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FHA Loan vs. Conventional Loan

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If you’re a first-time homebuyer, you’re probably trying to decide between an FHA loan and a conventional loan. Both offer paths to homeownership that don’t require a huge down payment, but there are major differences. We’ll break down the pros and cons of each loan type and help you decide which is a better fit for you.

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What is an FHA loan?

An FHA loan is a mortgage insured by the Federal Housing Administration (FHA). FHA loans are popular among homebuyers who can’t qualify for a conventional loan, either because their credit score isn’t great or because they don’t have a large enough down payment. FHA loans can only be used to finance a primary residence, though, so you won’t qualify if you’re trying to buy an investment property or a second home.

What is a conventional loan?

A conventional loan is any mortgage not backed by a government agency like the FHA, U.S. Department of Agriculture (USDA) or U.S. Department of Veterans Affairs (VA). Conventional loans usually conform to a set of rules created by federal regulators, but they don’t have to. Fannie Mae and Freddie Mac will only purchase loans that follow those rules, but some lenders are more interested in catering to borrowers with unique needs than in being able to sell their loans on the secondary market. Conventional loans can be used to finance a primary residence, second home or rental property and can be issued by a bank, credit union or private lender.

  For the purposes of comparing FHA and conventional loans, we will stick to conventional loans that do follow Fannie Mae and Freddie Mac’s rules, also known as conforming loans.

Difference between FHA and conventional loan requirements

Credit score requirements

  FHA loan credit score: 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.

  Conventional loan credit score: Conventional lenders typically require at least a 620 credit score for loan approval.

Down payment requirements

  FHA loan down payment: The amount you’ll need to put down depends on where your credit score sits. If you have a credit score between 500 and 579, you’ll have to put down at least 10%. If your credit score is 580 or higher, you only need a 3.5% down payment. FHA rules also allow you to use gifted funds to make your down payment.

  Conventional loan down payment: Conventional loans are available with down payments as low as 3%, though some loan programs may come with income limits. The Fannie Mae HomeReady and Freddie Mac Home Possible programs, for example, both have a minimum 3% down payment but are only available to low- and moderate-income borrowers. If you’re earning a comfortable income, you can expect to end up making a higher down payment.

Income requirements and debt-to-income limit

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 don’t come with any of the pesky income limits you’ll find with some conventional loan programs, 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. The FHA doesn’t set any income limits for an FHA mortgage. While FHA guidelines prefer a 43% DTI ratio, you may qualify with a 50% ratio or higher if your credit scores are strong or you have extra cash reserves. And if you need help qualifying, a family member who doesn’t plan to live in the home with you can still use their income to boost yours and help reduce your DTI.

  Conventional income and debt requirements: Conventional lender guidelines set the DTI ratio maximum at 45% with exceptions possible for those with mortgage reserves and higher credit scores. As of Aug. 1, 2023, you’ll also pay a fee at closing if your DTI is over 40%. The HomeReady and Home Possible programs permit a portion of “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.

Waiting periods after bankruptcy and foreclosure

  FHA loan waiting periods: FHA loans are fairly forgiving when it comes to major negative credit events like bankruptcy or foreclosure. You may qualify if two years have passed since a Chapter 7 bankruptcy discharge or if you’ve made at least one year of payments after a Chapter 13 bankruptcy. You must wait three years to get another FHA loan after a foreclosure.

  Conventional loan waiting periods: You’ll need to wait two to four years to apply for conventional financing after a bankruptcy and up to seven years after a foreclosure.

Loan limits

Each year the Federal Housing Finance Agency (FHFA) sets loan limits that have big implications for both FHA loans and conforming conventional loans. Loan limits are set by county and based on median home prices, so they’re higher in areas with a higher cost of living.

  FHA loan limits for 2023 cap the amount you can borrow for a single-family home at $472,030 in low-cost areas, but the cap goes up to $1,089,300 in high-cost areas.

  Conventional loan limits for 2023 range from $726,200 in low-cost areas to $1,089,300 for a single-family home in the most expensive parts of the country.

Mortgage insurance

Mortgage insurance protects lenders against losses if you’re unable to make your payments and default on your loan. FHA loan mortgage insurance is generally more expensive than conventional mortgage insurance because FHA lenders take on more risk approving loans to lower-credit-score borrowers. However, if you have a high credit score, you may find that you’ll pay less with conventional mortgage insurance.

  FHA mortgage insurance: Upfront and annual mortgage insurance premiums are required on FHA loans. The upfront mortgage insurance premium (UFMIP) is 1.75% of the loan amount and is usually added to the loan balance. The annual mortgage insurance premium (MIP) is divided by 12 and added to your monthly payment. The cost ranges between 0.15% and 0.75%, depending on your loan amount and loan term. You’ll pay FHA mortgage insurance regardless of your down payment, and it can’t be avoided by making a larger down payment. Credit scores don’t have an impact on how much mortgage insurance you pay, either, but your loan amount and down payment amount do determine how long you’ll pay for it.
  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. Expect to pay around $30 to $70 per month for every $100,000 you borrow. You can cancel your PMI once you prove you have 20% equity in your home.

Appraisal requirements

An appraisal is a written report completed by a licensed home appraiser to determine your home’s value, 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.

  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 loan appraisal requirements: 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 $500 for a conventional appraisal unless you’re eligible for a property inspection waiver or an alternative method of valuation. Some lenders may offer an appraisal waiver if you’re making a large down payment (at least 20%).

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 (APR) of an FHA loan higher 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: Not all lenders are approved to offer FHA loans, so your first step will be to find FHA-approved lenders. A good place to start is LendingTree’s list of the best FHA lenders of 2023. Keep in mind that some may set higher credit score minimums than the FHA requires. Interest rates may vary significantly between lenders if your credit score is below 620, which is the minimum credit requirement for conventional loans, so you can’t afford not to comparison shop if you’re dealing with low credit.

  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, as you may see a lot of variability in PMI premiums from lender to lender.

FHA loan vs. conventional loan: Which is better?

Is a conventional loan better than an FHA loan? There’s no one-size-fits-all answer to this, unfortunately, but don’t be discouraged — you can answer this question for yourself by breaking down the pros and cons of each loan type.

FHA loan pros and cons

ProsCons

  You can qualify with a lower credit score

  You'll have access to an FHA streamline refinance if you choose to refinance later

  You can use a nonoccupying co-borrower to boost how much you’ll qualify for

  You'll have to make a slightly higher down payment

  You'll have to pay FHA mortgage insurance premiums

  You'll have to choose a home that meets stricter minimum property requirements

An FHA loan makes more sense 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

Conventional loan pros and cons

ProsCons

  You may only have to put down 3%

  Your PMI is cancellable

  You don't have to live in the home you purchase

  You'll need a higher credit score

  You'll have to pay PMI if you put down less than 20%

  You may pay a higher interest rate

A conventional loan makes more sense if:

  • You have at least a 620 credit score
  • You have a stable income and qualify on your own
  • You need to borrow more than FHA loan limits allow
  • You’re buying a second home or investment property

Alternatives to an FHA or conventional loan

FHA and conventional loans may be the most popular options, but there are other specialized loan programs worth considering if you qualify:

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

Jumbo loans If you want to purchase in a high-cost area or are looking for a luxury home, you may find that a jumbo loan is right for you. Jumbo loans are conventional but nonconforming since they allow you to borrow more than the conforming loan limits.

Nonqualified mortgages A nonqualified 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 through 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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