FHA vs. Conventional Loans: Requirements, Pros, and Cons
August 15th, 2023
One of the choices many homebuyers need to make is between FHA vs. conventional loans. The type of loan you get can determine your financial stability for the foreseeable future, so this is not a decision that should be made lightly.
In this article, we will explain what FHA and conventional loans are, what requirements they have, and how they are different from each other, in full detail. By the end of the article, we hope you will be able to make an informed decision about the type of loan that is best for you.
Definition of FHA and Conventional Loans
An FHA loan is a government-backed mortgage insured by the Federal Housing Administration (FHA), a government agency. Because the federal government subsidizes the loan, the lender is more protected in case a borrower defaults on payments. This allows FHA loans to have more lenient requirements compared to conventional loans.
FHA loans are only issued by FHA-approved lenders and this type of loan was first introduced in 1934, so it has quite a long lifespan. It is designed to help first-time homebuyers and those with lower credit scores or limited down payment funds.
However, FHA loans always come with upfront and monthly mortgage insurance premiums, regardless of the borrower's credit score or the down payment they make. Again, this is to protect the lender in case the borrower defaults.
On the other hand, a conventional loan is a mortgage not insured by any government agency but instead backed by private lenders like banks or credit unions. These loans typically have stricter qualification requirements, including higher credit scores and income ratio standards.
Conventional loans generally also demand a higher down payment, often around 20%, and may require private mortgage insurance (PMI) if the down payment is less than 20%. Private mortgage insurance is not a requirement in all instances, unlike with FHA loans.
So let's take a closer look at all of the differences.
Loan Limits
One of the first FHA vs. conventional loan distinctions are the loan limits, i.e., the amount of money you can borrow to buy a property. So let's delve into it.
Conventional Loan Limits
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are two government-sponsored enterprises that set the loan limits for conventional mortgages. These entities buy mortgages from lenders, providing liquidity to the mortgage market.
The loan limits depend on the specific county where the property is located. In some areas, the limits may be lower due to lower housing costs, while in higher-cost areas, the limits may be higher. These limits are periodically reviewed and updated to align with housing market trends.
Since 2008, conventional loan limits have been calculated based on the rules set out in the Housing and Economic Recovery Act (HERA). You can find how conventional loan limits are calculated under HERA in 2023 here.
Additionally, you can get a jumbo loan under specific conditions, but that is not the focus of this article as jumbo loans are not considered conventional mortgages.
FHA Loan Limits
FHA loan limits are set each year, in part based on the loan limits set by Fannie Mae and Freddie Mac for conventional loans. Additionally, the loan limits are determined by the area you live in (e.g., lower-cost areas will have lower limits and higher-cost ones higher limits) and the type of property you intend to buy.
Here are the minimum and maximum loan limits for different types of properties as of 2023:
| Type of Property | Single unit | Two units | Three units | Four units |
|---|---|---|---|---|
| Loan limit floor (low-cost areas) | $472,030 | $604,400 | $730,525 | $907,900 |
| Loan limit ceiling (high-cost areas) | $1,089,300 | $1,394,775 | $1,685,850 | $2,095,200 |
Credit Score Requirements
Another difference between FHA loans and conventional loans is the credit score you need in order to qualify for a mortgage loan. Here's the breakdown.
Minimum Credit Score for an FHA Loan
If you're considering an FHA loan, one advantage is that the credit score requirements are often more lenient compared to conventional loans. The Federal Housing Administration understands that not everyone has a perfect credit history. That's why they're willing to work with borrowers who have lower credit scores.
To qualify for an FHA loan, the minimum credit score requirement is typically around 580. Some lenders are willing to offer FHA mortgage loans to borrowers with scores as low as 500. However, having a credit score below 580 means that you will need to make a larger downpayment and you would likely get less favorable loan terms.
Additionally, it's important to note that some lenders may have their own requirements and may require a slightly higher score. So be sure to check with different lenders to find out their specific credit score requirements.
Remember, your credit score is not the only factor lenders consider when approving a loan. They also look at other factors such as your income, employment history, and debt-to-income ratio. But having a higher credit score can certainly increase your chances of securing a favorable loan.
Minimum Credit Score for a Conventional Loan
Unlike FHA loans, conventional lenders have stricter criteria when it comes to credit scores. Usually, a minimum credit score of 620 is required to qualify for a conventional loan. Again, keep in mind that lenders vary in their requirements, so it's wise to check with different lenders to find out their specific criteria.
Having a higher credit score will increase your chances of approval and open doors to better interest rates and loan terms. It's essential to work on improving your credit score if it currently falls below the minimum requirement. Paying bills on time, reducing credit card balances, and minimizing new credit inquiries can positively impact your creditworthiness.
Debt-To-Income Ratio Requirements
The debt-to-income ratio is a crucial factor that lenders consider when evaluating your loan application. It is a calculation that compares your monthly debt payments to your monthly income. This ratio helps lenders assess your ability to manage your monthly mortgage payment along with your other financial obligations.
To calculate your debt-to-income ratio, add up all your monthly debt payments, including credit card payments, car loans, student loans, and any other outstanding debts. Then, divide that total by your gross monthly income. Multiply the result by 100 to get a percentage.
For example, if your total monthly debt payments amount to $1,500 and your gross monthly income is $5,000, your debt-to-income ratio would be 30% ($1,500/$5,000 x 100). The lower the percentage, the better off you are as far as getting a loan goes.
To improve your chances of meeting the income ratio requirements, you can consider paying down existing debts, increasing your income, or reducing your monthly debt payments. Keeping your debt-to-income ratio in check will help demonstrate your financial stability and increase your chances of securing a loan.
Maximum Debt-to-Income Ratio for an FHA Loan
For an FHA loan, the maximum debt-to-income ratio allowed is typically 43%. This means that your total monthly debt payments, including your projected monthly mortgage payment, cannot exceed 43% of your gross monthly income.
However, some FHA lenders may consider approving loans with higher debt-to-income ratios, up to 56.9% according to FHA guidelines, if there are compensating factors such as a higher credit score, significant cash reserves, or steady employment.
Maximum Debt-to-Income Ratio for a Conventional Loan
When it comes to conventional loans, the maximum debt-to-income ratio allowed can vary depending on the lender and the specific loan program. However, in most cases, a debt-to-income ratio of 45% or lower is preferred by conventional lenders.
Some lenders may give you a loan if your debt-to-income ratio is as high as 50%, but, as with FHA loans, you would need to have compensating factors. Additionally, as with all loan requirements, the lower your debt-to-income ratio, the more negotiating power you have when taking out a mortgage loan.
Downpayment Requirements
The FHA vs. conventional loan discussion needs to include the downpayment you need to make in order to qualify for a loan. Like with the other requirements, you won't be surprised that FHA loans have more lenient ones. Let's take a closer look.
Downpayments for FHA Loans
One of the standout advantages of FHA loans is the lower downpayment requirement compared to conventional loans. With an FHA loan, you may only need to put down as little as 3.5% of the purchase price. This lower downpayment requirement can make homeownership more attainable for those who may not have substantial savings.
However, this is dependent on your credit score - you need to have a credit score of 580 or above to be able to get a mortgage loan with a 3.5% downpayment. With a lower credit score, you would be required to make a 10% downpayment.
Downpayments for Conventional Loans
Typically, conventional loans require a down payment of at least 20% of the home's purchase price. This 20% down payment helps to reduce the lender's risk and may eliminate the need for private mortgage insurance, which is typically required when the down payment is less than 20%.
However, if a 20% down payment is not feasible for you, there are other options available. Some conventional loans allow for down payments as low as 5% or even 3%, but in these cases, PMI will be required.
It's important to note that larger down payments can also lead to benefits such as lower interest rates and reduced monthly mortgage payments. So, if you can afford a larger down payment, it is generally the best option.
Premium Mortgage Insurance
We've mentioned private mortgage insurance, so let's expand on it a bit. Private mortgage insurance (PMI) is a type of insurance paid by borrowers that is intended to protect lenders in case the borrower defaults on payments. In some situations, you cannot take out a mortgage loan without paying PMI.
When it comes to conventional loans, premium mortgage insurance is often required when the down payment for a conventional loan is less than 20% of the home's purchase price, as we've mentioned. PMI is typically added to your monthly mortgage payments.
On the other hand, FHA loans have their own form of premium mortgage insurance called the upfront mortgage insurance premium (UFMIP) and monthly mortgage insurance premium (MIP). The UFMIP is a one-time fee that is usually financed into the loan amount, while the MIP is paid monthly with your mortgage payment.
Importantly, you always need to pay PMI when taking out a FHA loan.
FHA vs. Conventional Loans Pros and Cons
When deciding between FHA loans and conventional loans, it's important to consider the pros and cons of each option. Here is a summary of the key factors:
FHA loans:
- Pros: FHA loans are more accessible for first-time homebuyers, as they require a lower down payment (as low as 3.5%) and allow for lower credit scores (typically a minimum score of 580). They also have more flexible qualification requirements, including higher debt-to-income ratios. FHA loans are insured by the government, which provides protection for lenders in case of borrower default.
- Cons: FHA loans require both an upfront mortgage insurance premium (financed into the loan) and a monthly mortgage insurance premium, which increases the overall cost of the loan. FHA loan limits may also apply, restricting the amount you can borrow. In some cases, sellers may hesitate to accept FHA offers due to potential appraisal and inspection requirements.
Conventional loans:
- Pros: Conventional loans do not require mortgage insurance if the down payment is at least 20% of the home's purchase price. They offer flexibility in loan options, including fixed-rate and adjustable-rate mortgages. Conventional loans may also have higher loan limits, making them suitable for higher-priced properties.
- Cons: Conventional loans typically require a higher credit score (generally a minimum of 620) and a larger down payment. Private mortgage insurance is required for conventional loans with a down payment of less than 20%, adding an extra cost to the monthly payment. Additionally, qualification requirements may be stricter, including lower debt-to-income ratios.
In summary, FHA loans can be a great option for first-time homebuyers with lower credit scores and an inability to make a large downpayment. Conventional loans, on the other hand, offer more flexibility and cost-saving opportunities for borrowers with stronger credit profiles and higher down payment potential. Consider your financial situation and goals to determine which loan option aligns best with your needs.
Decided on the Loan Type? Make Your Purchase Easier
Unfortunately, even after you are approved for a mortgage and find a property you wish to buy, finishing the transaction is not a simple process. But Lightspeed Escrow can make it as simple as it can be.
We are a team with a background in real estate that offers professional escrow services. We take care of the bureaucracy quickly and accurately, so that you don’t have to worry about it. If you need escrow services or have any questions, feel free to contact us to talk with one of our agents.