Differences between FHA and conventional loans

Household 3 min read

If you’ve decided to buy a home or refinance your existing mortgage, one of the first things to consider is what type of mortgage loan is best.

Conventional mortgage loans and Federal Housing Administration (FHA) loans are two of the most common options for first-time buyers, repeat buyers, and current homeowners looking to refinance their existing mortgage.

What’s the difference between these popular loans? Which one is right for you?

FHA background

When the FHA was created in 1934, the housing industry was flat on its back with the U.S. still struggling from the Great Depression.

Two million construction workers had lost their jobs. Homebuyers seeking mortgages found it difficult to qualify for loans. Mortgage loan terms were limited to 50% of the property’s market value, with a repayment schedule spread over three to five years and ending with a balloon payment.

America was primarily a nation of renters. In fact, only four in 10 households were homeowners.

Meanwhile, the government wanted to increase homeownership rates nationwide. With more homeowners, the government reasoned, neighborhoods would stabilize, and the U.S. economy would get back on track.

From this, the FHA and its flagship mortgage program were born, offering a mortgage loan backed by the U.S. Department of Housing and Urban Development.

Since its inception, FHA has grown to be the largest mortgage insurer in the world, covering over 47 million properties.

FHA vs. conventional loans

Once viewed as primarily for first-time homebuyers, FHA loans have become a popular go-to option for many repeat homeowners and refinancers alike. Due to relaxed underwriting guidelines and low down payment requirements, roughly 40% of homebuyers end up with an FHA loan.

In some instances, however, conventional mortgage loans offer greater benefits. This is especially true for those with higher credit scores and the means to put down a large down payment.

Here are some clear comparisons of various qualification and loan aspects for would-be homebuyers and homeowners planning a refinance:

 

Item Conventional loan FHA loan
Down payment As low as 3%, advantages for larger down payment As low as 3.5%
Credit score 620 minimum 500 minimum
Mortgage rates Higher than FHA Lower than conventional
Occupancy Can be non-owner-occupied Must be owner-occupied
Loan amount Can be as high as $483,350 Determined by county
Debt ratio Generally capped at 45% Generally capped at 56%
Assumability Not assumable Assumable
Mortgage insurance Not required with 20% equity Required, regardless of equity position
Refinancing Credit check, income verification, and appraisal required Streamlined refinancing (no appraisal, credit check, or income verification required)

Typically, there are three factors that determine whether you’re better off with one loan type or the other.

1. Credit scores

In general, due to lower credit requirements, mortgage applicants with lower credit scores are likely to end up with an FHA loan. While the FHA has a low minimum credit score requirement, most FHA lenders want to see a score of at least 580.

For conventional loans, most lenders want a minimum credit score of 620. Some may require higher scores.

An important note here: Regardless of the loan type, many banks and lenders have “overlays” that ultimately decide how high your credit scores needs to be in order to get approved. Be sure to ask your lender about their specific requirements.

2. Debt ratios

Another common reason your lender may recommend an FHA loan is related to your other existing debt. This is because FHA allows for higher debt-to-income (DTI) ratios. Your DTI is used to quickly determine the amount of income dedicated to debt repayment.

Many lenders allow you to go up to a 50% DTI ratio with an FHA loan. Others may allow you to go as high as 56%.

Conventional loans have stricter limitations here. Some lenders may cap your DTI at 43% (total debts, including the new housing payment, divided by your monthly income). However, many lenders allow for ratios of 45% to 50% for conventional loans.

3. Down payment

When buying a home using a conventional loan, if you put 20% down or have least 20% in equity for those refinancing, no mortgage insurance is required. Alternatively, FHA loans always require mortgage insurance, regardless of the down payment.

If you adamantly oppose paying for mortgage insurance and/or have the means to put down 20%, a conventional loan is likely to cost less than an FHA loan.

Choosing the best type of loan

Both FHA and conventional mortgages have their advantages and disadvantages.

If you’re a potential homebuyer or an existing homeowner with credit challenges, low income, or not a whole saved up for a down payment, you may have a tough time qualifying for a conventional loan. Fortunately, an FHA loan could be a great solution.

The FHA loan’s combination of low rates, low down payments, and flexible lending guidelines make it one of the most common loan choices for home buyers today.

Research today’s mortgage rates and terms to determine your options and the best fit for you.

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