If you’re buying a home for the first time, you may qualify for a conventional or FHA loan, depending on your financial profile. However, each loan type works uniquely, and qualification requirements also vary. As a result, choosing between the two loan programs can be challenging for many homebuyers.
Understanding the difference between FHA and conventional loans will help you decide which mortgage is right for your needs.
What Are Conventional Loans?
A conventional loan is a mortgage that’s not insured or guaranteed by a government agency. Since the federal government doesn’t back conventional loans, they present the most risk to lenders. For this reason, borrowers must meet higher qualifying standards.
Generally, conventional loans have higher down payments and credit score requirements than government-sponsored loans. Additionally, homeowners who use this loan may still need to pay for mortgage insurance if they put down less than 20%.
Conventional loans can be divided into two categories: conforming and non-conforming. Conforming conventional loans meets the lending standards set by Fannie Mae and Freddie Mac, a government-sponsored enterprise that guarantees conventional lenders. Non-conforming loans do not follow these rules, so their requirements might be flexible.
What is the Federal Housing Administration (FHA) Loan?
An FHA loan is a government-sponsored mortgage backed by the Federal Housing Administration. FHA loans have more flexible requirements than conventional mortgage loans since they protect FHA-approved lenders if a borrower defaults. That being the case, lenders offer more favorable terms, including lower interest rates, even if you don’t have a good credit score.
However, an FHA home loan comes with additional costs in the form of mortgage insurance. As a homebuyer, you’ll need to pay FHA mortgage insurance premiums (MIP). The cost will be added to your monthly mortgage payments.
Despite the extra cost, an FHFA home loan might save a lot of money over time, especially if you get a lower interest rate.
FHA Loans vs. Conventional Loans: Overview
Here’s a quick overview of the difference between FHA loans and conventional loans.
Minimum Down payment
- FHA Loans: 3.5%
- Conventional Loans: 3%
Minimum Credit Score
- FHA Loans: Either 500 or 580
- Conventional Loans: 620
Maximum Debt-to-Income Ratio
- FHA Loans: 43% for most lenders but may go up to 50%
- Conventional Loans: 45% but in some cases may go up to 50%
Loan Limit in 2024
- FHA Loans: $498,257
- Conventional Loans: $766,550
Mortgage Insurance
- FHA Loans: Required despite the down payment
- Conventional Loans: Required only if the down payment is less than 20%
Purpose
- FHA Loans: They can only be used to finance primary residences
- Conventional Loans: They can finance primary residences, second homes, vacation homes, and rental properties
Differences Between an FHA Loan and a Conventional Loan
Credit Score
Your credit score is by far the most important aspect in determining the type of mortgage you qualify for. Credit history also affects your monthly mortgage payments, too.
Credit score requirements for FHA home loans are lenient. You need a minimum score of 580 with a 3.5% down payment. A score between 500 and 579 is required if you put down at least 10% of the purchase price.
On the flip side, conventional lenders need a minimum score of 620 for you to qualify for a conventional mortgage.
Down Payment
Both FHA and conventional loans have down payment requirements that borrowers must meet to get approved for a loan.
A down payment of at least 3.5% is needed for FHA loans if you have a credit score of 580 and above. With a 500 to 579 score, borrowers must make a 10% minimum down payment.
For conventional loans, on the other hand, borrowers need to put down at least 3% of the purchase price.
Interest Rates
Conventional mortgages typically come with higher interest rates than FHA home loans. This is because of the risk-based fees imposed by Fannie Mae and Freddie Mac on conventional loans. Since FHA loans lack these fees due to their governance structure, their rates tend to be low.
Generally, a high credit score may qualify you for lower interest rates for both mortgages.
Loan Limit
FHA and conventional loans have loan limit requirements that change each year based on the housing market. The Federal Housing Finance Agency sets limits for conforming conventional loans, while the Department of Housing and Urban Development puts in place FHA loan limits.
FHA loan limits in 2024 stand at $498,257 for a one-unit property for most regions in the United States. In high-cost areas, limits may go up to $1,149,825.
Conversely, the maximum conforming conventional loan limit for a single-family home is $766,550.
Mortgage Insurance
Mortgage insurance protects lenders in case borrowers default on loan payments. Whether you’ll pay private mortgage insurance (PMI) or not depends on the type of mortgage you choose and the down payment you make.
There are generally two types of mortgage insurance for FHA loans: an upfront fee and a monthly fee added to your monthly mortgage payments. The upfront mortgage insurance is 1.75% of the base loan amount. The monthly fee ranges from 0.45% to 1.05%, depending on your loan amount and loan term.
On the other hand, paying the PMI on conventional mortgages is not needed, provided that you put 20% down. But with a lower down payment, you’ll need to make monthly PMI payments until you have 20% equity in your home.
Property Requirements
The purpose of your property determines the mortgage loan you qualify for.
To be eligible for an FHA loan, the property you plan to purchase must be your primary residence. Unlike FHA loans, you can use a conventional loan to buy a second home, vacation home, or investment property.
When a Conventional Loan Makes Sense
A conventional loan isn’t for everyone. Here are some of the situations to consider a conventional loan:
- Your property won’t pass an FHA appraisal: FHA appraisal guidelines are more stringent than conventional ones. If you don’t pass the strict FHA guidelines, a conventional loan might be a better choice.
- You’re purchasing a second home: You can use a conventional loan to buy a primary residence, vacation home, or investment property.
- You have good credit of at least 620: The minimum credit score for conventional loans is 620, though it can vary by lender.
- You have a sizable down payment: The minimum down payment for a conventional loan is 3%. But if you want to avoid paying PMI, you need to put down at least 20%.
When An FHA Loan Makes Sense
An FHA home loan might be a perfect fit for you if:
- You’re purchasing a primary residence: You can only use an FHA loan to purchase a primary residence.
- You have poor credit: FHA loans are always a good option for first-time homebuyers with lower credit scores.
- Your debt-to-income (DTI) ratio is high: If you carry a higher debt than your income, an FHA home loan might be right for you.
- You need a small loan amount: FHA loans generally tend to be lower than conventional loans.
