January 27 2021

FHA vs Conventional Loans: Which Is Better?

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FHA vs Conventional Loans: Which Is Better?

When it comes to affording a new home, you have a few types of home loans to choose from. Prospective homebuyers often compare the FHA vs. the conventional loan when researching loans. Each loan type has certain stereotypes associated with them, but we are here to give you the facts about both FHA and conventional loans. This post will help you understand what each loan is, familiarize you with the differences between them, and provide some guidelines for how to pick which one is best for you.

What Is an FHA Loan?

An FHA loan is insured by the Federal Housing Administration (FHA). These loans are issued by private lenders, but lenders are protected from losses by the FHA if the homeowner fails to repay. FHA loans are generally used to refinance or buy a home.

What Is A Conventional Loan?

A conventional loan is supplied by a private lender and isn’t federally insured. Requirements for obtaining a conventional loan vary depending on the lender. When used to buy property, conventional loans are typically known as mortgages.

Differences Between FHA and Conventional Loans

The main difference between FHA and conventional loans is whether they are insured by the federal government. Conventional loans aren’t federally backed, so it’s riskier for the lender to loan money. On the other hand, FHA loans are protected by the government, and as a result of less risk, they can typically offer better deals.

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This difference in federal insurance is the reason FHA and conventional loans vary when it comes to the details of the loan. Keep reading to learn the differences regarding credit requirements, minimum down payments, debt-to-income ratios, loan limits, mortgage insurance, and closing costs.

	FHA Loan	Conventional Loan
Minimum Credit Score	500	620
Minimum Down Payment	3.5%	3%
Maximum Debt-to-Income Ratio	Credit score of 500: 43% Credit score of 580+: 43-50%	Credit score of 620: 33-36% Credit score of 740+: 36-45%
Loan Limits	Low-cost counties: $356,362 High-cost counties: $822,375	Contiguous US: $548,250 High-cost counties, AK, HI, and US territories: $822,375
Mortgage Insurance	Mortgage insurance premiums required.	Private mortgage insurance required with down payments less than 20%.
Property Standards	Stricter standards, property purchased must be a primary residence.	Flexible standards, property purchased doesn’t have to be a primary residence.

Credit Score

Your credit score is a determining factor in your loan eligibility. Your credit score is measured on a scale of 300 (poor credit) to 850 (excellent credit). Good credit helps you get approved for loans more easily and at better rates. FHA and conventional loans differ in their credit score requirements and represent financial options for individuals at either end of the credit spectrum.

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Minimum Credit Score for FHA Loan: 500

Accepts a credit score as low as 500, but usually with a 10% down payment
These loans accept lower credit scores because they are insured
Note: Some lenders may only issue FHA loans with higher credit scores

Minimum Credit Score for Conventional Loan: 620

Accepted score may vary from lender to lender
These loans are usually offered to individuals with strong credit because they present less risk to lenders

Minimum Down Payment

A down payment is the sum of money that is paid as a percentage of your purchase up-front.

Minimum Down Payment on an FHA loan:

10% of your purchase with 500 credit score
3.5% of your purchase with 580+ credit score

Minimum Down Payment on a Conventional Loan:

3% of your purchase can be put down with good credit
5% to 20% of your purchase price is typical

Debt-to-Income Ratio

Your debt-to-income ratio is the amount of money paid toward debt each month divided by your total monthly income. To be eligible for a loan, you must be at or below the maximum debt-to-income (DTI) ratio.

Maximum DTI Ratio Guidelines for FHA loans:

43% with a credit score of 500
43–50% with a credit score of 580

Maximum DTI Ratio Guidelines For Conventional Loans:

33-36% with a credit score lower than 740
36-45% with a credit score of 740 or higher
50% highest allowed through Fannie Mae

Loan Limits

Both FHA and conventional loans have limits on the amount that you can borrow. Loan limits vary based on your location and the year your loan is borrowed. Find 2021 loan limits specific to your county through the Federal Housing Finance Agency.

2021 FHA Loan Limits

High-cost counties: $822,375
Low-cost counties: $356,362

2021 Conventional Loan Limits

Contiguous US (excluding high-cost counties): $548,250
Alaska, Hawaii, US territories, and high-cost counties: $822,375

Mortgage Insurance

Mortgage insurance is taken out to protect the lender from losses in case you fail to repay your loan. Whether you will pay private mortgage insurance or mortgage insurance premiums is based on your loan type and down payment percentage.

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FHA Loan

Mortgage insurance is required for all FHA loans.
It is paid to the FHA in the form of mortgage insurance premiums and includes an up-front and monthly premium.
MIP payments last the entire life of your FHA loan.
To get rid of MIPs after paying 20% of your loan, you can choose to refinance into a conventional loan.

Conventional Loan

Private mortgage insurance (PMI) is only required when a down payment below 20% is made.
PMI comes in different forms: monthly premium, up-front premium, and split premiums.
PMI requirements stop once you have met one of three requirements:
1. Principal loan amount is reduced to 80% before the loan term ends.
2. At least 78% of the principal balance is scheduled to be paid down.
3. The halfway point of your loan term has passed.

Property Standards

There are different property standards that must be met to use each loan. FHA loans have stricter requirements, while conventional loans have more flexibility.

FHA Loan

Property purchased with FHA loans must be your principal residence, meaning the borrower has to occupy the residence
FHA loans can’t be used to invest in property (e.g., renting out or flipping)
Title must be in the borrower’s name or name of a living trust

Conventional Loan

Property purchased with a conventional loan doesn’t have to be a principal residence — second or third residences are allowed
Conventional loans can be used to purchase investment properties

Pros and Cons of FHA vs. Conventional Loans

As a result of the differences between FHA and conventional loans, each type has its respective pros and cons.

	FHA Loan	Conventional Loan
Pros	Qualify with low credit and high DTI Smaller down payments overall More affordable with low credit	Lowest option for down payments with good credit PMI cancellable More affordable with good credit Property doesn’t have to be your main home
Cons	Mortgage insurance premiums required for life of loan Property purchased must be your main home	Need higher credit and lower DTI to qualify Typically has larger down payments PMI required with a down payment less than 20%

Pros and Cons of FHA Loans

FHA loans are government-regulated and insured to extend flexible opportunities for homeownership. They’re flexible regarding credit and DTI, but stricter about insurance and property standards.

Pros

Flexible qualification with low credit and high DTI
Smaller down payments overall
More affordable with low credit

Cons

Mortgage insurance premiums required for life of loan
Property purchased must be your primary residence

Pros and Cons of Conventional Loans

Conventional loans can also offer flexibility, but generally only if you have good credit and demonstrate reduced risk to the lender. These loans have stricter qualifications, but flexibility in other areas.

Pros

Lowest option for down payments (3% with good credit)
Private mortgage insurance can be canceled (must meet requirements)
More affordable with good credit
Property purchased doesn’t have to be a primary residence

Cons

Strict qualifications require higher credit and lower DTI
Larger down payments are typical
Private mortgage insurance required with a down payment less than 20%

Which Loan Is Better for You?

Both FHA and conventional loans have their advantages and disadvantages. Here are some general guidelines for when to use an FHA loan or a conventional loan.

When To Use an FHA Loan

You have a low credit score (500–619)
Your DTI ratio is on the higher side (between 45–50%)
You can only afford a small down payment
You plan to use the property as your primary residence

When to Use a Conventional Loan

Your credit score is fairly good (620 or above)
Your DTI ratio is on the lower side (33–36%)
You can afford a larger down payment
You want flexibility with insurance and repaying your loan

It’s important to thoroughly research your options before choosing a loan. A key takeaway when comparing FHA vs. conventional loans is that FHA loans are federally insured and conventional loans aren’t. This distinction results in different qualification and payment requirements for each loan.

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Use the information in this post to carefully compare the differences in accepted credit scores, minimum down payments, loan limits, maximum debt-to-income ratios, mortgage insurance and property standards. In doing so, choose the loan that works for your circumstances and helps you best afford the home of your dreams.

Sources: FHA Single Family Housing Policy Handbook | US Dept. of Housing and Urban Development | Federal Housing Finance Agency | Freddie Mac