Conventional Loans vs. FHA Loans

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UPDATED FOR 2021

Conventional loans and FHA loans are both very popular types of mortgages and it is essential to know the differences between them to make the best possible decision regarding your homeownership. In general, FHA loans are better for people with lower credit scores and are easier to qualify for as compared to conventional loans. However, some conventional loans have better minimum down payment and debt-to-income (DTI) ratio requirements than FHA home loans. Therefore, the following page will not only explain what these two types of loans are but also their requirements, guidelines, and differences.

What is an FHA Loan?

FHA loans or FHA-insured loans are non-conventional mortgages that are insured by the Federal Housing Administration (FHA) and are targeted at low to moderate-income earners. The Federal Housing Association does not provide the mortgage loan itself; it has FHA approved lenders that provide the insured loan. FHA loans have easier qualifications as the program’s main goal is to increase homeownership among low-income households. FHA home loans can also help individuals who have been delinquent or bankrupt in the past. This loan program is good for first time home buyers who have a low credit score and do not have enough saved for a large down payment. Use our FHA loan calculator to determine your monthly mortgage payment.

What is a Conventional Loan?

Conventional loans are not insured or guaranteed by government agencies, instead, they are insured by private lenders. Conventional loans can be further divided into two different types, conforming loans and non-conforming loans. Conforming loans are mortgages that meet the guidelines and requirements outlined by Federal National Mortgage Association (Fannie Mae) & Federal Home Loan Mortgage Corporation (Freddie Mac). These agencies purchase mortgages from various lenders and create investment securities which are then sold to investors. Non-conforming loans are mortgages that do not meet the conforming loan limits requirements set by Fannie Mae and Freddie Mac. A jumbo loan is an example of a non-conforming conventional mortgage. Use our mortgage calculator to determine your monthly mortgage payment for a conventional loan.

Conventional Loan vs. FHA Loan: Summary Table

There are several differences between the two types of loans from their minimum down payment to their mortgage insurance. The following summary table outlines the differences between the two mortgages:

CriteriaConventional LoanFHA Loan
Loan Term10, 15, 20, or 30 years15 or 30 years
Mortgage Rate*2.25% - 3.55%2.25% - 3.75%
Minimum Credit Score620500
Minimum Down Payment3%3.5%
Maximum LTV Ratio97%96.5%
Maximum DTI Ratio50%43%
Mortgage InsuranceIf down payment < 20%All FHA loans
Mortgage Insurance PremiumPMI: 0.5% - 2%Upfront MIP: 1.75%
Variable MIP: 0.45% - 1.05%
Loan LimitNo limit$331,760
Income LimitNo limitNo limit
Down Payment Gifts100% allowed100% allowed
Down Payment AssistanceYesYes
Property StandardsNormalRigorous
*Mortgage rate accurate as of January 6th, 2021

Conventional Loan vs FHA Loan: Loan term & interest rates

Conventional loans have a variety of options from 10 years to 30 years. There are several advantages of having these options as it allows you to tailor your monthly mortgage payment to the loan term that you can afford. Mortgages are amortized over the loan term, such that a longer loan term will result in lower monthly mortgage payments and higher total interest, whereas, a smaller loan term will result in lower monthly mortgage payments. Use our amortization calculator to determine the optimum monthly payment that best suits your needs. Conventional loans also have the option to be fixed-rate or an adjustable-rate mortgage.

FHA loans only have two loan terms either 15-year or 30-year. FHA loans also offer fixed-rate and adjustable-rate mortgages. Adjustable-rate mortgages have a variable component and an additional credit spread, the variable component is typically a benchmark index like the Prime rate which is connected to the Fed funds rate.

Conventional Loan vs FHA Loan: Credit score

Conventional loans have a minimum credit score requirement of 620. Most lenders will prefer a higher credit score as it shows the individual is less likely to default on their debt payments making them low risk. A lower credit score will result in a higher mortgage rate which increases your monthly mortgage payment. For example, on a 30-year fixed $400,000 home, a mortgage rate of 3.5% results in a monthly mortgage payment of $2,890. Whereas, a higher mortgage rate of 4.5% for the same mortgage will result in a monthly mortgage payment of $3,120 or $230 higher.

FHA home loans have a minimum credit score requirement of 500 if the down payment is at least 10% of the home value. For example, if you want to purchase a $200,000 home, a down payment of $20,000 is required if your credit score is at least 500. If you do not have a 10% down payment available, the minimum credit score required increases to 580. Therefore, if you have a low credit score FHA loan might be the better option for you as compared to conventional loans.

Conventional Loan vs FHA Loan: Down payment

Conventional loans have a minimum down payment requirement of 3%. There are a few loan options such as the conventional 97 which offer such low-down payment requirements. However, standard conventional loans require a down payment of 20%. If the down payment is less than 20% then the lender will require you to get private mortgage insurance (PMI).

FHA loans have a minimum down payment of 3.5% if the credit score is at least 580. If the credit score is between 500 and 580 then a minimum down payment of 10% is required.

Conventional Loan vs FHA Loan: Loan-to-value (LTV) ratio

The loan-to-value (LTV) ratio is one of the financial tools used by lenders to determine the risk associated with your mortgage. The LTV ratio is a percentage of the total funds being borrowed as a proportion of the home value. For example, if the home value is $400,000 and the initial upfront down payment is $50,000, the mortgage amount is $350,000 then the LTV ratio is 87.5% ($350,000/$400,000). The LTV ratio measures the initial amount of equity the borrower has in the home. A good LTV ratio is any value less than 80% as private mortgage insurance (PMI) is not required.

Conventional loans require the LTV ratio to be less than 97%, therefore, the borrower must put up 3% of the home price upfront. For example, on a $300,000 home, the borrower must have an upfront payment of $9,000 ($300,000*3%). In other words, the borrower must have a minimum down payment of 3%.

FHA loans have a maximum LTV ratio of 96.5%, the borrower must put up 3.5% of the home price at the start of the mortgage.

Conventional Loan vs FHA Loan: Debt-to-income (DTI) ratio

The debt-to-income (DTI) ratio is another financial tool used by lenders and is often an eligibility requirement for a majority of conventional and non-conventional mortgages. The DTI ratio is calculated by taking your monthly debt payments as a percentage of your gross monthly income. For example, if your monthly debt payments are $2,000 and your gross monthly income is $5,000, your DTI ratio is 40% ($2,000/$5,000). The DTI ratio measures your ability to pay the monthly debt payments and your financial capacity to take on more debt. A good DTI ratio including your mortgage is any value less than 36%.

Conventional loans have a maximum DTI ratio requirement of 50%, therefore, if more than half of your monthly income goes towards debt and interest repayments you will not be eligible for a mortgage. For example, on a monthly income of $6,000, your monthly debt payment cannot exceed $3,000 ($6,000*50%).

Most FHA lenders require your DTI ratio to be less than 43%. For example, on a $2,000 monthly income, monthly debt expenses cannot be greater than $860 ($2,000*43%). If you have a DTI ratio greater than 43% then it is essential to reach out to several lenders because some lenders might be flexible in their DTI ratio requirement.

Conventional Loan vs FHA Loan: Mortgage insurance

Mortgage insurance is an important distinction between the two types of programs. Conventional mortgages require private mortgage insurance (PMI) if the down payment is less than 20%. Whereas, all FHA home loans require FHA mortgage insurance premium (MIP). The differences are outlined in the table below:

CriteriaConventional – Private Mortgage Insurance (PMI)FHA – Mortgage Insurance Premium (MIP)
RequirementDown payment < 20%All FHA loans
Credit ScoreFee is affectedFee is not affected
Fee StructureAnnual onlyUpfront + Annual
Upfront FeeOptional1.25% of the loan amount
Annual Fee0.5% - 2.25% of the loan amount0.45% - 1.05% of the loan amount
DurationLTV < 78% or Home Equity < 80%Down payment < 10% = Full loan
Down payment > 10% = 11 years

Conventional loans are only required to get PMI if the down payment is less than 20% of the home value. For example, on a $400,000 home, the minimum down payment to avoid PMI is $80,000 ($400,000*20%). Credit score does have an impact on the annual fee that you are charged, if you have a higher credit score you will have a lower PMI fee as compared to an individual who has a lower credit score. PMI upfront fees are optional as the annual fee can be chosen to be paid upfront rather than financing it into the monthly mortgage payment. PMI fee can be removed automatically if you attain an LTV ratio of 78% or it can be manually removed by reaching out to the lender once you own 20% of the home.

FHA loans are required to get FHA MIP for all loans irrespective of down payment or other requirements. On the other hand, as FHA is targeted towards individuals with a low credit score, the fee is not affected by a lower or higher credit score. This is a big advantage in favor of FHA loans as your mortgage insurance does not increase any further if you have a low credit score. FHA MIP is divided into an upfront fee and an annual fee, the annual fee is determined based on loan term, loan size, and down payment. FHA MIP can be removed in 11 years if your down payment is greater than 10% otherwise the insurance has to be paid for the life of the loan.

Conventional Loan vs FHA Loan: Loan limits

Conventional loans essentially do not have loan limits because of non-conforming loans. As explained above, conventional loans are divided into conforming loans and non-conforming loans. Conventional conforming loans have loan limits based on location and in 2021 they range from $548,250 as the base limit to $822,375 in high-cost areas. You can find your county’s 2021 loan limit on the Federal Housing Finance Agency page. Whereas non-conforming loans such as jumbo loans do not have any limits, therefore, conventional loans do not have limits.

FHA loans are non-conventional loans and have loan limits. The base floor limit in 2021for most counties is $356,362 and for high-cost counties, the loan limit is $822,375. You can find the FHA loan limit for your county on the Housing and Urban Development page.

Conventional Loan vs FHA Loan: Income limits

Both conventional home loans and FHA home loans do not have income limits. This means you can earn any income and can still qualify for each mortgage program as long as you meet the other loan requirements. Although these programs do not have income limits, income limits do come into play for other programs such as the USDA loan program which is insured by the United States Department of Agriculture.

Conventional Loan vs FHA Loan: Down payment gifts

Down payment gifts are funds that are provided by external parties towards the down payment of your home. External parties can include either friends & family or government organizations that provide first time home buyer programs. There are several rules and regulations around gift money, and it is crucial to do your research before accepting any gift money.

Conventional loans allow for 100% of the down payment to be a gift if it is a 1-unit home and the home is the primary residence of the borrower. If the home is not the primary residence or it is a multi-unit home, the down payment gift works as follows:

  1. If the down payment that you are making is 20% or more then the entire down payment can come from gift money.
  2. If the down payment that you are making is less than 20% then you must contribute at least 5% of the down payment and the rest can come from gift money.

FHA loans allow for the entire down payment to come in from gift money. Therefore, the minimum down payment of 3.5% can be provided by gift money.

Conventional Loan vs FHA Loan: Down payment assistance programs

Down payment assistance programs are provided for both conventional loans and FHA loans. For conventional loans, down payment assistance varies by state. For example, in New York, there are several first-time home buyer programs with down payment assistance available. Similarly, for FHA loans, down payment assistance can be provided by local municipalities and states.

Conventional Loan vs FHA Loan: Property Standards

Property standards are requirements for the home to meet to qualify for the mortgage program. Conventional loans do not have strict property standards as the home can be the primary home, investment home, or even a vacation property.

FHA loans have strict property standards that have to be met in order for the home to qualify for the program. The property has to meet safety and quality standards such as the type and material of construction must be up to local code restrictions. FHA appraisals are also more stringent than conventional mortgage appraisals. FHA homes must be the primary residence of the borrower as second homes and investment homes are not eligible for this program.

Summary: Which mortgage program should I get?

The program that you should select should best fit your current financial capabilities and your future needs and objectives.

You should consider a conventional loan if:

  1. You want a flexible loan term
  2. You have a decent credit score such as above 620
  3. You have a large down payment of 20% or higher
  4. You want PMI insurance to be canceled during the mortgage
  5. You want an expensive home that is higher than conventional loan limits
  6. You want relaxed property and appraisal standards

You should consider an FHA loan if:

  1. You want less stringent loan qualifications
  2. You have a low credit score such as between 500 – 620
  3. You want to make a small down payment of 3.5%
  4. You have been bankrupt or delinquent in the past
  5. You want your mortgage insurance rate to be unaffected by credit score

Conclusion

Conventional loans are provided by private lenders which are insured by private organizations such as Fannie Mae and Freddie Mac. Whereas, FHA loans are provided by FHA approved lenders and the mortgage is insured by the Federal Housing Administration.

Conventional loans offer a variety of options from conforming and non-conforming loans. Borrowers with a good credit score and less debt can benefit from lower mortgage rates and lower monthly mortgage payments. If PMI mortgage insurance is taken, it can be removed after you make enough payments to principal to achieve a LTV of 78% or less.

FHA loans have their own set of requirements; however, it is one of the best options for first-time home buyers who have a low credit score and very little saved for a down payment. FHA loans require FHA MIP and most will require it for the life of the loan. However, if you want to stop paying FHA MIP, you can choose to refinance your mortgage into a conventional loan.

Apart from conventional and FHA loans, if you are a veteran you should consider the alternative option of a VA loan, or if you stay in a rural area you can consider a USDA loan. Therefore, there are several mortgage options available to potential homeowners, the important thing is to choose the option that best suits your financial needs and goals.