Conventional Loan Vs FHA Loan: Which Loan is Best for You?

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Conventional loans and FHA loans are both very popular types of mortgages. It is essential to know the differences between these two programs to make the best possible decision regarding your homeownership, before starting the process of getting preapproved. In general, FHA loans are better for people with lower credit scores and are easier to qualify for as compared to conventional loans. However, in some situations conventional loans are cheaper than FHA home loans. Therefore, this page will not only explain what these two types of loans are but also their requirements, guidelines, and differences.

Illustrative Example of Mortgage Cost vs. Credit Score

This figure is for illustrative purposes only

At very low credit scores, only FHA loans are available. When both FHA and conventional mortgages are available, the cost of a conventional mortgage decreases faster with increasing credit score, as both the interest rate and insurance premium are dependent upon the borrower’s credit score. On the other hand, FHA MIPs are not dependent on credit scores. Note mortgage cost depends on many factors, including loan term and down payment, and that this figure is only for illustrative purposes.

Characteristics of a Conventional Loan

• Conventional loans are not insured or guaranteed by government agencies.
• If the down payment by the borrower is below 20%, their mortgage must be insured by a private mortgage insurer.
• 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) or Federal Home Loan Mortgage Corporation (Freddie Mac).
• These agencies purchase mortgages from various lenders and create investment securities backed by mortgages which are then sold to investors. These mortgage-backed securities (MBS) naturally bring the financial crisis of 2007-2008 to mind.
• Non-conforming loans are mortgages that do not meet the requirements of Fannie Mae and Freddie Mac. The most important of these requirements are limits on the value of a loan set by the Federal Housing Finance Agency (FHFA) which is the regulator of 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.

Characteristics of an FHA Loan

• 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 Administration has FHA-approved lenders that provide the insured loan.
• FHA loans have easier qualification criteria as the program’s main goal is to increase homeownership among low and moderate-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.

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 mortgage programs:

Loan Term and Interest Rate Structure

Continuing our comparison of conventional vs. FHA mortgages, we should compare what terms are available for each of these categories of mortgages. 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 results in lower monthly mortgage payments but higher total interest cost, whereas a shorter loan term results in higher monthly mortgage payments but lower total interest cost. Use our amortization calculator to determine the optimum monthly payment that best suits your needs. Conventional loans also have the option to be a fixed-rate or an adjustable-rate mortgage.

FHA loans only have two loan term options, either 15-year or 30-year. FHA loans also offer fixed-rate and adjustable-rate mortgages (ARM). A variable component plus a credit spread constitute the ARM interest rate. The variable component is typically a benchmark index like the Prime rate, which is related to the Fed funds rate.

Credit Score

There is a rule called the “ability to repay rule”. This rule says a mortgage lender is required to assess the ability of a borrower to repay their mortgage. The home loan can only be offered if the lender determines that the borrower is able to repay the loan. One of the means of determining if a borrower is able to repay the loan is by looking at their history of honoring debt. Credit score is a number which summarizes one's history of honoring their debt. Conventional loans have a minimum credit score requirement of 620. Most lenders 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 results 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.

Note that a lender might require a credit score higher than those in the table below. For conventional loans, based on other factors, a lender may decide that you are able to repay the loan, in spite of your credit score being lower than the threshold. So if one lender rejects your loan application, you might try other lenders. As larger lenders are more regulated, a smaller lender is more likely to show flexibility.

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 requires you to get private mortgage insurance (PMI).

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

In conventional loans, the larger your down payment, the smaller your interest rate and PMI premiums. For FHA loans, the larger your down payment, the smaller your monthly MIP payments and also your interest rate. This similarity is because lenders for both conventional and FHA loans use risk-based pricing to determine the interest rate they charge.

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. The LTV ratio in this situation 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 for such LTV ratios.

Conventional loans require the LTV ratio to be less than 97%, therefore, the borrower must put up at least 3% of the home price upfront. For example, on a $300,000 home, the borrower must have an upfront payment of at least $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%, which means that the borrower must put up at least 3.5% of the home price at the start of the mortgage.

Debt-to-income (DTI) ratio

Continuing our comparative study of FHA loans vs. conventional loans, we consider the DTI ratios tolerated in each lending program. 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). Note that the numerator of DTI should include your housing expense, which would either be your monthly rent payment or your monthly mortgage payment. Also note that the denominator of DTI ratio is gross income, which is your monthly income before income taxes or any other deductions. 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.

When determining your mortgage eligibility to buy your primary residence, you should substitute your monthly mortgage payment for your rent in your DTI calculation to get the DTI value which determines your mortgage eligibility. When buying an investment property you can add 75% of appraised rental income of your future property to your income and your mortgage payment to your debt.

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% of the home price. On the other hand, all FHA home loans require FHA mortgage insurance premium (MIP). The differences are outlined in the table below:

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 impacts 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 insurance fee can be chosen to be paid upfront rather than as part of the monthly mortgage payment. The PMI fee is 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 equity. This can be achieved as a combined result of your payments and your home's price appreciation.

FHA loans are required to pay FHA MIP for all loans irrespective of down payment or other factors. On the other hand, as FHA is targeted towards individuals with a low credit score, the fee is not affected by the value of the 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 after 11 years if your down payment is greater than 10% of the home value, otherwise the insurance has to be paid for the life of the 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 county-specific loan limits based on where the purchased property is located. In 2023, conventional limits range from $726,200 as the base limit to $1,089,300 in high-cost areas. You can find your county’s loan limit on the Federal Housing Finance Agency page. Whereas non-conforming loans such as jumbo loans do not have any limit, therefore, conventional loan amount is not limited.

FHA loans are non-conventional loans and have loan limits. The base floor limit in 2023 for most counties is $472,030 and for high-cost counties, the loan limit is $1,089,300. You can visit our page on FHA loan limits to learn more.

Income Limits

Both conventional home loans and FHA home loans do not have explicit 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. Note that limitations in DTI ratio indirectly require your income to be high enough to pay down the mortgage for your chosen home.

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 and family or government organizations that have 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 single unit property and the home is the primary residence of the borrower. If the home is not the primary residence or it is a multi-unit property, 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% for a single-family home, then you must contribute at least a 5% down payment and the rest can come from gift money.
3. Properties with two-units require the borrower to make at least a 3% down payment if the entire down payment is less than 15%
4. Properties with three or four units require the borrower to make at least a 3% down payment if the entire down payment is less than 25%

FHA loans allow for the entire down payment to come from gift money. Therefore, the minimum down payment of 3.5% can be provided by gift money. Note that for conventional loans this gift can only come from a close family member; while FHA would allow the gift almost from any source.

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.

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 residence, investment property, 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, for example 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 FHA loans.

Reason for Creation of FHA

Conventional mortgage is called conventional because it is the mortgage which historically existed. The lender would bear the risk of default by the borrower. Thus until the Great Depression, taking out a mortgage was very difficult. Buying a home required making a minimum of 50% down payment. At this time most Americans were renters and the homeownership rate was around 10%. Financial markets have changed a lot since that time and it is now possible to take a conventional mortgage with as little as a 3% down payment.

In 1934 due to the Great Depression, around 2 million construction workers had lost their jobs. At this time, Congress created the FHA to stimulate housing demand. The idea was that if the government accepted the risk of default on home loans, financial institutions would be far more willing to initiate mortgages. Mortgages offered to more people causes larger home sales which in turn encourages builders to build more houses.

Summary: Which Mortgage Program Should I Choose?

The program that you select should best fit your current financial situation 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 a score above 620
3. You have a large down payment of 20% or higher
4. You want PMI payments to be canceled during the mortgage
5. You want an expensive home that requires a loan larger than FHA loan limits
6. You prefer 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 MGIC, Essent and Radian. Whereas FHA loans are provided by FHA approved lenders such as Wells Fargo, Citibank and TD Bank. Then the mortgage is insured by the Federal Housing Administration.

Conventional loans are divided into 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 is taken, it can be removed after you make enough payments to principal to achieve a LTV of 80% or less.

An FHA loan has its 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 may require it for the life of the loan. However, if you want to stop paying FHA MIP and you have accumulated enough equity in your home, you can choose to refinance your mortgage into a conventional loan. If you have not accumulated enough equity to get rid of mortgage insurance, you might still be able to benefit from lower rates by refinancing.

Apart from conventional and FHA loans, if you are a veteran you should consider the alternative option of a VA loan, or if you are in a rural area you can consider a USDA loan. As you see there are several mortgage options available to potential homeowners. One needs to consider all options available together with their own financial situations and life goals to choose the best option which is subjective.