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FHA Vs. Conventional Loans: An In-Depth Comparison

June 2, 2024

FHA and conventional loans are among the two most common alternatives homebuyers turn to when they seek funding to move forward with their purchases. While you may use either one to purchase a new home, you may also use them to refinance an existing mortgage. Looking at the conventional vs. FHA loan comparison closely before determining which one might work better for you is important because each loan comes with notable differences.

What Is an FHA Loan?

Backed by the Federal Housing Administration (FHA), FHA-approved private lenders across the U.S. provide FHA loans. The FHA insures mortgages to safeguard the interest of lenders in case borrowers default on their loans. FHA insures mortgages on single-family homes and multifamily properties alike. However, the home you purchase will need to serve as your primary residence.

People with less-than-perfect creditworthiness who feel they might not qualify for conventional mortgages might benefit by looking at what FHA loans have to offer because they come with less stringent credit score requirements.

What is a Conventional Loan?

Most conventional loans meet the requirements prescribed by Freddie Mac or Fannie Mae, and you may also refer to the ones that do as conforming loans. However, they do not come with any type of government-backed guarantee. Unlike FHA loans that you may use to buy only primary residences, you may use the proceeds from a conventional loan to purchase a second home or an investment property.

Conventional loans that do not meet Freddie Mac and Fannie Mae guidelines surrounding aspects such as maximum loan amounts, applicants’ incomes, down payment requirements, and credit standards fall under the non-conforming loans bracket. Jumbo loans classify as non-conforming loans. Non-conforming loans tend to have a smaller market and come with higher-than-usual interest rates.

Eligibility Requirements

Whether you qualify for an FHA loan, a conventional loan, or both depends on multiple factors such as your credit score and the down payment amount. However, FHA loans have more relaxed eligibility criteria surrounding acceptable credit scores and debt-to-income ratios, which is why they come first in this section of the FHA vs. conventional mortgage comparison.

FHA Loan Requirements

• You need a minimum credit score of 500.
• Down payment can be as low as 3% based on your credit score.
• The home must pass a professional home inspection.
• An FHA-approved appraiser needs to appraise the home.

Conventional Loan Requirements

• You need a minimum credit score of 620, although you get better terms with a higher score.
• Down payment for first-time homebuyers can be as low as 3%.
• Down payment for a second home needs to be at least 10%.

Limits on Loan Amounts

FHA and conventional loans have maximum limits surrounding how much money you might be able to borrow, and these limits vary by county. In addition, these limits are subject to change each year.

According to the Federal Housing Finance Agency (FHFA), the conforming loan limits (CLLs) across most parts of the U.S. for one-unit properties in 2024 is $766,550, and it is $981,500 for two-unit properties.

Similarly, FHA’s countrywide floor and ceiling forward mortgage limits for one-unit properties in 2024 stand at $ 498,257 and $ 1,149,825, respectively.

Debt-to-Income Ratio Requirements

Your debt-to-income (DTI) ratio gives lenders an indication of how much money you need to use from your monthly income to make repayments toward your existing debt. Calculating your DTI ratio requires that you divide your total monthly debt payments by your monthly income and multiply it by 100. For example, if your monthly debt payments amount to $1,500 and your monthly income is $4,000, your DTI ratio is 37.5% (1500/4000*100).

The conventional loan vs. FHA loan comparison tilts in favor of the latter when it comes to acceptable DTI ratios. For FHA loans, your DTI ratio should be 50% or lower. When it comes to conventional loans, most lenders look at DTI ratios of 36% or lower with favor.

It’s important to note that the maximum allowed DTI ratio does not apply to each applicant. Lenders might view borrowers with the higher end of acceptable DTI ratios with favor if they appear to be strong borrowers through compensating factors such as excellent creditworthiness or access to adequate cash reserves.

Down Payment Requirements

Just how much down payment you need to make when buying a home varies based not just on the type of loan you choose, but other factors as well. While common perception suggests that you need at least a 20% down payment to get a conventional loan, this is far from the fact.

For instance, the Conventional 97 Loan is a 3% down payment loan alternative for first-time homebuyers, as well as for homeowners who wish to refinance their Fannie Mae loans, and you don’t have to fall in the low-income bracket to qualify.

The minimum down payment you need to provide to get an FHA loan depends on your credit score. You need to provide at a least 10% down payment if your credit score is between 570 and 579. If it’s 580 or higher, you may pay as little as 3.5%.

From the down payment requirement, the Conventional 97 vs. FHA loan comparison tilts slightly in favor of the former because you can make a lower down payment.

You may consider making a large down payment, even more than 20%, if you feel to can afford to because it comes with multiple benefits. With conventional loans, it takes away the need to pay extra for private mortgage insurance (PMI). In both cases, you may look forward to paying lower monthly payments and interest charges throughout the course of the loan term. You’ll also get to build equity in your home faster.

Mortgage Insurance Requirements

Mortgage insurance helps safeguard a lender in case you default on your loan. If you plan to get a conventional mortgage and pay less than 20% of a home’s selling price as down payment, you will need to get PMI. Once you build 22% equity in the home, you no longer need to make PMI payments.

With FHA loans, while FHA insures your mortgage, you still need to pay mortgage insurance premium (MIP). You need to keep making these payments until you pay off your loan in full.

Since you need to make mortgage insurance payments toward an FHA loan for the life of the loan, PMI might be more cost-effective in the long run, especially if you have good or excellent creditworthiness. This is because your credit score plays a role in the PMI rate you get.

Property Standard Requirements

The condition of the home you wish to buy plays an important role in the FHA vs. conventional loans comparison. This is because FHA appraisals follow more stringent guidelines than conventional appraisals. While assessing the value of a home is part of an FHA appraisal, you may also expect an FHA appraiser to pay due attention to aspects such as adherence to local codes, quality of construction, and overall safety of the property.

FHA does not require the fixing of problems that do not affect the soundness or safety of a home. If you feel the home you wish to purchase might not pass an FHA appraisal, you may get the seller to make the required repairs beforehand. Alternatively, you may think about applying for a conventional loan that has more relaxed norms surrounding property standards.

Bear in mind that from the point of view of an FHA appraisal vs. a conventional appraisal, while the former focuses more on a property’s safety and security, the latter’s focus rests more on a property’s condition and value.

Is a Conventional Loan Better Than an FHA Loan?

If you’re wondering whether a conventional loan is better than an FHA loan, know that both come with their share of advantages and disadvantages. For example, while you may qualify for an FHA loan with less-than-perfect creditworthiness, you’ll need to keep making MIP payments until you pay off the loan completely.

The Pros and Cons of FHA Loans

The main advantages of getting an FHA loan include:

• Down payments can be as low as 3.5%
• Low closing costs
• Lower minimum credit scores required when compared to conventional loans
• Higher DTI ratios accepted when compared to conventional loans

The possible drawbacks of getting an FHA loan come in the form of:

• Need to pay mortgage insurance premium through the course of the loan’s term
• More stringent property standard requirements than conventional loans
• Need to use the home you buy as your primary residence
• Interest rates might be higher than conventional loans owing to less stringent eligibility requirements

The Pros and Cons of Conventional Loans

You might benefit by getting a conventional loan in different ways.

• Flexibility in terms
• Nonconforming loans come with no maximum limits
• No need to get PMI if your down payment is 20% or more of the home’s selling price
• Can use the proceeds of the loan to buy a second or an investment home

Like FHA loans, conventional loans also have some shortcomings.

• Typically stricter eligibility requirements than FHA loans
• Need a higher credit score to qualify when compared to FHA loans
• Need a lower DTI ratio to qualify
• Need to pay extra for PMI if your down payment is below the 20% mark

Tips to Reduce Your FHA or Conventional Loan Expenses

One common factor in the FHA loan vs. conventional loan comparison is that you get the ability to lower your loan expenses in both cases.

Compare Loans Estimates

It is important that you compare loan estimates provided by different lenders. Doing this requires paying attention to interest rates, monthly principal and interest payments, monthly mortgage insurance payments, total monthly costs, upfront loan costs, lender credits, as well as the amount of money you need to cover closing costs.

Select a Suitable Loan Term

Selecting a loan term has a bearing on the immediate and long-term cost of your mortgage. For instance, a longer loan term would result in lower monthly payments, and the converse holds true as well.  However, the longer the loan term, the more you would end up paying as interest.

Make a Large Down Payment

Making a down payment of 20% or more can help you avoid the added cost of private mortgage insurance if you get a conventional loan. In addition, a large down payment – toward an FHA or conventional loan – would result in lower upfront fees, overall interest, and monthly payments. You might even benefit by getting a better interest rate.

Reduce Closing Costs

Closing costs refer to the expenses that buyers and sellers incur when transferring a property’s ownership. These may include loan origination fees, appraisal fees, title insurance charges, property taxes, escrow deposits, mortgage tax, and underwriting fees.

These costs tend to vary from one county to the next, and typically range from 3% to 6% of the loan amount. What helps is you may take measures to lower your closing costs by paying attention to all the fees you need to pay.

The first thing you may do to bring down your closing costs is to get the seller to contribute partially. The possibility of this happening is more likely if you’re buying in a market that’s not favorable for sellers. Another option is to negotiate with your lender, especially if you’ve compared multiple loan estimates and have found lower costs through other lenders.

You may also benefit through lower rates and fees if you’ve been a longstanding customer of the financial institution through which you’re seeking a mortgage.

If you’re unable to fund closing costs on your own, you might ask your mortgage provider to include the same in the loan amount. If your lender agrees, these costs get added to the principal amount, which you repay over time.

Conclusion

Which is better, an FHA or a conventional loan? You may consider applying for the former if you have less-than-perfect creditworthiness or if you don’t have enough money to make a large down payment. This is also the case if you’re looking at buying a primary residence or if you have a high debt-to-income ratio.

While conventional loans tend to come with stricter eligibility requirements, they may lead to savings in the form of low or no mortgage insurance payments. A conventional loan might also work well for you if you wish to buy a home that will not pass an FHA appraisal, if you’re buying a second home, or if you’re in it for the long haul.

If you’re still unsure about where the FHA vs. conventional loan comparison stands based on your situation, you may consider speaking with a reputed mortgage provider who can take the specifics of your case into account and then guide you in making a more well-informed decision.