Which mortgage is right for you? That’s a question that many people are asking themselves these days, as the market for home loans has become more competitive. In this post, we’ll take a look at two of the most common types of mortgages – FHA and conventional – and see how they compare. By the end of it, you should have a good idea of which one is right for you. So let’s get started!
What is an FHA loan?
An FHA home loan is a type of loan that is backed by the Federal Housing Administration. This protects the lender if the borrower defaults on the loan.
The Federal Housing Administration insures FHA loans, which are government-backed mortgages. FHA home loans have lower credit history and down payment requirements than many conventional financing, making them particularly appealing to first-time homeowners. In fact, according to the FHA’s 2020 Annual Report, applicants purchasing their initial houses accounted for even more than 83 % of all FHA loan originations. These loans are insured by the government, but they are assessed and operated by third-party mortgage companies.
An FHA mortgage loan also:
- Requires a credit score of at least 500
- Requires mortgage insurance premiums (MIPs), regardless of your credit score or down payment amount
- Helps people who otherwise wouldn’t qualify for home financing
What is a conventional loan?
A conventional mortgage loan is the most common type of mortgage.
Any sort of home buyer’s loan that is not given or guaranteed by a government agency is referred to as a conventional loan or conventional mortgage. Private financing, such as banking, community banks, and mortgage brokers, offer regular mortgages instead. However, two government-sponsored firms, the Federal National Mortgage Organization (Fannie Mae) as well as the Federal Home Loan Mortgage Corporation, can guarantee some conventional mortgages (Freddie Mac).
A conventional loan also has these features:
- Requires a credit score of at least 620
- Requires you to buy private mortgage insurance (PMI) if you place less than 20% down
- Can have less costly PMI payments compared to FHA mortgage insurance
The differences between FHA and conventional loans
FHA loans have more relaxed financial standards than conventional loans. However, FHA loans have stricter property standards and mortgage insurance requirements. Conventional loans have stricter financial standards but more relaxed property standards and mortgage insurance guidelines.
Credit score requirements
If you have a credit score of 580 or higher, you will usually qualify for an FHA loan with just 3.5% down. If your credit score is 500 to 579, you will need to put down 10% to get an FHA loan.
Most lenders want you to have a credit score of 620 or more to get a conventional home loan. But as with FHA loans, some lenders may require a higher score. The better your credit score, the lower your interest rate is likely to be.
Your debt-to-income ratio is a percentage that lenders use to figure out how much you can afford to borrow each month. This number is calculated by dividing your monthly debt payments by your monthly income.
Let’s look at how to calculate your DTI:
(Total monthly debt) / (Gross monthly income) x 100 = DTI
FHA loans have the same standards as conventional loans when it comes to DTI.
- FHA loans50% maximum DTI
- 45% maximum DTI
Keep in mind that the maximum DTI may not be the same for everyone. Lenders only allow these maximums if you are a strong borrower with compensating factors, like having a few months of cash saved up or a high credit score.
As mentioned before, if your credit score is 580 or more, you can put down as little as 3.5% on an FHA loan. If your credit score is between 500 and 579, you will have to put down at least 10%.
Let’s suppose you’re purchasing a property for $225,000. If you put down 3.5% down payments, you’ll require $7,875. If you put down 10%, you’ll need $22,500.
Putting 20% down on a conventional loan reduces your monthly payment, allowing you to avoid PMI, but it’s possible to put down as little as 3%. That would be $7,750 in this example, even less than the amount required for an FHA loan.
Tip: If you want to get a conventional loan with a low down payment, you can opt for Fannie Mae’s 97% LTV Standard mortgage. This loan allows 3% down as long as at least one borrower is a first-time buyer. You can only use this loan to buy your primary residence.
The loan limit for FHA loans and conventional loans can vary depending on where you live. The FHA loan limit is much lower than the conventional loan limit in most places. However, how much you can borrow will also depend on how much money you make and how much debt you have.
The new baseline limit – which applies to most single-family homes – will be $420,680. That’s nearly a $65,000 increase over the previous FHA loan limit of $356,360. The Federal Housing Administration is raising its lending limits to keep pace with home price inflation.
Baseline conventional loan limits (also known as conforming loan limits) for 2022 increased 18.05%, rising $98,950 to $647,200 for 1-unit properties. Limits were also generally higher in high-cost areas, defined as those in which 115% of the local median home value is higher than the baseline conforming loan limit.
If you want to borrow more money than what is available in a conforming loan, you will need to shop for a jumbo loan. Jumbo loans require a larger down payment and better credit.
Mortgage insurance protects the lender if you can’t make your monthly payments.
Both FHA loans and conventional loans have mortgage insurance, but their differences are significant.
FHA loans require mortgage insurance premiums, regardless of how much you contribute. The two costs you’ll encounter are as follows:
- Upfront mortgage insurance premium: You will have to pay this every time you borrow money. It is 1.75% of the loan amount, and you can add it to your loan.
Annual mortgage insurance premium:
If you put down 10% or more, you will have to pay mortgage insurance premiums for 11 years. If you put down less than 10%, you will have to pay MIPs for the life of your loan, usually 15 or 30 years.
What is the cost of mortgage insurance in a year? It depends on your loan term, down payment, and loan amount.
For example: If you put down 3.5% on a $225,000 home, your loan amount will be $217,125. Your annual mortgage insurance premium will be 0.85% of this amount, or $1,845.56. This means you’ll likely pay $153.80 a month in mortgage insurance.
If you get an FHA loan, it is possible to refinance into a conventional loan in the future. This would mean that you would no longer have to pay for mortgage insurance. However, keep in mind that you will have to pay closing costs on your new loan and that home values and interest rates may change unfavorably over time
If you don’t put at least 20% down on a conventional loan, you will have to pay PMI. The cost of PMI depends on your loan term, down payment, and loan amount. Your credit score and loan type are also important factors in how much PMI costs.
Tip: PMI rates are higher on adjustable-rate loans than on fixed-rate loans.
Consider a $225,000 purchase price for our example and the low and high ends of what private mortgage insurance might cost on a 30-year, fixed-rate mortgage.
- High end: 3% down payment, 660 credit score: 1.50% annual premium, $272.81 monthly payment
- Low end: 15% down payment, 760 credit score: 0.19% annual premium, $30.28 monthly payment
Are FHA Mortgage Rates Lower than Conventional?
FHA mortgage rates are often lower than conventional loan rates. Depending on market circumstances and the lender in question, the spread may vary somewhat. However, you must consider not just the principle and interest portion of your housing payment. The cost of mortgage insurance premiums might have a significant impact on the calculation.
FHA loans usually have lower interest rates than other types of mortgages. However, you must consider the entire payment (including mortgage insurance) to determine what’s the better deal. The boxes above actually assume an interest rate of 3.02% for an FHA loan and 2.81% for a similar conventional one.
To find the current interest rates, you will need to shop around and compare interest rates. This is unusual because usually, the interest rates on FHA loans are lower. However, this spread can vary over time (shrink or widen) and depends on the mortgage lender.
Finally, there’s a good chance FHA mortgage rates will be lower than traditional ones, but keep an eye on current rates on both alternatives as you shop for lenders.
FHA Loans Are Hugely Popular with First-Time Buyers
If you’re a first-time house buyer, the most likely option is to apply for an FHA loan rather than a conventional loan.
Since first-time buyers often don’t have a lot of money saved up for a down payment, the Federal Housing Administration (FHA) program is often a good fit. FHA borrowers also usually have more debt than people who have bought homes before, and they usually need a higher loan amount. They also usually have lower credit scores than others.
However, if you have student loans, which a lot of first-timers probably do, the FHA can treat them more favorably when qualifying you for a mortgage. Recently, they made a change where just 0.5% of the outstanding loan balance is used as the monthly payment for DTI purposes, down from the former.
Meanwhile, Fannie Mae may use 1% of the outstanding student loan amount to calculate your DTI, making qualifying for an FHA mortgage less challenging. As a result, if you have student loan debt, keep this regulation in mind and/or check out the more flexible standards offered by Freddie Mac.
FHA loans have more restrictions than conventional loans when it comes to the property. FHA loans are only for people’s primary residences. The property must also meet specific standards for condition.
An appraisal will be required for an FHA loan. To determine whether the property is safe, sound, and secure, the appraiser must adhere to strict guidelines set forth by the FHA.
Here are a few standards the property must meet:
- Proper site drainage
- Safe drinking water
- Safe and comfortable heating
- Watertight roof with at least two years of life left
Conventional loans can be used for second homes, rental homes, and houses to be flipped, as well as for primary residences. A home purchased with a conventional loan must also be safe, sound, and secure.
When FHA loans make sense
FHA loans are best for people with lower credit scores and more debt than income. They want to own a home now, rather than waiting until their credit, debt, or income improves. This might be you if you are a first-time homebuyer.
People aren’t robots, and we don’t buy houses based on only financial factors. Even if you can’t obtain an ideal mortgage, personal circumstances may make homeownership more appealing than renting.
When conventional loans make sense
Conventional loans are a good choice for borrowers with high credit scores and low debt-to-income ratios. They will be cheaper in the long run.
FHA Loan Pros
- Low down payment requirement (3.5% down)
- Lower credit score needed (580 for max financing)
- Lower mortgage rates in most cases
- May be easier to qualify for than a conventional loan (higher DTIs allowed)
- Shorter waiting period to get approved after foreclosure, short sale, etc.
- No prepayment penalty
- No asset reserve requirement (for 1-2 unit properties)
- Gift funds can cover 100% of closing costs and down payment
- Streamlined FHA refinances are fast, cheap, and easy
FHA Loan Cons
- Slightly higher minimum down payment requirement (3.5% vs. 3%)
- Subject to mortgage insurance (for full term of mortgage in many cases)
- Must pay upfront and monthly mortgage insurance premiums
- Fewer loan type options than conventional loans
- Only available on owner-occupied properties
- Mandatory home inspection and strict appraisal guidelines
- Many condominium complexes aren’t approved for FHA financing
- Loan limits are lower in more affordable regions of the country
- Generally only allowed to have one FHA loan at a time
- May take longer to close your loan
- Sellers tend to favor buyers with conventional loans because they’re generally easier to fund
Conventional Loan Pros
- Lower minimum down payment requirement (3%)
- No mortgage insurance requirement if 80% LTV or lower
- Can cancel mortgage insurance at 80% LTV
- Can be used on all property and occupancy types
- Many more loan program options available
- Can hold numerous conventional loans at given time
- No maximum loan limit and conforming loan limit much higher than the FHA floor
- More lenders to choose from (nearly every bank offers conventional loans)
- Might be able to close your loan faster
- No mandatory home inspection and more flexible appraisal guidelines
Conventional Loan Cons
- Higher credit score requirements (minimum 620 credit score)
- Slightly higher mortgage rates
- May be more difficult to qualify for than an FHA loan
- Mortgage insurance still required for loans above 80% LTV
- Reserves may be required to qualify
- Possible prepayment penalty (not common these days)
- Student loan payments could push you over DTI limit
FHA vs. Conventional Loans: Which One’s Right for You?
Choosing between an FHA loan and a conventional loan can be difficult. Both have their own pros and cons, and depending on your unique financial situation, one may be better for you than the other.
We would advise you to talk to your lender and your real estate agent to fully understand which loan is right for you. Both can be really good options.