FHA vs Conventional Loans – Which Home Loan is Right for You?

Once you begin looking for new home, it can be easy to get overwhelmed by all the different types of home loans, how they work, and what’s right for you. 

We’re here to walk you through the differences between two common types of mortgages and help you figure out which is right for you: FHA or Conventional. 

FHA vs Conventional Loans

Conventional loans and FHA loans both offer homebuyers mortgages to assist them in purchasing a home. But what’s the difference? 

First, let’s answer the questions, “What is an FHA loan?” and “What is a conventional loan?”, and look at why they’re different.

What is an FHA Loan?

FHA loans are insured by the Federal Housing Administration–part of the U.S. Department of Housing and Urban Development–and are designed for low- to moderate-income buyers who may have lower credit scores or savings. Because these loans are insured by a government agency, lenders can offer a better deal.

What is a conventional loan?

On the other hand, conventional loans are obtained from a private lender and are not funded or guaranteed by the federal government. Instead, they are guaranteed by two government-sponsored enterprises nicknamed Fannie Mae and Freddie Mac. 

While all FHA loans conform to restrictions set by the FHA, some–but not all–conventional loans conform to restrictions set by Fannie Mae, Freddie Mac, and the Federal Housing Finance Agency (FHFA). These restrictions include things like approval requirements and loan limits. 

Let’s get into the specifics.

Differences Between FHA and Conventional Loans

Down Payment Requirements

When you buy a home, you’ll have to pay a down payment out-of-pocket. Then, you can take out a loan to cover the remainder. 

The traditional recommendation for a down payment is generally 20%, as it implies less risk to lenders and can offer perks like better rates, and the smaller overall loan you’ll need to take out means lower monthly payments. 

But 20% is no small cost. If you are purchasing a $500,000 home, that’s $100,000 upfront and out-of-pocket.

So, you may be looking to take out a larger loan and pay a smaller down payment to buy the home. However, both FHA and conventional loans have minimum requirements. 

Since there are many types of conventional loans, there isn’t total consistency around a minimum requirement. Generally speaking, conventional loans require a minimum of 5% down. However, first-time homebuyers may be approved at as little as 3%, and depending on the lender or type of loan, there may be a 10% or 15% requirement in place. 

Okay, so how does a 5% down payment compare to 20%? For that same $500,000 home, you would be paying just $25,000 upfront. 

FHA loan down payments are intended to make homeownership more accessible, so they have lower down payment requirements for homebuyers with less savings. You can pay as little as 3.5% of the price of the home with these loans. 

If you purchased that $500,000 home with an FHA loan, and elected for the minimum down payment of 3.5%, you’d be paying just $17,500 upfront. 

Credit Score Requirements

Your credit score is a major factor when applying for loans. This is because it gives lenders a look into how well you have been able to repay your credit in the past, helping them assess how likely you are to pay back the loan. 

A lower credit score indicates potential risk to lenders, which may lead them to decline your application or approve it–with higher interest rates or other factors in place. 

Since FHA loans are insured by the federal government, lenders aren’t quite as concerned about the risk you pose. Minimum credit score requirements for FHA loans tend to range from 500 to 580–considered “Poor” to the low end of “Fair” FICO scores–depending on the size of your down payment.

Conventional loan lenders typically require a minimum credit score of 620, which is considered a “Fair” FICO score.

Mortgage Insurance

Private Mortgage Insurance, or PMI for short, is a way lenders can protect themselves if you don’t repay your loan. 

It’s typically required by conventional mortgage lenders if your down payment or home equity is less than 20%. 

Conventional loan PMI is an additional cost to you, billed with your monthly mortgage at a rate of roughly 0.58% to 1.86% of the loan amount. Once you reach 20% equity, you can request to remove it. When you reach 22% equity, it will be removed automatically.

The upside of PMI requirements is that you may be able to get approved for a loan you wouldn’t otherwise. For example, if your credit is hovering just around the minimum 620 and your down payment is just around 5%, PMI may give the lenders enough assurance to approve you for a conventional loan for the $500,000 house. 

If you compare a conventional loan for the $500,000 house with a 20% down payment versus a 10% down payment with 1% PMI until reaching 20% equity, you can really begin to see the difference. 

In the mortgage with the 10% down payment, you’d need to pay $417 in PMI each month for 100 months. That’s $41,667 in PMI alone over the course of your loan! 

This would then bring your monthly payments–not including property taxes or other fees–to $3,420. 

In the 20% down payment option, you don’t need to pay PMI, meaning monthly payments would be around $2,670.

With a $50,000 smaller loan to pay off thanks to your down payment, you would save $111,784 on PMI and interest by making a 20% down payment.

Since FHA loans are insured by the federal government, they do not require private mortgage insurance. However, FHA loans do require a Mortgage Insurance Premium (MIP) that includes an upfront (UFMIP) and annual fee. 

UFMIP is 1.75% of the total loan amount. MIP is 0.15% to 0.75% of the loan annually, depending on your down payment and loan term. 

With FHA loans, your mortgage insurance premium is not avoidable or based on equity. However, if you make a 10% down payment, you can stop paying MIP after 11 years. You can also refinance your loan to a conventional loan to drop the premium.

Let’s compare an FHA loan for the $500,000 house with a 3.5% down payment versus a 10% down payment with an 11-year MIP duration.

For the mortgage with the 3.5% down payment, you’ll end up spending $8,750 on upfront MIP, plus a cumulative total of $79,613 on 0.55% annual MIP. 

For the mortgage with the 10% down payment, you’d spend the same $8,750 upfront MIP, but only $27,225 on annual MIP over the term of the loan.

That means that with a down payment high enough to qualify for a 11-year MIP duration, you could save around $52,387 on annual MIP. As an added bonus, you’d also save more than $45,000 in interest thanks to a larger down payment and smaller loan. 

Here’s a side-by-side breakdown comparing each of these four scenarios, all of which are based on a $500,000 property with a 30-year loan term and 7.03% interest rate. Fees like property tax and home insurance are not included:

Loan Limits

Remember when we said the FHA sets regulations and restrictions that all FHA loans and some–but not all–conventional loans follow the regulations of Fannie Mae, Freddie Mac, and the FHFA? Here’s an area where that becomes very evident. 

Each year, the FHA and Federal Housing Financing Authority (FHFA) set their respective ceilings for loans–a limit to how much lenders can give you. 

The FHFA uses a formula to calculate how much they should increase or decrease the limit based on the average price of homes on the House Price Index.

In 2023, the vast majority of the country has a loan limit capped at $726,200. 

However, some counties, regions, or states, including Alaska, Hawaii, the metropolitan areas of New York City, Boston, Washington D.C., Nashville, Denver, Seattle, Los Angeles, and San Francisco, are considered high-cost areas and have a loan limit ranging up to $1,089,300. 

You can view the Federal Housing Finance Authority’s map to see the loan limit in your county. 

But, there is a type of conventional loan called a “jumbo loan” that does not follow these limits. As its name implies, jumbo loans are a way for homebuyers to take out more than the FHFA’s cap. Jumbo loans can range from $726,201 to several million dollars.

The FHA sets its loan limits based on average home price geographically, also including low-cost areas and high-cost areas. These are also influenced by the FHFA’s limits, with low-cost area limits not able to be less than 65% and high-cost area limits not able to be more than 150% of the FHFA national conforming limit value.

In 2023, FHA loan limits can be as low as $472,030 in low-cost areas, and as high as $1,089,300 in high-cost areas.

Specific limits are set for each county, and the FHA offers limits for multi-unit properties as well. You can search for your county’s FHA loan limit, view a list of counties with limits between the FHA’s minimum and maximum, or view a list of counties at the FHA loan limit ceiling on the HUD website.

To put it simply, both FHA and conventional loans have limits influenced by average home prices and geography. However, if you take out an FHA loan, you may find that their limits are more granular to the specific location of the home you are interested in buying, while conventional loans have one limit that covers the vast majority of the country. If you’re looking to take out a mortgage for a multi-million dollar home, an FHA loan probably isn’t a viable option for you. Instead, you’ll have to go to a conventional loan lender for a jumbo loan. 

Property Standards

If you choose to take out an FHA loan, you’ll have to purchase a home that meets the FHA’s minimum property standards. 

The FHA has these standards in place to protect homebuyers from unsafe living situations and protect lenders by ensuring the property has enough value to be used as collateral against the loan.

FHA loan borrowers must have an appraiser assess the property and report back to the FHA whether it meets their three minimum standards: 

• Safety: The home should protect the health and safety of the occupants.
• Security: The home should protect the security of the property.
• Soundness: The property should not have physical deficiencies or conditions affecting its structural integrity.

These requirements mean if the home you are purchasing has any problems like exposed wires, leaky roofs, broken water heaters, excessive noise nuisances, unsafe or inadequate access, structural defects, asbestos, or doesn’t have a toilet, sink, or shower, these issues will need to be fixed by the seller before the sale can close. 

While cosmetic issues, minor defects, and normal wear that don’t affect the safety, security, and soundness aren’t required to be repaired before closing, this does mean FHA loans probably aren’t the best choice for house flippers or buyers looking for a true fixer-upper. 

Conventional loans, however, are borrowed through private lenders and do not have any minimum property requirements.

This means if you borrow a conventional loan and during inspection learn the home you are purchasing has a structural issue, you can negotiate these repairs with the seller, but your ability to close on the home whether the repairs are made or not is not limited by the terms of your mortgage. 

So, let’s say your offer on the $500,000 home is accepted by the seller. You conduct a home inspection and learn that there are some cracks in the foundation and the water heater needs to be replaced. You request the seller make these repairs as a contingency in the contract. The seller agrees to fix the foundation but refuses to replace the water heater. 

If you are purchasing the home with an FHA loan, the terms of your mortgage would prevent you from closing on the home until the water heater is replaced. If the seller continues to refuse the request, it’s likely you’d have to withdraw your offer and find a new home. 

If you have a conventional loan, the terms of your mortgage would not have any say in whether you close on the home without the new water heater. You could accept the seller’s counteroffer, close on the home, and replace the water heater yourself prior to moving in. 

Pros and Cons of FHA Loans

FHA loans can make mortgages possible for homebuyers with lower savings and credit scores, but have more restrictions and require annual premiums.

Pros of FHA Loans	Cons of FHA Loans
Lower Down Payment Requirements	Mortgage Insurance Premiums
More forgiving Credit Requirements	Limited Loan Amounts
Lower Interest Rates	Stricter Property Requirements

Advantages & Pros of FHA Loans

FHA loan requirements are generally less strict and more widely accessible than conventional loan requirements. They allow homebuyers with less cash available for down payments and lower credit to be approved for mortgages. 

Lower down payment requirements

FHA loans offer homebuyers the ability to purchase a home with a down payment as low as 3.5%. Compared to conventional loan’s common 5% minimum down payment, this can save you thousands of dollars in upfront costs. 

While homebuyers with lower credit scores may be required to put 10% down in order to qualify, FHA loans are still generally easier to qualify for and can make homeownership accessible to people with less established finances.

More forgiving credit requirements

FHA loans require a minimum credit score of 580, which is significantly lower than conventional loans.

Buyers with a credit score between 500 and 579 may still qualify if they are able to pay a larger down payment. 

The higher your credit score, the better your interest rate offer.

Lower interest rates

FHA loan interest rates are often lower than conventional loans. Since they are insured by the federal government, the chance of you defaulting on your loan poses less risk to lenders. So, it’s typically easier to get a better interest rate. 

However, the rate you are offered ultimately depends on a combination of factors, including the size of your down payment, your financials, and the market. 

Disadvantages & Cons of FHA Loans

While smaller down payments and less strict personal finance requirements make FHA loans attractive, additional restrictions and costly premiums may be a bit of a catch.

Mortgage insurance premiums

FHA loans allow you to avoid private mortgage insurance required until you reach 20% equity on conventional loans. However, FHA loans do require a Mortgage Insurance Premium (MIP). These premiums exist primarily for the same reasons as PMI: risk mitigation for lenders. If you default on your loan–that is, you don’t repay it–the impact on the lenders won’t be as bad, as they have been collecting this insurance premium. 

This premium is made up of an upfront fee and an annual fee, which you can only stop paying by refinancing to a conventional loan or by paying for 11 years if your down payment was at least 10%.

The upfront premium (UFMIP) is 1.75% of the amount of your loan. The annual premium will be somewhere between 0.15% and 0.75% of the loan, depending on your down payment and loan term. 

Let’s say you purchased the $500,000 home with an FHA loan, opting to put down the minimum 3.5% down payment. This would mean you are taking out a loan totaling $482,500.

To take out the loan, you will need to pay the 1.75% UFMIP, which would equal $8,443.75. 

Then, you will need to pay the annual MIP, anywhere between 0.15% and 0.75%, which would equal $723.75 to $3,618.75. Annual MIP is generally split up and paid monthly, along with your mortgage payment, meaning this cost would break down to add an additional $60.32 to $301.57 to your monthly bill.

Limited loan amounts

The FHA sets floors and ceilings for their loan limits based on the average price of homes on a county-by-county basis. They also use the FHFA’s national conforming loan limit to ensure none of their limits are less than 65% of the national conforming limit. 

This means that FHA loan limits may vary if you are searching for a new home in multiple counties. Depending on the county your new home is in, the FHA limit may also be significantly lower than a conventional loan’s would be. 

In 2023, the FHA high-cost area mortgage limit is no higher than the FHFA’s.

Property requirements

FHA loans come with stipulations for homes the loan can and cannot be used on. The stipulations require the home’s condition to meet a specific set of requirements that render it safe, secure, and sound prior to closing. 

While these requirements were put in place to protect buyers from unsafe living conditions, with inspections bringing up surprising issues, sellers being reluctant to make repairs, and the presence of more red tape, it’s possible for these requirements to hold up or prevent a purchase.

These restrictions can also limit buyers looking for a fixer-upper or flip, as issues from a leaky roof to a sinking foundation to a one-bathroom house not having a toilet installed could cause it to not meet the FHA’s property requirements. 

Pros and Cons of Conventional Loans

Conventional loans offer flexibility but can be harder to qualify for with their stricter personal finance requirements.

Pros of Conventional Loans	Cons of Conventional Loans
No mortgage insurance required with a 20% down payment	Higher credit score requirements
Opportunity for jumbo loans	Higher down payment requirements
More flexibility in property standards	Higher interest rates

Advantages & Pros of Conventional Loans

Conventional loans come in many forms, meaning there’s probably a set of loan terms that fits your situation.

No mortgage insurance required with a 20% down payment

While conventional loans require you to pay for private mortgage insurance at a rate of 0.58% to 1.86% of your loan per month, it’s only required until you reach 20% equity in your home. 

This means that if your down payment is at least 20%, you already have the equity you need to avoid PMI altogether, potentially saving tens of thousands of dollars. 

Opportunity for jumbo loans

Conventional loans come in many forms and terms that can be tailored to your needs. For example, you can opt for fixed interest rates or pursue adjustable interest rates. 

One useful type of conventional loan is the jumbo loan, which allows you to take out a mortgage above the maximum baseline loan amount set by the FHA and guaranteed by Fannie Mae and Freddie Mac. In 2023, these limits range from $726,200 to $1,089,300 depending on the location of the home you are purchasing. 

While jumbo loans may lead mortgage lenders to increase their credit score, debt-to-income ratio, down payment, and cash reserve requirements, they give homebuyers the opportunity to borrow several million dollars–significantly more than a conforming loan.

More flexibility in property standards

Conventional loans aren’t contingent on any standards of the property, meaning you can use them for whatever home you want, despite any structural issues.

This makes conventional loans more appropriate than FHA loans for fixer-uppers, flipping properties, or properties where you will remove the existing structure.

Of course, it’s still advisable to have the home you’re purchasing inspected and make repair requests to the sellers to ensure the building is safe and livable. 

Disadvantages & Cons of Conventional Loans

While conventional loans have many benefits and are often a great option, their relatively strict financial requirements may make them restrictive to homebuyers. 

Higher credit score requirements

Most lenders require a minimum credit score of 620, which is considered a “Fair” FICO score. Conforming loans with smaller down payments and jumbo loans may require a “Very Good” credit score of at least 740. This is compared to FHA loan requirements, which tend to range from 500 to 580–considered “Poor” to the low end of “Fair” FICO scores–depending on the size of your down payment.

Higher down payment requirements

Most conventional loans require you to make a down payment of at least 5%. To get a good deal on your interest rates, you’ll probably have to put at least 10-15% down. For bigger savings on interest and to avoid paying for PMI, you’ll have to put down 20%. 

Higher interest rates

Generally speaking, conventional loans tend to have higher interest rates than FHA loans, because they are not backed by the government and therefore have more risk to lenders. 

However, several factors will ultimately determine your interest rate, including your personal finances, loan term, and market conditions. 

Which Loan is Right for You?

As you can see, there are tons of similarities, differences, and nuances between conventional and FHA loans. But which should you choose when buying a new home? 

Factors to Consider

Credit Score

If your credit score is below 620, then FHA loans are probably the right option for you. Above 670, then a conventional loan might be the right fit. For anything in between, you’ll probably want to weigh other factors before deciding.

Down Payment

No matter how you slice it, buying a home is an investment, and there are many factors you’ll need to consider when trying to make the right financing and budgeting decisions. For example, do you expect to live in the home for decades, or only for a couple of years? Do you plan to put a lot of money into the property right away for renovations and furnishing? What cash reserves do you have available now? How much will you have later? 

If you don’t have a ton of savings you can allocate to your home, want to put a lot of money into renovations, or plan to live there for less than a decade, you may determine it’s the right choice for you to make as small a down payment as possible. For FHA loans, that’s just 3.5%, making them a great option for this situation. 

Conventional loans aren’t totally out of the question here–minimums are usually just slightly higher at 5%. However, you’ll typically need to put more down, at least 10-15%, to get the best deal. 

For a house that you expect to be a long-term investment or a forever home, it may be worth making a 20% down payment. In that case, conventional loans are ideal, as you’ll avoid pricey mortgage insurance.

Loan Amount

Loan limits will also help you make a decision. FHA loans have limits based on the average price of homes in your county, while conventional loans generally follow one national limit based on a Home Price Index. Conventional loans also offer the option of a jumbo loan, for homes above that national limit. 

This means that with an FHA loan, you may be restricted to a lower price range than you would be if you chose to get a conventional loan.

Property Type

If you want a fixer-upper, a conventional loan is the clear choice for you. 

The FHA requires that homes purchased with their loans meet a specific set of guidelines to ensure safety, security, and soundness. This can make closing on a home more difficult, as it’s possible for repair requests to draw out negotiations or lead to a sale falling through.

Conventional loans do not have any of these requirements.

Conclusion

When deciding between an FHA loan and a conventional loan, you’ll have to evaluate your personal finances, intentions for your home, and long-term situation. 

FHA loans are a great option for those with lower credit scores or savings, including people who are still working to establish themselves financially. However, mortgage insurance premiums may make monthly payments more expensive in the long run, and property requirements may make closing on a home more difficult. 

Conventional loans have the flexibility to tailor the terms of your loan to your personal situation, but stricter personal finance requirements may make them more difficult to qualify for and larger down payment requirements could require more out-of-pocket cash than you’re able to pay.

For information on mortgages offered by K. Hovnanian, visit khovmortgage.com.

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Last Updated on December 10, 2024