FHA and Conventional Loans: What You Need to Know
FHA and conventional loans are two of the most popular financing options for would-be homebuyers. However, there are significant enough differences between the two that one is often a noticeably superior option for an individual’s circumstances.
Here’s what you should understand about the FHA vs. conventional loan programs to determine which one makes the most sense for you, including their qualification requirements, potential costs, and financing limitations.
FHA vs. Conventional Loans
Mortgages come in many different variations, and while none of them are necessarily better than the other, some are always going to be a better fit for your situation than others.
Generally, choosing one means figuring out which ones you can qualify for and which of those will cost you the least amount of money over the life of the loan. To that end, these are the relevant details for FHA and conventional loans.
Credit Score Requirements
One of the primary advantages of FHA loans is that they have lower credit score requirements than conventional loans. You can qualify for an FHA loan with a score as low as 500, though it’ll be easier if your score is at least 580.
In contrast, most mortgage lenders demand a credit score of at least 620 before they’ll give you a conventional loan. They’re more willing to take risks with FHA loans because the Federal Housing Administration insures part of their balances.
For context, FICO scores range from 300 to 850, and the average credit score in the United States is 716 in 2021. A 500 credit score is very attainable for most prospective homeowners.
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Minimum Down Payment Requirements
Consumers consistently report that saving up for a down payment is the most significant obstacle preventing them from homeownership. In this arena, conventional loans have an advantage over FHA loans.
To get conventional financing, you need to put down at least 3% of the home value, which means you can have a maximum loan-to-value (LTV) ratio of 97%. For example, you can buy a $300,000 house by putting down $9,000 and borrowing $291,000.
Meanwhile, FHA loans have a 3.5% minimum down payment requirement. On a $300,000 house, that would mean saving up an extra $1,500. However, you can only get away with putting down 3.5% if your credit score is at least 580.
If your score falls between 500 and 580, you’ll have to put down at least 10% to qualify. That would mean saving an extra $21,000 for that $300,000 property. Because of this, it’s often worth waiting to become a home buyer until you build a higher credit score.
If you don’t have the money for a deposit, you may still be able to get a mortgage loan, even if you also have bad credit. Find out How to Buy a House with No Money Down and Bad Credit.
Debt-to-Income Ratio Requirements
Your debt-to-income (DTI) ratio equals your total monthly debt payments divided by your gross monthly income. For example, say you have a $600 auto loan and a $400 student loan payment. If you make $4,000 per month, your DTI ratio is 25%. ((600+400)/4000)
Mortgage lenders will consider your DTI ratio before and after accounting for your prospective mortgage payment, but the latter is their priority. It’s commonly referred to as your back-end DTI ratio.
Generally, FHA lenders are less strict about this number than conventional lenders. You can get an FHA home loan with a back-end DTI ratio as high as 50%, while you’ll usually need to have one no greater than 43% to get a conventional loan.
Your DTI ratio is another way for lenders to assess the likelihood that you’ll be capable of paying them back. The lower the ratio, the more room you have in your paycheck to afford a mortgage payment and the safer it is for them to lend to you.
To maximize your chances of qualifying for the highest loan amounts and the lowest interest rates, try to keep your back-end DTI ratio below 36%.
Mortgage insurance is an additional expense that you pay for all FHA loans and some conventional loans, depending on your down payment. It’s supposed to protect your lender if you ever default on your home loan.
Conventional loans have a clear advantage in this area. If you put down at least 20%, you can avoid the mortgage insurance, known as private mortgage insurance (PMI), altogether.
Even if you put down less than 20%, you can request that your mortgage lender cancel it once you reach 20% equity through principal paydown or property appreciation. If not, your lender should automatically cancel it when you hit 22% equity anyway.
Conversely, there’s no way to avoid FHA mortgage insurance. No matter how much you put down, you’ll have to pay a mortgage insurance premium (MIP). If you put down at least 10%, it’ll expire after 11 years. Otherwise, it’ll last the life of the loan.
In addition, MIP is more expensive than PMI. MIP costs 1.75% of the loan amount upfront and up to 1.05% annually, while PMI costs nothing upfront and averages between .56% to 1.86% annually, depending on your credit score.
FHA and conventional loans also differ in their maximum loan limits. There’s no clear winner in this category since your borrowing power with each program depends on where you live.
For one-unit, single-family homes in 2022, the maximum FHA loan limits range from $420,680 in the lowest-cost areas to $970,800 in the highest-cost ones. The FHA sets these limits using the local median home value and cost of living.
You can use FHA financing to buy properties with up to four units, and the maximum limit increases the more you add. Look up the FHA loan limit for your location using the Department of Housing and Urban Development’s online database.
Conventional loans also have a maximum loan limit that varies by location. For most counties, it’s $647,200 in 2022, up from $548,250 in 2021.
Anything above that is a jumbo loan, not a conforming loan, and Fannie Mae and Freddie Mac only buy conforming loans.
If your property value exceeds the limit for one program or the other, you probably won’t be able to use them to finance your transaction. It’s usually best to look up the limits in your area first and use them to shop for a house instead of the reverse.
The last significant difference between conventional and FHA purchase loans is that you can’t use FHA financing for as many types of properties.
In fact, you can generally only use FHA loans to buy your primary residence. That means you must live in the property you purchase with an FHA loan for most of the first year of the mortgage.
In other words, you should reside in the property for at least 186 of the first 365 days of your FHA loan. Failing to do so means committing occupancy fraud, a felony punishable by fines and potentially, even jail time.
Conventional loans, on the other hand, are much more flexible. In addition to primary residences, you can use them to finance properties that you want to use for vacation or investment purposes.
That said, even lenders that offer conventional loans often prefer to work with people who plan to live in the property rather than investors.
As a result, they may still include an owner-occupancy clause in their loan agreement, so make sure you disclose what you want to use the property for when you apply.
When Does a Conventional Loan Make Sense?
Now that we’ve covered the differences between the FHA and conventional loan programs, let’s discuss when you should choose one or the other. Fortunately, it’s usually not a difficult decision.
In short, if you have the chance to choose between the two, it makes the most sense to go with a conventional home loan. They have lower down payment requirements and mortgage insurance costs.
In other words, they’re generally cheaper than FHA loans, though their interest rates won’t necessarily be lower.
In addition, conventional loans are your only option if you’re looking to finance something other than your primary residence.
If you’re shopping for a vacation or investment property, you won’t be able to use an FHA loan unless you’re willing to live there for the majority of the first year.
To qualify for a conventional loan, you’ll need to have a credit score of at least 620 and a back-end DTI ratio below 43%. If you meet those requirements, a conventional loan is probably a better mortgage option for you than an FHA loan.
When Does an FHA Loan Make Sense?
While conventional loans generally have more attractive terms, FHA loans are significantly easier to obtain. That means an FHA loan makes the most sense whenever you’d have trouble qualifying for a conventional loan.
More specifically, if your credit score is below 620 or your back-end DTI ratio is more than 43%, and you don’t have the time or ability to do anything about it, then an FHA loan makes more sense than a conventional mortgage.
You can qualify for FHA financing with a credit score as low as 500 and a DTI ratio as high as 50%, as long as you’re able to save up for a 10% down payment.
Even if you can’t afford to put 10% down, an FHA loan is generally more attainable than a conventional loan. If you can get your credit score to at least 580, you only need to put down 3.5% to get an FHA loan.
Remember that you can only use an FHA mortgage to finance primary residences up to a certain value. They’re also only viable for single-family properties, which excludes any property with more than four units.
Why Would You Choose FHA Over Conventional?
Typically, the only reason you’d choose an FHA loan over a conventional loan is if you have no choice. Conventional loans usually cost you less over the loan term, but they have higher qualification requirements.
For example, lenders usually want you to have a credit score of at least 620 before giving you a conventional loan. Meanwhile, you can get an FHA loan with a credit score as low as 500, as long as you’re willing and able to put down 10%.
FHA loans are more accessible because the FHA insures part of their principal balances, which makes them less risky to the lender.
What Is the Downside of an FHA Loan?
The downside of an FHA loan is that they generally cost more than any other home loan type, including conventional loans. While their interest rates aren’t necessarily different, there’s no way to avoid their mortgage insurance.
Meanwhile, you can avoid paying for mortgage insurance on conventional loans, as long as you put down 20%. Even if you don’t, their private mortgage insurance is relatively cheap.
FHA loan mortgage insurance premium costs 1.75% upfront and up to 1.05% annually for at least 11 years, and potentially even the life of the loan.
Meanwhile, there are no upfront mortgage insurance premium costs for conventional loans, and their annual private mortgage insurance rates average .58% to 1.86%.
If you can qualify for a VA loan, you could put down 0% and pay nothing in mortgage insurance.
In addition, FHA loans require higher down payments than other home loans. You may have to put down as much as 10% to get an FHA loan, while conventional loans never demand more than 3% down.
Are FHA Loans More Expensive Than Conventional?
Your actual loan costs depend significantly on your circumstances and which lenders are willing to work with you. That said, FHA loans are generally more expensive than conventional loans.
First, FHA loans require that you provide a higher down payment. You have to put down at least 3.5%, and you may need to put down as much as 10% if your credit score isn’t high enough. Conversely, conventional loans never require more than 3% down.
In addition, FHA mortgage insurance premiums are significantly higher. Every FHA borrower pays 1.75% upfront and can face up to 1.05% in annual costs, while a conventional borrower pays nothing upfront and may pay as little as .58% per year.
However, there’s ultimately no way to know which will offer you the lower interest rate or total monthly payment.
For example, the loan officer at the local credit union might be willing to give you a deal on an FHA loan that’s more affordable than a conventional mortgage elsewhere.
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