FHA and conventional mortgage loans are two great ways to purchase a home property. Both of these loan options offer low down payments to purchase a home. Buyers do not need to be first-time home buyers to use these two loan programs. Also, these programs are typically the best options for refinancing or renovating a home. This article will help you decide between FHA vs conventional mortgage.
However, you must first understand the difference between these two types of loans and weigh all the pros and cons to see which option can help you get the best results in your current situation.
What is a Conventional Loan?
A conventional loan is a mortgage not guaranteed or insured by the government, such as the Federal Housing Administration (FHA) or the Department of Veterans Affairs (VA). Instead, private lenders offer conventional loans that are subject to the guidelines and requirements set by Fannie Mae and Freddie Mac.
Fannie Mae (Federal National Mortgage Association) was established in 1938. Freddie Mac (Federal Home Loan Mortgage Corporation) was chartered by Congress in 1970. Both were designed to support the U.S. housing finance system and to help ensure a reliable and affordable supply of mortgage funds across the country. Neither Fannie nor Freddie lend directly to borrowers; they acquire and buy loans from originating lenders that meet their standards and guidelines. Lenders can provide more loans to qualified borrowers.
Fannie Mae and Freddie Mac operate in the U.S. secondary mortgage market and help keep capital flowing into the housing market by selling mortgage-backed securities to investors. Credit unions, banks, or other non-bank mortgage entities will service the loans for Fannie Mae and Freddie Mac. Conventional home loans have been the most used type of mortgage for quite some time. Conventional mortgage loans have accounted for over 80% of all the mortgage loans closed in 2021 and 2022.
Conventional home loans can be divided into two categories: conforming and non-conforming. Conforming loans are the most common form of conventional loans that follow all the agency rules set by the Federal Housing Finance Agency and adhere to strict compliance regulations by the law. Inversely, non-conforming loans don’t follow the previous rules and depend entirely on the terms each lender specifies when negotiating the deal. These loans are sometimes referred to as “portfolio loans.”
Each of these conventional loans can help you borrow different amounts of money depending on which one you choose. The Federal Housing Finance Agency (FHFA) determines the maximum conforming loan amount. The current maximum conforming loan amount limit for 2023 is the Contiguous States, the District of Columbia, and Puerto Rico for one unit home, which is $726,200.00 (there is a high balance agency loan based on each county.)
The non-conforming loans, referred to as “Jumbo Loans,” will allow higher loan amounts.
Pros of Conventional Loans
Although conventional loans must follow the requirements set by Fannie Mae and Freddie Mac, this type of mortgage does come with several notable advantages, including the following:
- Flexible Loan Amounts: Conventional loans are available for various loan amounts, from small to high-value mortgages. This flexibility allows borrowers to choose a loan amount that suits their needs.
- Competitive Interest Rates: Conventional loans often come with competitive interest rates, especially for borrowers with strong credit histories. Borrowers with excellent credit may qualify for some of the lowest interest rates.
- No Upfront Mortgage Insurance: Unlike FHA loans, which typically require upfront mortgage insurance premiums (MIP), conventional loans do not have this requirement for most borrowers. This can save borrowers money at closing.
- No Monthly Mortgage Insurance (With Adequate Down Payment): If you make a down payment of at least 20% of the home’s purchase price, you can avoid the cost of private mortgage insurance (PMI), typically required on conventional loans with smaller down payments. PMI can add to the overall cost of a mortgage. When choosing a lower down payment option with a conventional loan, the mortgage insurance required can eventually be removed when the property has sufficient equity.
- Various Loan Term Options: Conventional loans offer a range of loan term options, such as 15, 20, or 30 years. Borrowers can choose a loan term that aligns with their financial goals and budget.
- Flexible Eligibility Criteria: While conventional loans have stricter credit and income requirements compared to some government-backed loans, they are more flexible than you might find with specialized loan programs like VA or USDA loans. Borrowers with good credit and stable income can qualify more easily.
- No Property Type Restrictions: Conventional loans can purchase various property types, including single-family homes, condominiums, multi-unit, and investment properties.
- Refinancing Options: Conventional loans can also be used for refinancing existing mortgages, allowing homeowners to take advantage of lower interest rates or to tap into their home equity.
- Jumbo Loan Options: Conventional loans, often called jumbo loans, can be used to finance high-value homes. While these loans may have stricter requirements, they finance more expensive properties.
What is an FHA Loan?
An FHA (Federal Housing Administration) loan is a government-backed mortgage loan designed to help make homeownership more accessible, especially for first-time homebuyers and individuals with lower credit scores or smaller down payments. The FHA does not lend money directly to borrowers but instead insures loans provided by approved FHA lenders. This insurance protects lenders, allowing them to offer more favorable terms to borrowers who might not qualify for conventional mortgages.
Pros of FHA Loans
Since FHA loans are designed to make homeownership more accessible, they come with several advantages, including:
- Lower Down Payment: FHA loans typically require a lower down payment than conventional loans. The minimum down payment requirement can be as low as 3.5% of the purchase price. This makes buying a home easier for borrowers who may not have substantial savings.
- More Lenient Credit Requirements: FHA loans are generally more forgiving of lower credit scores and past credit issues than conventional loans. Borrowers with credit scores as low as 580 can qualify with a 3.5% down payment. Those with scores below 580 may still be eligible for a larger down payment. With a 10% or higher down payment, FHA will consider approval for a credit score down to 500.
- Competitive Interest Rates: FHA loans often have competitive interest rates, which can make homeownership more affordable over the life of the loan.
- Easier Qualification: The FHA’s underwriting guidelines are somewhat more flexible than conventional loans, making it easier for some borrowers to qualify. This includes factors like higher debt-to-income ratios.
- Assumable Loans: FHA loans are assumable, which means that if you decide to sell your home, the new buyer can assume your existing FHA loan. This feature can be attractive to potential buyers and may increase the resale value of your home.
- Low Closing Costs: FHA regulations limit the closing costs charged to the borrower, which can help reduce the upfront costs of buying a home.
- Rehabilitation Loans: FHA 203(k) loans allow borrowers to finance both the purchase of a home and the cost of necessary repairs or renovations in a single loan, making it easier to buy fixer-upper properties.
- Down Payment Assistance: FHA loans are often compatible with down payment assistance programs offered by state and local governments, nonprofit organizations, and employers, reducing the upfront cash required.
- No Prepayment Penalty: FHA loans do not have prepayment penalties, so borrowers can make extra payments or pay off the loan early without incurring additional fees.
- Home Inspection Protection: FHA loans typically require a home appraisal and inspection, which can help ensure that the property is in good condition and that you’re making a sound investment.
Despite these advantages, it’s essential to be aware of the potential downsides of FHA loans, such as mortgage insurance premiums (MIP) that can increase the overall cost of the loan and property requirements that must be met. Additionally, FHA loans are subject to loan limits, which vary by location and property type. It’s crucial to carefully evaluate your financial situation and compare loan options to determine whether an FHA loan is right for your specific circumstances.
Eligibility Requirements for Conventional Loan versus FHA loan
When deciding between a conventional loan and an FHA loan, one of the key factors to consider is the eligibility requirements. These criteria can often make or break your decision since they directly influence whether you qualify for one or both home loans. Let’s delve into the different eligibility aspects, such as credit score, down payment, and debt-to-income ratios involved in conventional vs. FHA loans.
Credit Score Requirements for FHA vs Conventional Home Loan
The first major difference lies within their requisite credit scores. A conventional mortgage usually requires a higher credit score threshold than an FHA mortgage. Whereas the minimum acceptable score for most conventional mortgages circles around 620, an entry-level figure for an FHA loan stands at approximately 500. This significant discrepancy in required scores makes the FHA option quite appealing to borrowers with robust credit histories or past issues like bankruptcies or foreclosures.
Down Payment Requirements for FHA Loans vs Conventional Loans
Some conventional loan options require as little as 3% down payment, while most programs require a minimum of 5%. For FHA, the minimum down payment for borrowers with a credit score of 580 or higher starts at 3.50%.
Debt-to-Income Ratio Requirements for Conventional Home Loan vs FHA Loan
Generally, with approval through the automated underwriting system, a conventional mortgage will require your DTI to be 49% or less. The debt-to-income is calculated by dividing the total monthly minimum debt payments ( the new house payment, auto loan payments, student loan payments, and minimum credit card payments) by your total gross monthly income.
However, when comparing FHA loans to conventional loans, you’ll find more leniency with FHA-conforming lenders. With approval through the automated underwriting system, FHA could be okay with a borrower whose DTI is 50%.
Just remember, while these requirements give an impression of FHA loans being easier to qualify for overall, every prospective homeowner’s situation is unique. Thus, evaluating every aspect thoroughly and maybe seeking professional advice before deciding which path to walk down for your home loan journey is essential.
Loan Limits for Conventional vs. FHA Loans
Loan limits for conventional and FHA loans can vary depending on location and property type. Conventional loans, which are not government-backed, have their loan limits set by the Federal Housing Finance Agency (FHFA). In 2023, the standard conforming loan limit for most parts of the United States is $726,200 for a one-unit property. However, the high balance loan limit could be raised to as much as $1,089,300 in areas with significantly higher home prices. These limits also extend to multi-unit properties, with higher limits for duplexes, triplexes, and fourplexes.
On the other hand, FHA loans, which the Federal Housing Administration insures, also have loan limits determined by location and property type. In 2023, the FHA loan limit for single-family homes in most areas of the U.S. was $472,030. Like conventional loans, FHA loan limits increase in high-cost areas, reaching a maximum of $1,089,300 for one-unit homes. FHA also establishes specific loan limits for multi-unit properties, allowing for higher limits on properties with more units.
Remember that these loan limits can change from year to year based on market conditions and government policies, so it’s advisable to check with a mortgage lender or consult the FHFA and FHA websites for the most up-to-date information regarding loan limits in your area.
Mortgage Insurance for Conventional vs. FHA Loans
Mortgage insurance plays a significant role when comparing conventional and FHA loans, and it differs between these two loan types.
For conventional loans, borrowers must typically pay Private Mortgage Insurance (PMI) if their down payment is less than 20% of the home’s purchase price. PMI safeguards the lender in case the borrower defaults on the loan. The cost of PMI can vary based on factors like the borrower’s credit score and loan-to-value ratio. Borrowers can request the removal of PMI once their equity in the home reaches 20% (22% to 25% within the first five years of the loan) through monthly payments or home price appreciation.
In contrast, FHA loans mandate two forms of mortgage insurance. An upfront cost known as the Upfront Mortgage Insurance Premium (UFMIP) is usually financed into the loan amount and equals 1.75% of the base loan amount. Additionally, borrowers must pay an annual Mortgage Insurance Premium (MIP), calculated based on the loan amount and term. Unlike PMI, FHA MIP doesn’t automatically terminate when a specific loan-to-value ratio is reached. Borrowers must either refinance or pay off the loan to eliminate MIP.
Both conventional and FHA loans require some form of mortgage insurance when the down payment is less than 20%, but FHA loans involve upfront and ongoing insurance costs in the form of UFMIP and MIP. Conversely, conventional loans typically involve PMI, which can be removed when the borrower’s equity in the home reaches 20%. When deciding between the two loan types, borrowers should consider the upfront costs and the long-term implications of mortgage insurance on the overall loan cost, taking their financial situation into account.
Which Loan Works Better For You?
When comparing conventional mortgages vs. FHA, certain aspects, such as lower eligibility thresholds, might initially make an FHA mortgage seem more attractive. However, it does come with its set of restrictions and conditions. This includes yearly MIP (Mortgage Insurance Premium) fees, which can prove somewhat hefty depending on your circumstances.
Striking a definitive answer here warrants a deeper dive into other variables – such vital comparison points fall under credit score requirements, loan limits, and their impact on picking between conventional vs. FHA loans.
When to Consider a Conventional Loan
- Higher Credit Score: If your credit score is significantly higher than the minimum required for an FHA loan (typically 620 or higher), you may qualify for better terms and lower interest rates with a conventional loan.
- Larger Down Payment: If you have a substantial down payment (usually 20% or more of the home’s purchase price), you can avoid private mortgage insurance (PMI) and may benefit from lower overall costs associated with a conventional loan.
- Strong Financial Profile: Conventional loans often have stricter income and debt-to-income ratio requirements, so if you have a strong financial profile, including stable employment and low debt, a conventional loan may be more suitable.
- Property Type: If you want to finance an investment property, a second home, or a high-priced luxury home that exceeds FHA loan limits, a conventional loan may be your only option.
- Lower Long-Term Costs: If you plan to stay in your home for an extended period, a conventional loan may offer lower long-term costs due to the absence of ongoing mortgage insurance premiums.
When to Consider an FHA Loan
- Lower Credit Score: If your credit score is below 620 or you have a limited credit history, you may have an easier time qualifying for an FHA loan.
- Smaller Down Payment: If you have limited funds for a down payment (as low as 3.5%), an FHA loan may be a more accessible option.
- More Lenient Qualification: If your debt-to-income ratio is higher, FHA loans tend to have more flexible qualification criteria.
- Previous Credit Issues: If you have a history of bankruptcy or foreclosure, FHA loans are often more forgiving of past credit issues than conventional loans.
- Down Payment Assistance: If you need down payment assistance, FHA loans can often be used with various government and nonprofit assistance programs.
- Lower Interest Rates: In some cases, FHA loans may offer competitive interest rates, especially for borrowers with lower credit scores.
- Remember that the decision between a conventional loan and an FHA loan should be based on your unique financial situation, credit history, and homeownership goals. It’s advisable to consult with a mortgage lender or financial advisor to determine which loan type is the best fit for your needs.
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Rob Sturms, the seasoned Colorado mortgage broker behind Rob’s Mortgage Loans, offers over 30 years of expertise for a seamless home-buying experience. A third-generation Colorado native, Rob’s commitment to honesty, reliability, and client satisfaction ensures low rates and personalized guidance. Choose Rob’s Mortgage Loans for a trusted partner in making your homeownership dreams a reality.
Regardless of where you are in the home-buying process, I am confident I can help you determine whether a conventional or FHA loan is the best option. My years of experience and connections can help open doors that may not be available when working with larger corporate lenders.
If you want to see what I can do for you or have additional questions about conventional vs. FHA loans, I’m more than willing to schedule a time to talk. Together, we can make your homeownership dreams come true.
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