Homebuyers
FHA vs. Conventional Loans: Key Differences
June 23, 2023
As you search for your dream home, you'll come across many different types of home loans. Mortgage options vary, from specialized loans like VA loans for veterans and service members to broader, more traditional loans like Conventional loans. With so many different types to choose from, it's important to do your research and work with a lender like New American Funding to find out which loan works best for your unique needs. The two most popular home loans are FHA and Conventional loans.
What Is An FHA Loan?
An FHA loan is a mortgage that is guaranteed by the United States government. They are under the governance of the Federal Housing Administration and were designed to be a more accessible alternative to the stricter credit requirements of a Conventional loan. FHA loans have more lenient qualifications and conditions than many other loan types.
The FHA does not issue the loan itself. They insure the borrower's mortgage payments to allow more borrowers to finance their dream homes. Borrowers have to pay a mortgage insurance premium (MIP) to the FHA, which the FHA then uses to guarantee the loan. This makes FHA loans a less risky option for lenders since they are protected from total loss if the borrower defaults on the loan.
FHA loans are often a beneficial choice for first-time homebuyers. They are for and were created to help homebuyers with less-than-perfect credit. They have become one of the most popular loans in the mortgage industry.
There are several types of FHA loans available. They include:
FHA 30-Year Fixed-Rate Loan: A fixed-rate loan that generally requires a small down payment. This loan may be obtained by buyers with low credit scores.
FHA 15-Year Fixed-Rate Loan: Similar to the 30-Year Fixed-Rate Loan, it offers the benefits of a stable monthly mortgage payment, except that the interest you pay over the life of the loan is significantly less because the loan is expected to be paid in half the time.
FHA 203k 30-Year Fixed-Rate Loan: The 203k loan program provides borrowers special financing to purchase a fixer-upper with enough extra money to complete necessary renovations.
What Is A Conventional Loan?
Conventional loans are the most common home loans. Unlike FHA loans, a Conventional mortgage is not backed by the government. Instead, they follow guidelines set by Fannie Mae and Freddie Mac, two publicly traded corporations created to expand the mortgage market. Conventional loans follow their guidelines and often have more flexible requirements since they do not have to adhere to government restrictions.
Fannie Mae and Freddie Mac guidelines establish certain criteria such as:
- The maximum loan amount
- Borrower income
- Credit standards
- The down payment necessary to get a home loan
Loans that are above the maximum loan amount set forth by Fannie Mae and Freddie Mac guidelines are called non-conforming loans and are also known as Jumbo loans. These loans are distributed on a smaller scale and have higher interest rates than regular conforming loans.
FHA vs Conventional Loans Comparison Chart
| Conventional 97 loan | FHA loan | |
|---|---|---|
| Minimum down payment | 3% | 3.50% |
| Minimum credit score | 620 | 500* |
| Maximum debt-to-income ratio | 45% | 57% |
| Loan limit for 2024 (in most areas) | $766,550 | $498,257 |
| Income limit | No income limit | No income limit |
| Minimum out-of-pocket contribution | 0% (Down payment and closing costs can be 100% gift funds, grants, or loans) |
0% (Down payment and closing costs can be 100% gift funds, grants, or loans) |
| Mortgage Insurance | Monthly payments are required if you have a down payment of less than 20%, but generally, the insurance auto terminates when your loan-to-value ratio reaches 78%. | Upfront Mortgage Insurance Premium is required, which may be paid in full at loan closing or financed over the life of the loan. For loans with a loan-to-value ratio greater than 90%, a monthly mortgage insurance premium is required for the life of the loan. For loans with an LTV ratio equal to or less than 90%, monthly mortgage insurance is required for 11 years. |
*Higher down payment may be required for credit scores below 580
FHA Loans vs. Conventional Loans Key Differences
There are quite a few differences between FHA and Conventional loans. The most significant are:
Credit Score: The credit score requirement is a major difference between Conventional and FHA loans.
The minimum credit score for a Conventional loan is 620, whereas borrowers may be able to qualify for an FHA loan with a credit score as low as 500 depending on the circumstances. Your credit score affects how much of a down payment your lender will require. The higher your credit score, the lower your down payment.
Minimum Down Payments: Conventional loans allow for down payments as low as 3%. FHA loans require a 3.5%-10% down payment depending on your credit score.
Debt-To-Income Ratio (DTI): FHA loans can have a DTI of as much as 57% depending on the circumstances. This is one of the things that makes them easier to qualify for than Conventional loans where the maximum DTI is 45%.
Mortgage Insurance: Both FHA loans and Conventional loans have different types of mortgage insurance requirements. FHA loans require a mortgage insurance premium (MIP). The actual amount you will pay will depend on the loan amount. All FHA loans require an upfront MIP payment of 1.75% plus a monthly payment for the life of the loan.
Conventional loans require Private Mortgage Insurance (PMI) if your down payment amount is under 20%. PMI is paid by the borrower to secure a mortgage with a lower down payment, this is to offset the risk to lenders since Conventional loans do not have the security of being backed by the government. If you can put down at least a 20% down payment, you will not have to pay PMI. If you are paying PMI, you will have the opportunity to cancel it once you've paid down your loan to 80% of the home's original value.
Loan Limits: Both Conventional loans and FHA loans adhere to different loan limits. Conventional loans can be broken into conforming and non-conforming loans. Conforming loans conform to the maximum loan limits set by the Federal Housing Finance Agency, which change annually.
FHA loans adhere to loan limits set by the Federal Housing Agency. These loans also change annually in addition to varying by county. Counties with more expensive housing have higher loan limits.
Mortgage Interest Rates: FHA loans often are lower than those of Conventional loans. However, interest rates for both depend on many factors.
External factors that affect interest rates can include economic fluctuations and changes implemented by the Federal Reserve.
Internal factors that will affect interest rates include things like your credit score, your loan amount, how much you can put down on your down payment, and what type of loan you secure.
Appraisal: Conventional loans and FHA loans have different requirements for the house appraisal process. A general home appraisal is required for a Conventional loan. An appraisal is also required for an FHA loan, but the process for approval is much stricter than for a Conventional loan.
Which Loan Is Best For You?
FHA loans can be a beneficial choice for borrowers who:
- Don't have a high credit score – FHA loans were created by the Federal Housing Administration as a resource for borrowers with less-than-perfect credit. They have a lower credit requirement than the 620 requirement for Conventional loans. The standard required credit score for FHA loans is 580, though lenders like New American Funding may go as low as 500 under certain circumstances.
- Don't have much money for a down payment – The down payment requirement for FHA loans depends on your credit score. They can go as low as 3.5% though, which can be helpful for borrowers who don't have as much saved for a down payment.
- Have a higher DTI – Allowing for a higher DTI is one of the main advantages of an FHA loan. DTI stands for debt-to-income ratio and is essentially the comparison of your monthly debt payments to your monthly income. A borrower can have a DTI as high as 57%, this is significantly higher than most other home loans.
Conventional loans can be beneficial to borrowers who:
- Have a credit score of at least 620 – The higher your credit score is, the more flexible your terms and conditions for a Conventional loan will be. Higher credit scores may also result in lower interest rates.
- Can afford a down payment of at least 3%, or 20% if you want to avoid PMI – The more you can put down for a down payment, the more beneficial the terms of your loan are likely to be. If you can put down at least 20% as a down payment, you will not be required to pay mortgage insurance on your Conventional loan.
- You have a low DTI – For Conventional loans, lenders prefer to see a DTI of 43% or lower. The lower your DTI the more capable you look to a lender of having the means to manage the debt of a monthly mortgage payment.
- You want flexible repayment terms – Conventional home loans have multiple options for repayment terms. Term lengths can be 10, 15, 20, 25, or 30 years.
For more information about our loan programs, contact New American Funding today. Our Loan Officers will answer your questions and help you decide which loan fits your unique needs.
Use our mortgage calculator to estimate how much your mortgage payments might be.
FAQs
Why do sellers prefer Conventional over FHA?
To some sellers, a homebuyer who secures Conventional financing is viewed as "safer" than borrowers who qualify for an FHA loan. That's because, in the eyes of some, FHA loans may be seen as a last resort for borrowers who can't qualify for another loan. Whether that's true or not is an entirely different question. Getting an FHA loan may make more financial sense than a Conventional loan, regardless of whether the borrower qualifies for a Conventional loan as well or not. Just be aware that that perception is out there.
Additionally, FHA loans may have different (or more rigorous) appraisal and inspection requirements since the loan is being insured by the government. That may turn off some sellers who don't want to be left haggling over who's going to be paying for needed home repairs in advance of the sale closing.
Which loan is better FHA or Conventional?
It depends on the situation. Each borrower is different. Each financial situation is different. Each home is different. Likewise, each loan has its benefits. FHA loans are easier to qualify for, but a Conventional loan is likely less expensive if you qualify. Loan Officers at New American Funding will be able to help you decide which loan is the right choice for your needs.
Why would someone get an FHA loan instead of a Conventional loan?
FHA loans are generally easier to qualify for than Conventional loans. This makes them more appealing to borrowers who are concerned they might be limited by their credit score or DTI.
Why do some sellers refuse FHA loans?
Some sellers may refuse an FHA loan because they perceive it as being riskier than other loan types. There are also stricter requirements for FHA loans, so sellers may prefer to not have to adhere to those different standards.
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