles. For those who do, there’s still the option to put five percent down.
Private Mortgage Insurance for FHA and Conventional Loans
If you put less than 20 percent down using any loan except for a VA loan, you’ll need to get Private Mortgage Insurance (PMI).
PMI protects lenders in the event that borrowers with low equity default on their loans—and the borrower gets to pick up the tab.
Conventional Loan PMI
When it comes to conventional loans, PMI is simple: make it to 20 percent equity and you’re free and clear. This can either mean initially putting 20 percent down on the house or paying PMI until you hit 20 percent equity with your monthly mortgage payments.
Your lender is legally required to drop your PMI automatically at 22 percent, or per your request at 20 percent.
FHA Loan PMI
For FHA loans, you’ll need to pay PMI for the life of the loan if you initially make a down payment of less than 10 percent. To get out of paying PMI, you’ll need to refinance once you build enough equity.
Another thing to keep in mind is that PMI tends to be higher for FHA loans than it is for conventional loans. This happens because FHA loans have slightly more relaxed credit and debt requirements.
Income Requirements for FHA and Conventional Loans
Debt-to-income (DTI) ratio is another factor you’ll need to consider when choosing conventional vs. FHA loans.
DTI is the percentage of your gross monthly income that will go toward paying off debt. Lenders use the following formula to calculate DTI, and you can too:
monthly expenses ÷ pre-tax monthly income = DTI %
While the exact requirements can vary from lender to lender, most will require a DTI ratio of 45 percent or lower for conventional loans.
Debt-to-Income Ratio Requirements for FHA Loans
With FHA home loans, lenders will be more flexible if the borrower is in otherwise good shape. In some cases, you might see DTI ratios as high as 55 percent accepted.
“I just did a loan this summer for a buyer who had a student loan,” Hastings said.
”Even though her parent paid for the loan, her DTI ratio was too high for conventional options. The FHA approved the loan, however – and without it, she would not have been able to buy a home. As it stands, her monthly payment is less than it would cost to rent.”
Interest Rates for FHA and Conventional Loans
FHA loans tend to come with lower interest rates than conventional loans. For the most part, this is because FHA borrowers have historically been less likely to pay off their mortgages early than conventional borrowers.
This makes the servicing of these loans more valuable and incentivizes banks to offer lower rates.
However, if FHA interest rates are the only factor that’s tipping you over the edge to using an FHA loan, you may want to think again.
The difference between the two has historically been fairly minor. Since rates vary from lender to lender anyway, the savings that come with an FHA could easily be offset by needing to pay PMI for the life of the loan.
If you’re concerned with getting the lowest interest rate possible, there are other ways to get a lower rate, like opting for an Adjustable Rate Mortgage (ARM), or paying points ahead of time.
Property Eligibility for FHA and Conventional Loans
Just because you qualify for a mortgage doesn’t necessarily mean your future house will. Since FHA home loans are backed by the government and are meant to help families, they place more restrictions on the sort of properties that qualify.
FHA Property Guidelines
- Must be occupied by the buyer
- Must be your primary residence (i.e. not a vacation or investment property)
- Must be occupied within 60 days of closing
- Must be assessed for safety with an additional home inspection
- Must be under the capped lending amount (this varies by location and property size)
Conventional Mortgage Property Qualifiers
Conventional loans have fewer restrictions. Second homes and investment properties both qualify, and you won’t need special inspections. They, too, have a capped loan amount called the conforming loan limit.
Conforming loan limits vary by area, so be sure to consult with a loan expert for more information. If you find yourself in need of more financing than the conventional limits, a jumbo loan is your next step.
Conventional 97 Property Qualifiers
Of course, it’s a different story if you’re planning on taking advantage of a conventional 97 loan to put just three percent down. As we outlined in our section on down payments, the requirements also dictate that:
- The property must be a one-unit, single-family home, co-op, PUD, or condo.
- The property will be the buyer’s primary residence
- The buyer (or one of the buyers) can’t have owned a house in the last three years
Refinancing a Conventional vs. FHA Loan
With both loans, you can refinance into just about any loan you want. You can change the term length, get a lower interest rate, or even take cash out.
Refinancing a Conventional Loan
The process of refinancing a conventional loan is similar to the process of getting approved. You’ll need to apply for a refinance, provide financial documentation, get approved, and go through a less involved closing process.
FHA Streamline Refinance
If you’re refinancing from an FHA loan to another FHA loan, you’ll need to do so using a special program called FHA streamline refinance. It generally allows you to refinance with:
- No new credit score
- No new appraisal
- No new income verification
Cash-Out Refinances: Conventional vs. FHA Loan
Cash-out refinances allow homeowners to tap into the equity they’ve built up in their home, increasing their remaining loan amount in exchange for liquid cash. This money can be used to finance renovations, investments, or education.
Conventional refinances allow homeowners to take a new loan for up to 80 percent of what their property is worth. Keep in mind that this process requires a new home appraisal.
Let’s say your property is worth $100,000 and you have 60 percent equity (or $60,000 paid off).
With a conventional cash-out refinance, you’ll be able to take out a refinance loan for up to $80,000. Once you pay off the remaining loan balance of $40,000, you’ll be left with $40,000 in cash and a new mortgage for $80,000.
Meanwhile, FHA loans allow for a loan-to-value ratio (or LTV) of up to 85 percent, giving owners the opportunity to take more out of their equity.
Can You Switch from an FHA Loan to a Conventional Loan?
Under current lending requirements, you can refinance from an FHA loan to a conventional mortgage after making six months of timely payments using an FHA streamline.
The odds of approval are higher if the home has increased in value (the home now has at least 20 percent equity) or if the borrower has improved their credit score during this time.
Lenders want you to have a DTI ratio of less than 43 percent, meaning less than 43 percent of your income before taxes is paid toward the mortgage, credit cards, loans, student loans, auto payments, and other forms of debt.
Refinancing to a conventional loan from an FHA loan makes sense if your family is planning on staying in the home long enough to recoup closing costs or if interest rates have gone down by at least one percentage point.
Can You Switch from a Conventional Loan to an FHA Loan?
Yes, you can switch from a conventional loan to an FHA loan. Some borrowers will choose to refinance from a conventional loan to an FHA loan in order to pull equity out of the home for renovations, like a cash-out, to pay off existing liens, or in the event of a negative equity situation.
In order to qualify, lenders would like to see:
- At least 12 months of on-time payments
- Use the home as your primary residence for 12 months or longer
- A credit score between 620 and 640
The only time these rules don’t apply is in the event of inheritance where you haven’t used the property as an income-producing property since the inheritance occurred.
If you have used it for income, you must occupy the property for 12 months as your primary residence before qualifying for equity cash-out.
Which Is the Best Option for You: FHA or Conventional Mortgage Loans?
Neither loan is objectively better than the other. It all ultimately depends on you, your financial situation, and your plans for the future.
When to Opt for an FHA Loan
- You have lower or no credit
- You have a lot of debt
- You already have an FHA loan and want to refinance
- You don’t plan on staying in the home long enough to his 20 percent equity
- You have a bankruptcy or foreclosure in your past
When to Opt for a Conventional Loan
- You have fair to excellent credit
- You have a reasonably low DTI ratio
- You need to be able to make the smallest possible down payment
- You want to avoid PMI without refinancing
- You’re buying an investment property or a second home
Apply for an FHA loan or Conventional loan with Total Mortgage
Both FHA and conventional loans have their unique limits, disadvantages, and benefits. Choosing the right loan option for you will depend on your financial situation.
If you need help making the right decision, find a Total Mortgage loan expert near you and schedule an appointment with a financial advisor. By answering a few simple questions about your goals and status, you’ll receive a list of loans that make the most sense for you.