FHA vs. Conventional Mortgage: Which Loan Is Right for You?
The government-backed Federal Housing Administration (FHA) mortgage is widely known as a good tool for helping first-time homebuyers qualify for a home loan. That’s useful to know if you are entering the housing market for the first time, but it is equally important to be aware you may have other options. Knowing the full range of options available to you could save you thousands of dollars in the long run.
In some cases, even first-time homebuyers might qualify for what is known as a conventional mortgage. These are harder to get than FHA loans but may be less restrictive and could save you money by allowing you to avoid or reduce mortgage insurance premiums.
So which is better for a first-time buyer: an FHA loan or a conventional loan? The answer depends a great deal on your circumstances. Shopping for a mortgage should start with deciding which type of loan is better for you. The following background and comparison of FHA and conventional mortgages should help you make that decision. (Note: FHA loans aren’t just for first-time homebuyers, which we’ll talk about later.)
In this guide, we’ll cover:
- The ins and outs of an FHA mortgage
- The ins and outs of a conventional home loan
- How FHA and conventional loans compare
- How FHA and conventional loan requirements compare
- Refinance options
- How to shop for a mortgage
- Frequently asked questions
- How to decide if an FHA or conventional loan is right for you
There is no doubt that FHA mortgages are popular with first-time homebuyers, especially younger homebuyers with limited credit histories. According to figures from the U.S. Department of Housing and Urban Development, which oversees FHA loans, it has insured more than 38 million single-family mortgages since the program’s inception in 1934, including 7.95 million currently insured.
Mortgage data company Ellie Mae’s 2017 Borrower Insights Survey found that while most baby boomers have a conventional mortgage, millennials are most likely to have a mortgage backed by the FHA or a similar government program. This indicates the extent to which younger homebuyers find FHA mortgages especially welcoming.
More details will follow later in this guide, but for starters, the following overview will give some insights into why many first-time homebuyers find FHA mortgages appealing.
An FHA mortgage is a home loan offered primarily to first-time buyers through approved private lenders. The federal government insures these loans, meaning lenders can take on the risk of giving a mortgage to a borrower who might not otherwise qualify for one, because if the borrower defaults, the government absorbs that cost, not the lender.
A key advantage of an FHA mortgage is the federally backed insurance gives lenders the confidence to make loans to homebuyers they may not otherwise approve. Borrowers can get FHA mortgages with lower down payments and lower credit scores than they could with conventional mortgages, which makes homeownership accessible to more consumers. FHA loans also tend to carry lower interest rates than conventional loans. While FHA mortgages require owner occupancy, they do allow for co-buyers who do not live in the home as long as that co-buyer is a U.S. citizen or makes their primary residence in the U.S. Unless the co-buyer is a family member, having a non-occupying co-borrower may limit the loan-to-value (LTV) ratio allowed on the loan.
A significant disadvantage of an FHA mortgage is that you will have to pay a mortgage insurance premium up front and for many years, possibly for the entire length of the loan. This premium supports the mortgage insurance program that makes FHA loans possible.
Another disadvantage is FHA mortgages have more restrictions, such as requiring the homebuyer or co-buyer to occupy the property and disqualifying applicants who have a history of default with any federal government agency.
An FHA loan makes the most sense when you are just starting to establish a financial track record, or have had some minor financial troubles in the past. It can also be a good option if you have limited time or resources for saving up a large down payment.
You need to be able to provide proof of employment and income, and you must have established enough of a credit history to have a credit score. Technically, this score can be as low as 500, but your loan terms and chances of approval will be considerably better if your score is above 580. (If you’re not sure where your credit stands, you can get one of your free credit scores here.) Also, scores below 580 will not allow you to qualify for an FHA loan unless you put at least 10 percent down. You also must have a clean record on the government’s CAIVRS database, which will indicate whether you are delinquent on any financial obligation to the federal government.
Homebuyers who can qualify for a mortgage without the backing of the FHA should consider what is known as a conventional loan. These are offered by private lenders, and because they do not have direct government backing, their requirements are generally more stringent than those for FHA mortgages. However, they may be more flexible in terms of the types of property that can be purchased, and they can allow the buyer to eliminate or greatly reduce the expense of mortgage insurance. According to data from Ellie Mae, some 72 percent of all homeowners have a conventional loan.
A conventional loan is a mortgage that does not require FHA mortgage insurance but qualifies for the underwriting requirements of government-sponsored mortgage finance companies such as Freddie Mac and Fannie Mae. These are private companies that purchase loans from various lenders, giving lenders the liquidity to keep making loans.
While organizations like Freddie Mac and Fannie Mae do not make loans to homebuyers directly, the liquidity they provide by buying loans is essential to the operation of ordinary mortgage lenders. In return, these finance companies dictate the underwriting terms to those lenders. Those terms are generally stricter than those required for an FHA mortgage, but they may involve less paperwork and expense and may apply to a broader range of homebuying circumstances than FHA mortgages.
A crucial advantage of conventional mortgages is they involve much lower cost in the form of mortgage insurance. Like FHA loans, conventional mortgages often do require some mortgage insurance to protect the owner of the loan, but these insurance rates are generally lower than for FHA loans and do not apply to mortgages with LTV ratios below 80 percent.
Conventional mortgages are also more flexible than FHA loans in some ways, in that the borrower does not have to occupy the property and does not have to meet the definition of a first-time homebuyer.
Without the backing of the FHA mortgage insurance program, lenders typically impose tougher underwriting requirements on conventional loan borrowers. Conventional loans generally require borrowers to have higher down payments, lower debt-to-income (DTI) ratios, and higher credit scores than FHA loans do. On average, conventional loans charge higher interest rates than FHA loans.
A conventional loan generally makes the most sense when the borrower has a strong credit history and more financial resources. This means the borrower will not only be able to qualify for a conventional mortgage but also may be able to provide a larger down payment to avoid paying mortgage insurance.
You need a fairly clean credit history, with no bankruptcies or foreclosures in the recent past. A high credit score (700 or better) is a definite plus. In addition, you will need to substantiate your income and show that your total debt payments will be less than 45 percent of that income.
Sizing up these two options head-to-head, the picture that emerges is that the best choice depends very much on your circumstances.
First of all, if you are buying a home you don’t plan on occupying yourself, will have a co-buyer occupying, or do not meet the definition of a first-time homebuyer, you won’t qualify for an FHA loan, so a conventional loan would be your only option. However, assuming you are looking to buy a primary residence and qualify as a first-time buyer, the key distinction between an FHA and a conventional loan comes down to the trade-off between credit history requirements and the expense of mortgage insurance.
FHA loans generally have more lenient credit requirements. They allow for lower credit scores, higher LTV ratios, and higher DTI ratios. They also have less of a waiting period required for approval after a major financial setback such as bankruptcy or foreclosure.
Of course, a major reason FHA loans are more lenient is that they require mortgage insurance premiums to protect against defaults. Conventional mortgages may require mortgage insurance as well, but the premiums are much lower than for FHA mortgages.
Also, if you have a conventional mortgage, you no longer need mortgage insurance once the LTV ratio drops below 80 percent, so you can avoid it altogether if you make a down payment of at least 20 percent. In contrast, you will have to continue paying mortgage insurance premiums on an FHA loan for at least 11 years, and depending on the nature of your loan, you may have to pay these premiums until you pay off the loan.
As a final note, interest rates on 30-year conventional loans are slightly higher than those on FHA mortgages, but this difference is more than offset by the difference in the size and duration of mortgage insurance premiums.
To put the head-to-head comparison in perspective, the following is a summary of some of the key attributes of FHA and conventional mortgages.
|FHA vs Conventional Loans Comparison|
|FHA Mortgage||Conventional Mortgage|
|Credit requirements||FICO credit score can be as low as 500 (on a 300 to 850 scale), but the average for approved loans is 683*.||Standards vary by lender and according to LTV. The minimum credit score for loans financed by Fannie Mae or Freddie Mac is 620, but the average for approved loans is 754*.|
|Down payment/LTV requirements||Can be as low as 3.5% (which translates to a 96.5% LTV) and the average LTV for new loans is 96%*.||Can be as low as 3% (which translates to a 97% LTV), but low down payments greatly affect interest rates and mortgage insurance. The average LTV for new loans is 80%*.|
|Mortgage insurance requirements||1.75% up front, then an annual premium that varies in amount and duration according to LTV, the length of mortgage, and the amount of the loan. These annual payments range from 0.45% to 1.05%, and may last from 11 years to the full length of the mortgage, depending on the LTV of the loan.||No upfront amount, then typically 0.51% annually. These payments can be discontinued when LTV drops below 80%.|
|Years after bankruptcy/foreclosure||In most cases, FHA mortgages require the passage of two years since bankruptcy discharge in the case of a Chapter 7 bankruptcy, or one year of the payout period under a Chapter 13 bankruptcy. FHA mortgages generally require the passage of three years since transfer of property title due to a foreclosure.||In most cases, conventional mortgages will not be approved until four years after a bankruptcy discharge or dismissal. In the case of a Chapter 13 bankruptcy, the waiting period may only be two years if the bankruptcy was discharged rather than dismissed. Conventional mortgages generally require a waiting period of seven years from the completion date of a foreclosure action.|
|Debt-to-income ratios||Maximums vary from 40% to 50%, depending on credit score and other circumstances, but the average is 43%*.||Maximums vary from 36% to 45%, depending on credit score and LTV, but the average is 35%*.|
|Average 30-year rates||4.25%*||4.34%*|
* In June 2017, according to Ellie Mae.
All of the above covers the nature of FHA and conventional loans for your purchase mortgages, but what options does each give you if you want to refinance later on?
When it comes to refinancing, FHA mortgages offer some nice advantages. For one thing, you have the option of refinancing from an FHA mortgage to either a new FHA mortgage or a conventional loan, while a conventional loan can only be refinanced into another conventional loan.
If you choose to refinance from one FHA loan into another FHA loan, you may be eligible for the FHA’s streamline refinance program. This can cut down on the underwriting paperwork, and under some circumstances may even allow you to avoid getting a new appraisal on your home.
On the other hand, while the streamline refinance program is convenient, you may want to consider refinancing from an FHA to a conventional loan. The advantage of this is to reduce or eliminate your mortgage insurance premiums. This approach makes sense if your financial situation and credit history have improved substantially since you got your first mortgage. This may mean that you would now qualify for a conventional mortgage, and if the LTV ratio of your refinanced loan is below 80 percent, you could eliminate mortgage insurance premiums immediately.
A final refinancing advantage of FHA mortgages is that whether you refinance to an FHA or conventional loan, FHA mortgages do not carry prepayment penalties. In contrast, conventional mortgages often charge you a penalty if you pay them off early, especially in the first five or so years of the loan.
Given the pros and cons of FHA and conventional loans in terms of both purchase and refinance mortgages, a good first step in making your decision is to check your credit report and credit score. This will give you a sense of whether or not you have a strong enough history to consider a conventional loan. Another advantage of checking your credit report early in the process is that it will give you time to correct any mistakes or clear up minor problems.
Once you have decided between an FHA or conventional loan, you can start shopping for a specific loan within that category. It is worth spending some time on this stage of the process, because your choice of loan could save — or cost — you money for years to come.
For starters, you should run some simulations on a mortgage calculator to see what size loan your budget can afford. While doing this, it is worth looking at both 15- and 30-year loans. Longer loans have the immediate appeal of offering lower monthly payments, but if you look at the total amount of interest you would pay over the life of each loan, you are likely to find that a shorter loan would save you thousands of dollars in the long run.
Having established the length and type of loan you want, you can start comparing lenders. LendingTree allows you to find and compare rates for both FHA and conventional loans, and there are other mortgage shopping sites such as HSH, Bankrate, and Trulia as well.
While interest rates are a starting point in comparing mortgage lenders, once you’ve narrowed down the field a bit you should also compare estimated fees and closing costs from each candidate. A mortgage calculator might help you assess the dollar impact of the trade-off between interest rates and other costs.
If you think you have identified the right lender and are serious about buying a home in the near future, a good step to consider is getting pre-approved for a home loan. This involves filling out an application and submitting to a credit check, and it may involve paying a fee. The advantage is that if it all works out, that lender will give you a commitment for mortgage approval up to a certain dollar amount and within a specified period of time.
Having this commitment will allow you to move ahead with the confidence that you will be able to get a loan once you find the right house, and having that commitment might give you a leg up with sellers who are weighing competing offers. There is a lesser type of reality check than a pre-approval called a pre-qualification. With pre-qualification a lender will provide a superficial assessment of your ability to qualify for a mortgage, but this does not represent a commitment on the lender’s part.
To help boil down some of this information, the following are some answers to frequently asked questions about FHA and conventional mortgages:
Can I get a mortgage if I have a bankruptcy in my past?
Yes, but it’s easier with an FHA mortgage. You must wait at least two years after a bankruptcy to get an FHA mortgage, while with a conventional mortgage it will generally take at least four years.
Can I do a cash-out refinance with my FHA mortgage?
A cash-out refinance is one in which the new mortgage exceeds the balance on the old mortgage by tapping into the equity on the property and makes the difference available to the borrower in cash. Cash-out mortgages are not eligible for streamline refinancing, so they are only available if you refinance into a conventional mortgage or go through the full FHA application and underwriting process, and even then additional occupancy and LTV restrictions will apply.
What credit scores and reports do you need to think about?
You should check both your credit score and a full credit report. You can get a free annual credit report once per year from each of the major credit reporting agencies on AnnualCreditReport.com. Be advised, though, that credit scores vary. You may not know which credit score a lender will use to evaluate your application, but keeping tabs on one of your scores can give you a good idea of where you stand. Beyond the credit score, you have to be concerned with whether or not you are listed on the CAIVRS database. The general public does not have access to this, but one advantage of getting pre-approved for a loan is that your lender can check that database.
Do I have to pay mortgage insurance with each type of loan?
Definitely with an FHA loan, both up front and for anywhere from 11 years to the length of the mortgage. For example, if you take out an FHA loan with an LTV greater than 90 percent, you will have to pay mortgage insurance for the life of the loan. A conventional loan may also entail mortgage insurance, but the rates are generally lower and it only applies as long as the LTV is above 80 percent.
Which type of mortgage is better for refinancing?
An original FHA mortgage may allow for easier refinancing and without penalty, though by the time you refinance it might be cost-effective to refinance into a conventional mortgage.
Are FHA loans only for first-time homebuyers?
No. FHA loans are often associated with first-time homebuyers, but as long as the purchase is for a primary residence, buyers who have previously owned might still find an FHA mortgage to be the best solution. There are also other types of FHA loans, including those for reverse mortgages, refinancing, energy-efficiency programs, and purchases of mobile homes and manufactured housing.
The choice between an FHA and a conventional mortgage depends on many factors specific to each individual, but the following are some tips for making this decision:
- If your credit score is above 700, you may well want to consider a conventional loan.
- If you have had a bankruptcy within the past four years, an FHA mortgage might be your best bet.
- If you have the resources for a substantial down payment (say 10%-20%), you could save money with a conventional mortgage.
- If you have had a foreclosure within the past seven years, you will probably qualify for an FHA mortgage long before you would qualify for a conventional mortgage.
In short, there is no universal answer to whether or not an FHA or conventional mortgage is better. However, there is a right answer as to which is the best fit for you and taking a look at your financial situation should help you find that answer.