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FHA Loan vs. Conventional Loan

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If you’re buying your first home, you’ll probably choose between a government-backed FHA loan and a conventional loan. Both programs are popular for homebuyers who don’t have much saved for a down payment. Understanding the difference between an FHA loan versus a conventional loan will help you decide which mortgage is the best fit for you.

What is an FHA loan?

An FHA loan is a mortgage insured by the Federal Housing Administration (FHA). It’s a popular program for homebuyers with limited down payment funds and bumpy credit. Many of these buyers can’t qualify for a conventional loan. Homebuyers must live in a home purchased with an FHA loan as their primary residence.

What is a conventional loan?

A conventional loan is a mortgage with rules set by government-sponsored enterprises Fannie Mae and Freddie Mac, which provide guarantees to conventional lenders. Conventional loans can be used to finance a primary residence, a second home or rental property. They aren’t insured by a specific government agency (whereas the FHA is), and borrowers must meet higher qualifying standards than FHA loans.

Differences between FHA and conventional loans

FHA and conventional lenders review credit scores, credit payment history, income, employment history and verify you have the funds for a down payment and closing costs. However, the minimum mortgage requirements are very different.

Loan FeatureFHA LoanConventional Loan
Minimum credit score500620
Minimum down payment3.5%3%
DTI Ratio43% with exceptions possible to 50%45% with exceptions possible to 50%
Loan limit$420,680 for a single-family home in most parts of the country$647,200 for a single-family home in most parts of the country
Mortgage insuranceRequired regardless of down paymentRequired only with a down payment less than 20%
Appraisal requirementAppraisal requiredAppraisal usually required unless eligible for waiver

Credit score requirements

FHA loan credit scores. Borrowers with credit scores as low as 500 may be eligible for an FHA loan, as long as they can come up with a 10% down payment. The credit score minimum is 580 for a 3.5% down payment.

FHA loans also give you added flexibility for major negative credit events: You may qualify if two years have passed since a bankruptcy discharge or three years after a foreclosure.

Conventional loan scores. Conventional lenders typically require at least a 620 credit score for loan approval. You’ll also need to wait at least four years to apply for conventional financing after a bankruptcy and up to seven years after a foreclosure.

Down payment requirements

FHA down payments.  A down payment of at least 3.5% is needed if you have a 580 credit score. The down payment can be gifted, provided by an employer or paid by a charitable organization. Borrowers with a score between 500 and 579 must make a 10% minimum down payment.

Conventional down payments. Conventional loans are available with down payments as low as 3%.  The Fannie Mae HomeReady® and Freddie Mac Home Possible® programs allow the down payment to be gifted and may include a second mortgage option to finance up to 105% of the home’s value.

Earnings and debt-to-income requirements

Your debt-to-income (DTI) ratio is the percentage of your monthly income that goes to debt payments and is measured by dividing your total debt by your gross income. FHA loans come with fewer income limitations and you may qualify with a higher DTI than conventional guidelines allow.

FHA income and debt requirements. FHA borrowers must document stable income to qualify for an FHA mortgage, and explain any major gaps in their job history. Income from a relative that doesn’t live in the home can be used to qualify with a minimum down payment. The FHA doesn’t set any income limits for an FHA mortgage. While FHA guidelines prefer a 43% DTI ratio, you may qualify for 50% or higher with strong credit scores or extra cash reserves.

Conventional income and debt requirements. Conventional lender guidelines set the DTI ratio maximum at 45% with exceptions possible up to 50% with mortgage reserves and higher credit scores.

Conventional loan guidelines require proof of stable income and typically don’t allow income to qualify from someone that doesn’t live in the home. The HomeReady and Home Possible programs permit “boarder” income if you can document rental income from someone who has lived with you for a full year. Income limits apply to both the HomeReady and Home Possible programs.

Loan limits

Both FHA and conventional loans are subject to loan limits that change yearly, depending on whether home prices are rising or falling.

FHA loan limits. In 2022, $420,680 is the maximum loan amount for low-cost areas of the country. However, the FHA loan limit spikes to $970,800 if you’re buying in a high-cost part of the U.S. The limits are higher for two- to four-unit properties.

Conventional conforming loan limits. Conventional loans are divided into two categories: conforming and non-conforming. Conforming conventional loans must meet the guidelines set by Fannie Mae and Freddie Mac and can’t exceed the loan limits set by the Federal Housing Finance Agency (FHFA).  In 2022, the maximum conforming conventional loan amount is $647,200 for the majority of the U.S., with a cap of $970,800 for high-cost areas.

Mortgage insurance

Mortgage insurance protects lenders against losses if you are unable to make your payments and default on your loan. FHA loan mortgage insurance is much more expensive than conventional mortgage insurance because FHA lenders take on more risk approving loans to lower credit score borrowers.

FHA mortgage insurance. Upfront and annual mortgage insurance premiums are required on FHA loans. The upfront mortgage insurance premium (UFMIP) is 1.75% and is usually added to the loan balance. The mortgage insurance premium (MIP) is charged annually, divided by 12 and added to your monthly payment and ranges between 0.45% to 1.05% depending on your loan amount and the term of the loan.  You’ll pay FHA mortgage insurance regardless of your down payment, and it can’t be canceled even if you make a minimum down payment. Credit scores do not have an impact on how much mortgage insurance you pay.

Conventional mortgage insurance. Private mortgage insurance (PMI) is required on conventional mortgages if you make less than a 20% down payment. Annual PMI premiums typically cost between 0.15% and 1.95% of your loan amount depending on your credit score and down payment. PMI can be removed once you prove you have 20% equity in your home.

Appraisal requirements

An appraisal is a written report completed by a licensed independent home appraiser to determine the value of your home based on a comparison of recent home sales with similar features in nearby neighborhoods. You’ll need an FHA appraisal if you’re buying a home with an FHA loan. Conventional lenders may offer an appraisal waiver if you’re making a large down payment and have high credit scores.

FHA appraisal guidelines. FHA appraisers are required to scrutinize both the value and condition of your home. The home must meet FHA property requirements, which tend to be more stringent than conventional appraisal guidelines. You’ll pay between $300 and $700 for an FHA appraisal — slightly more than the cost of a conventional appraisal.

Conventional appraisal guidelines. Conventional appraisers focus primarily on estimating a home’s value based on its features compared to recent home sales in similar areas. You’ll typically pay between $300 and $400 for a conventional appraisal unless you’re eligible for a PIW (property inspection waiver) mortgage.

FHA vs. conventional interest rates

Although FHA interest rates tend to be lower than conventional rates, the higher cost of FHA mortgage insurance may push the annual percentage rate higher (APR) than a similar conventional loan. APR measures the total cost to borrow a mortgage including origination fees, discount points, mortgage insurance and other costs.

How to shop FHA interest rates. Most lenders are approved to offer FHA loans, although some may set higher credit score minimums than FHA requires. Rates may vary significantly between lenders if your credit score is below 620.

How to shop conventional interest rates. Get at least three to five quotes from conventional lenders and compare rates and closing costs for the best deal. If you’re making less than a 20% down payment and have low credit scores, keep an eye on the difference in PMI costs —some lenders work with more competitive PMI companies than others.

FHA loan vs. conventional loan: Which should you choose?

You should choose an FHA loan if:You should choose a conventional loan if:
  • You have a credit score below 620
  • You earn too much income for conventional 3% down payment loans
  • You need to qualify with the income of someone who won’t live in your home
  • You can’t qualify for a conventional loan
  • You’re buying a primary residence
  • You have a credit score of at least 620
  • You have a stable income and qualify on your own You need to borrow more than the FHA loan limits allow
  • You’re buying a second home or investment property

Alternatives to an FHA or conventional loan

Although most homebuyers choose FHA or conventional loans to finance their homes, there are other specialized loan programs worth considering if you’re eligible.

VA loans. Eligible military borrowers can purchase a home with no down payment and no mortgage insurance if they qualify for a loan guaranteed by the U.S. Department of Veterans Affairs (VA).

USDA. The U.S. Department of Agriculture (USDA) backs loans to low- to moderate-income borrowers as long as they buy a home in a USDA-designated rural area. No down payment is required.

Non-qualified mortgages. A non-qualified mortgage (non-QM for short) may be worth a look if you don’t meet the guidelines for any of the conventional or government-backed loans listed above. With a non-QM loan you may be able to verify your income with bank statements instead of tax returns, qualify with major credit issues in the past year or convert a high net worth into income.

 

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