FHA vs. Conventional Loan: What’s the Difference? Roger Odoardi With such a wide array of existing loan options, it is crucial that home buyers understand which products and programs will work best for them. FHA loans and conventional loans are two of the most common options for homebuyers – but what’s the difference? Whether you are just starting out your research or are nearing the application process, this guide will help you to understand the differences between FHA and conventional loans. In this post, we’re covering everything from qualifications and requirements to the pros and cons of each loan type. Better yet, we’re even sharing our expert opinion on how to determine which option is right for you. What Is an FHA Loan? An FHA loan is a type of low down payment government loan insured by the Federal Housing Administration, an office of the U.S. Department of Housing and Urban Development. These loans have less restrictive qualifications than conventional loans, making it a good choice for home buyers who may be unable to come up with a significant down payment or who have a low credit score. What Is a Conventional Loan? The most common type of loan, conventional mortgages are private-sector loans that follow the guidelines set by Fannie Mae and Freddie Mac. These two widely known federally backed home mortgage companies were created to provide stability and affordability to the mortgage market. As opposed to FHA loans, conventional loans are not government backed and therefore have stricter requirements. Borrowers can choose between 15-year, 20-year and 30-year mortgages. For a potential borrower with good credit and money set aside for a down payment, conventional loans are a very affordable option in the long run. How to Qualify for FHA and Conventional Loans From the minimum down payment to the credit score requirements, there is no doubt that FHA loans are easier to qualify for than conventional loans. To understand where you may fit as a borrower, start by understanding the distinctions that can be made between each loan type’s requirements. Debt-To-Income Ratio Your debt-to-income ratio (DTI) is the percentage of your monthly gross income that goes toward paying debts. To qualify for a conventional loan, your DTI should be no more than 43%. However, some lenders will accept a max DTI between 45% and 50% for conventional loans. As for FHA loans, the recommended DTI to qualify is 50% or less. Again, this percentage may vary by your credit score or the specific lender’s expectations. Minimum Down Payment A minimum down payment is the amount of cash that a buyer is required to put down to qualify for a mortgage loan. For an FHA loan, a credit score of at least 580 will allow you to put down as little as 3.5%. With a score of 500 to 579, the minimum down payment will be 10%. The minimum down payment for conventional loans can be as low as 3%. However, most buyers using conventional loans will typically put down 20% because anything less requires an additional payment for private mortgage insurance (PMI). Credit Score Lenders will use your credit score to assess your creditworthiness. On average, the typical approved credit score for an FHA loan is 580 or higher. The minimum credit score requirement for conventional loans is 620. The requirement is higher for conventional loans compared to FHA loans because they are not government backed and therefore the lender is taking on more risk. Note that borrowers with credit scores of 720+ typically pay less per month with conventional loans, whereas borrowers with credit scores below 720 typically pay less per month with FHA loans. Pros and Cons of FHA and Conventional Loans Pros of FHA Loans Cons of FHA Loans Easier to qualify for Require slightly higher down payments Low down payment of 3.5% Stricter property standards (i.e., can’t always be used to purchase a second home or investment property) More forgiving of past bankruptcies / foreclosures Mortgage insurance mandatory regardless of down payment Allows non-occupant co-borrower to qualify for a loan Mortgage insurance cannot be canceled unless borrower refinances into a conventional loan Less restrictive DTI requirements Non-occupant co-borrower must be a relative to qualify for a loan Flexible credit review End up paying more over the life of the loan Fixed or adjustable rate Limited closing costs / seller can help pay closing costs Available to individuals with low credit scores or no credit history Special 203(k) program for home repairs Pros of Conventional Loans Cons of Conventional Loans Less expensive than FHA loans Harder to qualify Down payment as low as 3% Require higher credit scores Can be used to purchase a primary residence, second home or investment property Require PMI when the down payment is less than 20% Allows any non-occupant co-borrower to qualify for a loan No upfront mortgage insurance Potential for lower mortgage insurance rates or no mortgage insurance at all Stable interest rates More appealing to sellers Shorter underwriter approval process All About Mortgage Insurance In the event that you default on your loan, mortgage insurance will protect the lender. As for the buyer’s side, mortgage insurance is designed to make it possible for borrowers to make a much smaller down payment and still qualify for a home loan. Regardless of the down payment amount, FHA mortgages will always require mortgage insurance. The first fee that FHA loans require is an upfront premium of 1.75% of the loan amount. This fee can either be included in your closing costs or can be rolled into your loan amount, thus slightly increasing your monthly payments. The second fee required is a monthly premium, which is typically added to your mortgage payment. This cost of the monthly premium ranges from 0.45% to 0.85% of the loan amount and will vary based on the loan total, down payment and the length of the term. For conventional mortgages, a lender will only require you to pay for private mortgage insurance (PMI) if you put less than 20% down. The rationale behind this requirement is simply to protect the lender because the loan is not federally guaranteed or insured. FHA Loan and Conventional Loan Limits Both FHA and conventional loans have specific limits to the amount you can borrow, with the maximum loan sizes for both varying by county. For either loan type, the borrower cannot go over the loan limit amount. The loan limits for FHA loans are changed annually. In 2021, FHA loan limits for single-family homes is $356,362 in low-cost areas and $822,375 in high-cost areas. Conventional loans are subject to the conforming loan limit set by the Federal Housing Finance Agency. In 2021, conventional loan limits for single-family homes in the lower 48 states is $548,250. For Alaska and Hawaii, it is $822,375. If you need a loan for a home that exceeds these loan limits, you may want to consider a jumbo loan. Otherwise known as a non-conforming loan, these loans will generally have higher interest rates and higher down payments than Fannie Mae or Freddie Mac (conventional) loans. Rates will increase in parallel to the size of the loan. What If I Want to Refinance My Loan? While refinancing your loan is possible for both loan options, the process will be much easier with an FHA loan. One reason you may want to refinance your FHA loan could be to eliminate the monthly mortgage insurance payments – and if your down payment was 10% or higher, refinancing may be a feasible option. Refinancing your FHA loan will not require a credit check or income verification, and it is likely that there will be no home appraisal. Conditions do require that the refinance must be at least 6 months from when your current mortgage was issued, and that you are not delinquent on your current FHA loan. Additionally, borrowers will be limited to receive no more than $500 in cash from refinancing and closing costs will be required. It is also notable to mention that in order get rid of the monthly FHA premiums after you have accumulated 20% equity, you will have to refinance into a conventional mortgage. There are three types of FHA streamline finance loans: FHA Streamline 30 Year Fixed Rate Refinance Loan: Can be used to lower your current interest rate to either lower your payment on your current FHA loan or to convert an FHA Adjustable Rate Mortgage into a fixed rate mortgage. FHA 203k Streamline 30 Year Fixed Rate Refinance Loan: Also known as a low down payment government rehab loan, the FHA 203k loan allows borrowers to pull out equity as cash to repair or rehabilitate a damaged home. FHA Streamline 5/1 Adjustable Rate Refinance Mortgage: Establishes low initial interest rate for the first five years of the loan’s life. What Loan Is Right For Me? Wondering which loan type is best for you? While we strongly believe that it is best to speak with a mortgage expert prior to making any decisions, here is a general breakdown of our recommendations: We recommend an FHA loan if you have: A low credit score (580 or under) A minimal amount for down payment A high DTI (over 43%) We recommend a conventional loan if you have: A minimum credit score of 620 A minimum down payment of 3% or of 20% to avoid PMI A low DTI (43% or lower) A need for flexible repayment Our team of experts recognizes that every borrower is different, which is why we take the time to assess your financial situation and personal needs. Contact a member of the Blue Water team today to discuss which option will best suit you. Additional FAQs Q: Do property standards play a role when comparing FHA versus conventional loans? A: Yes! FHA appraisals are more strict than conventional appraisals. Q: Why do sellers prefer conventional over FHA? A: While it is not necessarily factual, you may find that some sellers are under the impression that an FHA loan is for those who cannot qualify for another loan type and therefore believe that conventional loans are the “safer” option. Q: How can I compare the two loans over the long term? A: In sum, FHA loans are easier to qualify for, but a conventional loan will ultimately save you money in the long run if you can qualify. To get a clear image of which option is right for you, we recommend sitting down with a mortgage expert or loan officer to calculate and compare your estimated monthly payments over the life of the loan. We hope that this guide has helped you to understand that while each of these loans can be viable options for home buyers, there is likely one that will provide you with a better outcome for your situation. Our team of experts at Blue Water is here to help you compare the two and to answer questions you may have throughout the home buying journey. Blue Water Mortgage is licensed in New Hampshire, Maine, Massachusetts, Connecticut, Florida, and North Carolina. Roger Odoardi Roger is an owner and licensed Loan Officer at the Blue Water Mortgage office in Hampton, NH. Roger graduated from the University of New Hampshire Whittemore School of Business and has been in the mortgage industry for over 20 years. Roger has originated over 2500 residential loans and is licensed in New Hampshire, Massachusetts, Maine, Connecticut and Florida.