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The Difference Between a Conventional and FHA Loan

Financing a home is a big decision, almost as big as finding the perfect home. You take on a loan for 15 to 30 years when you borrow a mortgage. Therefore, you should look for a loan with the most attractive terms to save the most money.

The two most common options are conventional and FHA loans. Both offer competitive terms but have different qualifying factors. Here’s what you should know.

What is a Conventional Loan?

A government entity doesn’t guarantee conventional loans. Therefore, they have stricter qualifying guidelines to ensure you can afford the loan. Typically, private lenders fund conventional loans, and Fannie Mae or Freddie Mac purchase them.

What is an FHA Loan?

FHA loans involve the FHA (Federal Housing Administration), which guarantees or backs the loan. Therefore, only FHA-approved lenders can offer them, and they typically have less strict qualifying factors to make qualifying easier.

FHA loans have the reputation of being a first-time homebuyer’s loan, but that’s not the case any longer. They have more flexible guidelines, so they are favorable for first-time buyers, but anyone who needs the more relaxed guidelines can apply for the loan.

Comparing Conventional vs. FHA Loans

So how do the qualifying factors differ for conventional vs. FHA loans? You might find that you qualify for both a conventional and FHA loan. Compare the rates, terms, and overall loan cost to make the best choice for you.

Here are the major differences.

Credit Scores

FHA loans are more lenient about credit scores. You can qualify for a loan with a credit score as low as 580 with an FHA loan. In some cases, you may also be eligible with a credit score of 500 – 579 but with a larger down payment and other stricter qualifying requirements.

However, most lenders prefer at least a 580. If your credit score is less than 580, you may have to shop around a little harder to find a loan.

Conventional lenders prefer at least a 620 credit score. However, most require a higher credit score, especially if you want the most competitive rates. Conventional lenders also look closer at your credit history, looking for any negative events that could affect your ability to repay the loan.

Debt-to-Income Ratios

Your debt-to-income ratio, or DTI, measures your monthly obligations to your gross income (income before taxes). The more debt obligations you have, the less money is available for the new mortgage payment.

When lenders calculate your DTI, they include minimum credit card payments and other debts, such as student, car, or personal loans. Finally, they include the new mortgage payment to ensure your DTI doesn’t exceed the limits.

Conventional lenders prefer a maximum 36% debt-to-income ratio and FHA lenders allow up to a 43% DTI.

Down Payment Requirements

The down payment often makes it hard to buy a home. Many believe you need 20%, or you can’t get a mortgage, but this isn’t the case. Conventional and FHA loans offer lower down payment options.

Of course, the more money you put down on the home, the lower your monthly payment, and you may also get better rates and terms.

Conventional loans require a 5% down payment unless you’re a first-time homebuyer. If you are, you can put down just 3%. However, to avoid Private Mortgage Insurance, you must put down at least 20% on the home. That’s $20,000 for every $100,000 mortgage loan.

FHA loans require a 3.5% down payment as long as you have a 580+ credit score. If you have a score between 500 – 579 and find a willing lender, you’ll need 10 percent down.

Property Type

Conventional and FHA loans are available on most property types, but there’s one exception. You can only get conventional financing if you’re buying a home for any purpose other than your primary residence.

FHA loans are only for the home you live in full-time, and you can only have one primary residence.

Loan Limits

Conventional and FHA loans both limit how much you can borrow. If you need more money than the current conventional or FHA loan limits, you’ll need a jumbo loan from a private lender.

In 2022, conventional loan limits are $647,200. This limit changes annually when the Federal Housing Finance Agency meets annually.

FHA loans have two limits – a limit in low-cost areas, which is $420,680 in 2022, and a high-cost area limit, which is $970,800 in select markets.

Mortgage Insurance

Mortgage insurance protects lenders if a borrower stops making payments and they must foreclose on the property.

Conventional and FHA loans have a type of mortgage insurance, but they work differently.

Conventional loan borrowers only pay Private Mortgage Insurance if they put down less than 20% on the home. However, you can cancel the PMI when you pay the mortgage down to 80% of the home’s original value. Some lenders also allow you to pay for a new appraisal if your home value increases faster and you owe less than 80% of the value.

The PMI rates you’ll pay depend on the amount of the down payment and your credit score.

FHA borrowers pay mortgage insurance for the entire loan term. Everyone pays the same amount, 1.75% of the loan at the closing and 0.85% of the outstanding balance annually. The annual payments are spread out in your 12 monthly payments and added to your mortgage payment.

The only way to remove FHA mortgage insurance is to refinance the loan into a conventional loan with at least 20% equity.

Final Thoughts

Conventional and FHA loans offer an affordable way to buy a home. Both loans have flexible guidelines, including low down payment requirements.

The key is finding the loan whose payment you can afford, with the lowest overall cost. If you’re buying anything but a primary residence, your only option is a conventional loan. However, if you’re buying a home to live in, an FHA loan is an option too.

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