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FHA vs. Conventional Mortgage: Which Loan Is Right for You?
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With so many options available, finding the right loan to buy a home can seem like an almost endless project. Still, one type of loan usually manages to grab the attention of first-time homebuyers. It’s the Federal Housing Administration (FHA) mortgage, which has helped millions of Americans buy homes since 1934 with low-interest-rate loans that are often easier to get than conventional loans.
Government-insured FHA loans are popular with first-time buyers. According to the Congressional Research Service, first-time homebuyers accounted for 83% of all FHA loans in fiscal year 2018.
Is an FHA loan right for you? In many cases, the answer may be “yes,” but it’s also important to understand the loans come with significant benefits and limitations. For some buyers, a conventional loan might actually be more affordable and have fewer limitations, especially if they have strong credit scores and are willing to put down slightly larger down payments. Here is a guide that will help you sort through these two choices:
- What is an FHA loan?
- What is a conventional loan?
- How FHA loans and conventional loans stack up
- Which loan is right for me?
What is an FHA loan?
The FHA loan was created in 1934 to help rescue a struggling U.S. housing market after the Great Depression. The loans are specially designed to help buyers achieve homeownership by offering lower down payment requirements (as low as 3.5%), more lenient credit score requirements and, often, lower interest rates. Since its founding, the FHA has issued more than 47.5 million loans.
The FHA doesn’t distribute loans itself. Instead, homebuyers work with private lenders, such as banks, savings and loan associations and mortgage companies. However, the federal government insures FHA loans, making it less risky for lenders to approve them for buyers who otherwise might not qualify for a mortgage.
By some measures, first-time homebuyers may be increasingly reliant on FHA loans to afford the homes they want. For example, mortgage data company Ellie Mae found that 26% of all loans issued in November 2018 to millennial borrowers were FHA loans, for an average of $186,454. That amount was up from $178,862 in 2017 and $170,167 in 2016.
FHA loan requirements
FHA loans are available nationwide, but they come with limits that depend on factors such as a home’s unit size (1-4 units, single-family or multifamily) and location, according to state and county (or metropolitan area). Loan limits tend to be more generous where the cost of living is higher, such as in large, urban areas.
To get an FHA-backed mortgage, borrowers need to meet certain requirements. For example, borrowers can’t get financing that exceeds 96.5% of the home’s sale price. The minimum down payment is 3.5%.
Proof of income is important, too. Whether you’re a first-time or repeat buyer, you’ll need to show a lender that you’ve had a reliable source of income and employment history over a two-year period and that your income is likely to continue at the same rate over the next three years. Sources of income for an FHA loan may include hourly wages, annual salaries, overtime payments and seasonal employment income.
As part of the application process, a lender will use your income to calculate a debt-to-income (DTI) ratio, an essential element in determining eligibility for government-backed loans. DTI ratios help lenders determine what qualifies as a manageable loan size for an individual borrower; borrowers with more modest incomes and higher DTIs ratios will mostly qualify for smaller home loans, while those with high incomes and lower DTIs can often get larger loans.
To qualify for an FHA loan, your standard DTI can’t be higher than 31%. However, your lender will also look at your total debt obligations, such as payments for credit cards and car loans. Together, these debt obligations can’t be higher than 43% of your income. If your DTI ratio is more than that, you may still be able to qualify for an FHA loan if you have another factor in your favor, such as a willingness or ability to come up with a down payment that is more than 3.5%.
Your credit score is an important part of applying for an FHA loan. If it’s 580 or higher, you’ll be more likely to receive the maximum loan amount that’s determined both by your household size and the location of your desired home. You’ll also be eligible for the minimum 3.5% down payment. On the other hand, if your score is between 500 and 579, you’ll need to put down 10% (if your score is below 500, you’re typically not eligible at all). If you’re applying for a mortgage with a spouse or partner, each borrower’s credit score will be evaluated, and loan eligibility will then be based on the lower score.
With an FHA loan, the home you hope to buy must meet certain property standards. You can use the loan to buy a wide variety of properties, such as single-family homes, townhouses, condominiums and even manufactured homes, but the property will need to meet local and national building codes. Be careful to consider these factors if you decide to apply.
Pros and cons of an FHA loan
Homebuying tends to get extremely busy, but it’s important to consider both the pros and cons of FHA loans before moving forward.
The biggest advantage of an FHA loan is that it can make it possible to own a home even if you have a modest income, less cash for a down payment and less-than-perfect credit. It may also be the best bet if you’ve filed for bankruptcy within the past four years.
Still, some buyers may find an FHA loan is too limiting if they’re looking for a home that costs more than the $314,827 limit the FHA has set for most of the U.S. Another reason to tread carefully: The FHA has set strict safety and livability guidelines for determining what makes a home eligible for an FHA loan. If you dream of buying a fixer-upper that requires a major overhaul to improve living conditions, you may want to find another source of financing. (You may also consider an FHA 203(k) loan, which is designed to roll the cost of renovation into the purchase loan.)
Before opting for an FHA loan, also consider potential insurance costs, which can add up quickly. With an FHA loan, you’ll need to pay both an up-front mortgage insurance premium, which equals 1.75% of the loan amount, and then an annual premium that’s broken down by month and added to your monthly mortgage payment. It’s possible to cancel your monthly payments if the down payment on your loan was 10% or more and you’ve already paid up for 11 years. Otherwise, expect these payments to last for the life of your loan.
What is a conventional loan?
Private lenders, such as banks and mortgage lenders, are responsible for providing consumers with both FHA and conventional loans. But, unlike FHA loans, conventional home loans are not federally insured, so prospective borrowers can expect strict requirements to qualify. These loans also require the purchase of private mortgage insurance if your down payment will be less than 20% of the cost of your new home.
Conventional mortgages still adhere to strict underwriting requirements, as laid out by Fannie Mae and Freddie Mac. These two, large private companies are sponsored by the federal government to both buy and resell loans, and this helps bring liquidity and stability to the mortgage market.
Conventional loan requirements
Lender requirements for conventional loans can change year to year, depending on market conditions and the lender. In general, however, applicants will need a minimum credit score of 620, although some lending institutions may require a score of at least 640.
Depending on the lending institution, a loan applicant may be able to put as little as 3% down, but that will usually require buying private mortgage insurance. With a 20% or more down payment, borrowers can avoid mortgage insurance entirely.
As with an FHA loan, borrowers looking for a conventional loan will still have to show they have a reliable income and steady employment history, especially from the previous two years. Lenders will also look at your debt-to-income ratio. Some lenders now allow for a DTI as high as 50%; but, to qualify, you may need a credit score of 700 or higher.
Pros and cons of a conventional loan
A conventional home loan may be right if you have a relatively high credit score and enough cash flow to easily put down a larger down payment, ideally 20% or more. In the past, average interest rates for conventional loans ran slightly higher than those for FHA loans; but, lately, the average rate for an FHA loan has been slightly more than for a conventional loan.
Still, if you lack cash for a sizable down payment — and have a limited credit history — an FHA loan might be an option that’s more immediately affordable. Your decision will also depend on whether you’re comfortable making a tradeoff to pay less mortgage insurance up front, but more on insurance overall during the life of the loan.
How FHA loans and conventional loans stack up
|FHA Loan||Conventional Loan|
|Down payment||As low as 3.5%, averaging out to 96.5% loan-to-value rate||As low as 3%; Low down payments may come with income limits|
|Mortgage insurance||Required at time of home purchase and through monthly payments during the life of the loan||Not required with downpayment of 20% or more; No longer required once principal is paid down to 78% of property value|
|Minimum credit score||As low as 500, but chances of approval are much greater if credit score is higher than 580; Credit scores below 580 will require at least 10% downpayment||620, although some private lenders may require minimum credit scores of 640|
|Maximum loan amount||Varies by state, county and property unit size;
For 2019, the maximum is $314,827 for a single-family home in lower-cost areas and $726,525 in high-cost areas
|Varies by state, county and lender;
For loans that conform to Fannie Mae and Freddie Mac standards, the maximum is $484,350 for a single-family home in lower-cost areas and $726,525 where housing costs are higher
|Applies to townhomes and condos?||Yes||Yes, but lenders may have additional restrictions and requirements|
|Income requirements||Provide documentation of income and employment history over a two-year period||Provide income history and show debt-to-income ratio is typically less than 45%|
|Average 30-year rates||4.91%*||4.88%*|
|Occupancy requirements||Must meet local and/or national safety and occupancy requirements||More flexible occupancy requirements;
Homeowner does not need to occupy the property as a primary residence
|Debt-to-income ratio||Standard is 31%;
Up to 43% when all debt obligations are included
|As high as 50%, although those with DTI higher than 45% should have a credit score above 700|
|Right for a first-time homebuyer?||Yes, designed to help ease consumers into owning homes||First-time homebuyers may qualify, although they will face more stringent requirements than with FHA loans|
|Refinancing available?||Yes, can be financed to another FHA loan or to a conventional loan||Yes, can only be refinanced with another conventional loan|
*In February 2019, according to Ellie Mae
Which loan is right for me?
Choosing between an FHA or conventional mortgage remains a personal decision. Luckily, you can make it easier to decide by taking a long look at your income, financial assets, immediate spending needs and the type of home you’d like or are willing to consider.
A conventional loan may be best if you and any other co-borrowers have a credit score above 700, enough saved to afford a down payment of 20% or more and would like to avoid the costs of mortgage insurance.
On the other hand, if you have a less-than-stellar credit score and fewer resources to be able to afford a downpayment greater than 3.5%, FHA loans may be a better choice. If you decide to go with an FHA loan, don’t forget to check the limits that may apply to your state and county. For more on FHA loan limits in general, check this resource from LendingTree. Lastly, here’s a guide to help you compare FHA loan rates.