FHA vs. Conventional Loans: Differences, Pros, and Cons

Should you do FHA or conventional?

You’ve found your dream home, and it is time to buy! You might be wondering what kind of loan you should go with. There are two popular types of loans available for home buyers: FHA and conventional.

In this article, we will compare both loans and determine their pros and cons.

FHA vs. Conventional Loans

FHA loans, otherwise known as Federal Housing Administration (FHA) loans, are government-backed home loans while conventional loans are often backed by private institutions such as banks and credit unions.

Conventional loans are also known as conforming loans as they follow all the guidelines set forth by Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are publicly traded companies that were created by the government. They buy mortgages from lenders, package them together, and sell them to investors.

FHA and conventional loans vary in the following criteria:

Credit Scores

Whether you are applying for an FHA loan or a conventional loan, lenders will take a look at your credit score.

You may get an FHA loan with a credit score as low as high 500s, but there are certain limitations. A credit score of 580 or higher is required by most FHA loan providers.

Since FHA loans are insured by FHA, they can be obtained with a lower credit score than other forms of loans.

The credit score qualifications for a conventional loan vary per lender. However, in order to qualify for a traditional loan, you must have a credit score of 620 or higher.

Because the lender takes on greater risk and conventional loans are not backed by a government agency, the credit score required for conventional loans is higher than for FHA loans.

Minimum Down payments

With an FHA loan, you can borrow up to 96.5% of the home’s value in 2021. This implies you’ll only have to pay a 3.5% down payment. A credit score of at least 580 is needed for you to qualify. If your credit score is between 500 and 579, you can still acquire an FHA loan as long as you have a 10% down payment.

The down payment for a conventional loan can range from 3% to 20%, depending on the type of property you’re getting. A credit score of at least 620, a two-year job history, steady income, and a debt-to-income ratio (DTI) of less than 43% are often required to qualify for a 3% down conventional loan.

Debt-to-income ratios

Debt-to-income (DTI) ratio is the percentage of your monthly pre-tax income required to pay your monthly recurring debt and determines your borrowing risk. The lower your DTI, the better.

To qualify for an FHA loan, your DTI must be less than 50%. In some instances, conventional loans allow debt-to-income ratios of up to 50%. Although lenders occasionally tolerate such high debt-to-income ratios, mortgage borrowers with DTIs of 43% or less are more likely to be approved.

Mortgage Insurance

Mortgage insurance safeguards lenders if you are unable to repay your loan.

Regardless of the amount of down payment, FHA loans require mortgage insurance, and two premiums must be paid: upfront mortgage insurance and the annual insurance premium.

The upfront payment is usually 1.75% of the loan balance (amount after the down payment) and can be paid from the beginning or can be rolled into the loan and repaid over time. Premium rates can range from 0.8% to 0.85% for base loan amounts of $625,500 or less. For those exceeding this amount and with loan terms of more than 15 years, the annual rates can range between 1% and 1.05%. Loans financed for 15 years or less come with rates of 0.45% to 0.95%. These premiums are paid for 11 years by borrowers who put down 10% or more. Anyone who puts down less than 10% on a house must make these premium payments for the term of their loan.

Most lenders require a loan-to-value ratio一the percentage of the home’s value represented by the loan amount一of 80% or less. So, with conventional loans, mortgage insurance is only required if your down payment is less than 20%.
With conventional loans, insurance can be canceled, once the borrower pays down enough of the loan’s principal.

Loan Limits

There is a limit to what you can borrow with both conventional loans and FHA loans and it can vary by county and is subject to change every year.

In 2021, the FHA loan limit in low-cost areas is $356,362 and $822,375 in high-end areas.

The conforming loan limit set by the Federal Housing Finance Agency applies to conventional loans. For most of the United States, the cap is $548,250 in 2021.

Property Type

FHA loans can only be used to finance a primary residence while conventional loans can be used to finance a primary residence, vacation homes, or rental properties.

FHA vs. Conventional Loans: Pros and Cons

FHA Loans:

✔ Lower credit score
✔ Lower minimum down payment for borrowers with at least 580 credit score

✖ Mandatory mortgage insurance premium
✖ Can only be used to finance a primary residence
✖ Slightly higher minimum down payment for borrowers with really bad credit score (less than 580)

Conventional Loans:

✔ Lower minimum down payment for borrowers with good credit (at least 620).
✔ Can finance a primary residence, vacation homes, or rental properties
✔ Mortgage insurance is only required if the down payment is less than 20%, and it can be canceled once most of the loan’s principal is paid.

✖ Higher credit score
✖ Lower debt-to-income ratio

There are many benefits to buying your own home, but getting the right loan is essential to ensuring you can get into a house that suits your needs. Assess yourself and explore your options. Choose the loan that best fits your situation.