Buying a home is a privilege, but it is also costly. Most buyers cannot afford the purchase price upfront, so they save up for a down payment and obtain a home loan from a private lender, bank, or credit union.
However, borrowers can use numerous loan products on the market to finance their homes. These programs have varying requirements, so learning about your options is the key to finding the right mortgage for your needs. Two of the most common mortgage products for residential real estate are FHA loans and conventional loans.
What is an FHA Loan?
FHA stands for Federal Housing Administration. It is a branch of the US government under the umbrella of the Department of Housing and Urban Development. To encourage Americans to buy homes, the FHA insures these government-backed loans to give lenders more flexibility with their loan approval standards. These types of mortgages are collectively known as FHA loans.
You can acquire an FHA loan by finding FHA-approved lenders who offer these products. Requirements to qualify for these loans may vary slightly from lender to lender, but they are generally the same across the country.
Pros and Cons of FHA Loans
Pros:
- Lower minimum down payment amount to reduce the barrier to homeownership
- Greater flexibility regarding the minimum credit score required of borrowers with short credit histories or multiple debt channels
- Access to a lower interest rate to reduce the total loan amount and monthly payments
- More favorable debt-to-income (DTI) requirement, which compares monthly debt obligations to income
Cons
- FHA mortgage insurance premiums tend to be higher because of increased risk for lenders, including the upfront mortgage insurance premium
- Depending on the down payment percentage, PMI could be required for the life of the loan.
- An FHA loan limit with a maximum amount that can be borrowed
What is a Conventional Loan?
A conventional loan is the most common form of mortgage in the United States. Most borrowers use this product to finance their homes because they have relative financial stability. Unlike FHA loans, conventional loans are not backed or insured by a government agency. This makes them a little riskier for lenders, so they have higher standards for borrowers than they do for FHA loans.
A conventional loan can be obtained from most credit unions, banks, and private lenders who provide mortgage products. Requirements for conventional loans can also vary slightly from lender to lender.
Pros and Cons of Conventional Loans
Pros
- More options are available since government standards for the loan do not bind lenders;
- Higher loan limits allow borrowers to purchase the homes of their dreams, even if they require a jumbo loan;
- Access to competitive interest rates and either adjustable or fixed-rate mortgages;
- Lower private mortgage insurance payments or none at all;
- There are fewer obstacles in the mortgage approval process.
Cons
- A higher interest rate that increases the total loan amount and monthly mortgage payments
- Although a conventional loan has a minimum credit score of 620, higher credit scores typically work best for getting approved. The lower the credit score, the larger the down payment and DTI need to be.
Comparison of Eligibility Requirements
Determining whether an FHA loan or conventional loan is right for you may come down to eligibility requirements. You may not be qualified for a conventional mortgage but could still be eligible for an FHA loan. On the other hand, most people who can apply for conventional loans are likely to prefer something other than the FHA alternative. Let’s look at the differences between FHA and conventional loan eligibility requirements.
Credit Score
A credit score reflects your history of paying back debts, such as previous mortgages, car loans, credit cards, and student loans. The higher your credit score, the more trustworthy you appear to lenders.
The minimum credit score requirement for an FHA loan is typically 580. However, some lenders will make exceptions for a credit score as low as 500, though a much higher down payment will likely be required.
A conventional loan is more challenging to qualify for. Most lenders set the lowest acceptable credit score at 620, though some may prefer higher scores like 650 or 700. Also, a higher credit score can give you access to more competitive mortgage rates, so the incentive to maintain a higher credit score is significant for future buyers.
Down Payment
A down payment is the amount of money you pay upfront to reduce the total cost of the loan. For example, a $200,000 home for which you make a down payment of $20,000 will have a total loan balance of $180,000 at the start.
The minimum down payment for an FHA loan is 3.5% of the home’s purchase price, which is the most common amount. However, it is important to note that PMI is slightly less expensive with at least a 10% down payment, and it can be removed after 11 years.
Conventional down payment requirements are very similar. Some lenders will accept a down payment amount as low as 3% of the property’s sale price. However, there is an even greater incentive to hit 20% with your down payment, as it will eliminate mortgage insurance. Plus, the total loan balance will be lower with a larger down payment so that you will pay less interest over the life of the loan.
Debt-to-Income Ratio (DTI)
The debt-to-income ratio measures your total monthly obligations and how they compare to your monthly income. The DTI is a reflection of your ability to cover monthly payments. The lower the percentage, the greater your chance of being approved for a mortgage. You can calculate your DTI by dividing the total monthly payments by your gross monthly income and multiplying the result by 100.
FHA loans generally have a maximum DTI of 43% in most cases, but lenders may allow up to 57% for trustworthy borrowers. This means that 43% of your monthly income goes toward your current debt obligations.
Most conventional loans require a similar DTI of 45% or less. Again, reliable borrowers with solid credit history or cash assets may get away with 50%, but it is not a guarantee and depends on the lenders’ policies.
Appraisal Process
Lenders want to ensure they are providing a financing solution that matches the home’s actual value. Otherwise, the asset becomes far riskier, and borrower defaults are more likely. As a result, an accredited appraiser will appraise the home to ensure you are getting the house for a fair price. This appraisal process is different for FHA loans and conventional loans.
Conventional Loans
Conventional appraisals are less stringent than FHA appraisals. There is less government involvement, so the appraiser does not need to ensure the property meets every standard set by HUD. Appraisers will look for any safety issues with the home and problems that would make it hard for the lender to sell on the open market if the buyer defaults on the payments.
FHA Loans
An FHA appraisal can only be conducted by a government-approved appraiser. Before approval, the property must meet all HUD standards, including strict requirements for structural integrity, safety, and livability. Appraisers will usually inspect the home within a few days of the seller accepting the buyer’s offer and draft a report 7-10 days later.
FHA vs. Conventional Loan Limits
Loan limits for FHA and conventional loans vary from state to state and even county to county. You can quickly look up FHA loan limits in your area, but the FHA loan limit in most parts of the country for 2024 is $498,257. If you want to borrow more than your area’s limit, you may have to seek a conventional mortgage instead.
The conventional loan limit is more complicated. Conventional loans are divided into two categories: conforming and nonconforming. Conforming loans are those below the limits set by Fannie Mae and Freddie Mac, two non-government entities that somewhat control the mortgage loan market and are regulated by the Federal Housing Finance Agency. Nonconforming loans, or jumbo loans, are above that conforming loan limit. In 2024, the conforming loan limit in most parts of the country is $766,550.
In addition, VA loans have limits if the borrower does not have full entitlement. Research VA loan limits if you are a veteran, active-duty service member, or surviving spouse looking to finance a home.
FHA vs Conventional Loan Eligible Properties
Not all properties are eligible for borrowers with FHA loans. First, there is a strict appraisal process, so the property must be deemed safe, structurally sound, and livable. The home must also be the borrower’s primary residence, and they must move in within 60 days of closing.
On the other hand, there are very few limitations on the type of property you can buy with a conventional loan. You could be buying a long-term rental, a vacation rental, a primary residence, a second home, or whatever you like as long as your finances meet the lender’s requirements.
FHA vs. Conventional Loan Interest Rates
The Federal Reserve sets the interest rate throughout the year, which impacts how much money banks and other lenders can borrow to give out as loans to consumers. Those banks then set their own interest rates, usually in line with the current Federal Reserve rate.
FHA interest rates are usually lower than conventional rates for the same loan value. This is because the government insures FHA loans, so FHA-approved lenders have more flexibility to lower rates and entice borrowers. However, a conventional borrower with an excellent credit score can still find a competitive rate because of their strong credit scores.
FHA vs Conventional Loan Mortgage Insurance
Private mortgage insurance dramatically impacts your monthly costs as a homeowner. An FHA loan will include mortgage insurance payments because of the low down payment and higher risk for the lender. If the borrower makes a down payment of at least 10% and makes all their
payments on time, FHA mortgage insurance can be dropped after 11 years. It can also be dropped if the borrower refinances into a conventional loan.
For conventional loans, mortgage insurance is dropped when the remaining principal balance is 78% of the home’s original value or if the loan term is halfway done. It is also possible to request your mortgage insurance be dropped if you have 20% equity and have lived in the home for several years, but this will depend on your lender.
Choosing Between FHA and Conventional Loans
FHA loans and conventional loans are both tools designed to help people achieve their dreams of homeownership. The more people who own homes, the more stable the economy is. This is why the government sometimes makes homes more affordable through government-backed mortgages. Let’s break down which home loan product is the right fit for your borrowing needs.
Why You Should Go with FHA Loans
The FHA loan program was created to help get more Americans into homes and out of the endless cycle of rental payments. With lower credit score requirements, smaller down payments, and more competitive interest rates, FHA loans are generally more accessible to those who may not have a solid financial history.
You may have only been building credit for a few years and cannot qualify for a conventional loan. Maybe your debt-to-income is too high for basic conventional mortgages. In this scenario, an FHA loan makes sense for your needs because you don’t have the resources to cover a conventional loan’s upfront expenses and monthly costs. Limited income could also be a reason to seek out FHA loans rather than an alternative.
Why You Should Go with Conventional Loans
Conversely, a conventional loan makes sense if you have more financial stability. A strong credit score will allow you to qualify for the loan while also giving you access to lower interest rates, reducing your monthly premiums and the total loan cost. Conventional loans are also ideal if you have saved up enough money to cover 20% of the home’s sale price for a down payment, so you don’t have to pay mortgage insurance premiums each month. A lower debt-to-income ratio is also a good indicator of your readiness for conventional mortgages.
Conventional lenders have higher qualification standards, so borrowers with higher credit scores and large down payments tend to prefer conventional loans because of the various options offered.
Final Thoughts
When comparing FHA and conventional loans, it is essential to start with some self-analysis. What are your goals for buying a home? What kind of home do you want? How much of a monthly payment can you afford? Consider playing around with a mortgage calculator to understand better how the numbers play out for conforming conventional and FHA loans.
Speaking with an experienced lender is key to gaining valuable insight into your decision. The Arnaiz Mortgage team has years of experience helping prospective buyers find the financing solution that fits their needs. Depending on your financial situation, you may need a loan backed by the Federal Housing Administration or want to shop around for competitive rates with a conventional loan. We can discuss your options to determine the best solution for your home-buying objectives.
Call Arnaiz Mortgage today at 623-806-4645 or fill out the contact form with any questions you may have. Let’s start the conversation today if you are curious about what FHA loans require or how to get more favorable loan terms with conventional mortgages.