What Is a Conventional Loan vs. an FHA Loan?

The U.S. mortgage market offers various financing options, with conventional loans and those insured by the Federal Housing Administration (FHA) being common choices. Understanding the distinctions between these loan types is important for prospective homeowners. This article clarifies the characteristics and comparative factors of conventional and FHA loans.

Understanding Conventional Loans

Conventional loans are mortgages not insured or guaranteed by a government agency. Private lenders, such as banks and credit unions, offer these loans. They typically adhere to guidelines set by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.

Borrowers generally need a solid financial profile. Lenders typically require a minimum credit score of 620, with higher scores leading to more favorable terms. A stable income and manageable debt are also important, with lenders preferring a debt-to-income (DTI) ratio of 45% or lower, though exceptions can extend to 50%.

Conventional loans require Private Mortgage Insurance (PMI) if the down payment is less than 20% of the home’s purchase price. PMI protects the lender if the borrower defaults, as a lower down payment increases risk. This insurance is typically paid monthly.

Conventional loans offer fixed-rate options, where the interest rate remains constant, and adjustable-rate mortgages (ARMs), where the rate can change after an initial fixed period. Terms and requirements vary among private lenders but generally follow Fannie Mae and Freddie Mac guidelines.

Understanding FHA Loans

FHA loans are mortgages insured by the Federal Housing Administration (FHA), an agency within the U.S. Department of Housing and Urban Development (HUD). Their purpose is to make homeownership more accessible, especially for those with lower credit scores or limited down payment funds. Private lenders originate and service these mortgages, though the FHA insures them.

FHA loans have lower minimum credit score requirements. Borrowers with a FICO score of 580 or higher can qualify with a down payment as low as 3.5%. For scores between 500 and 579, a 10% down payment is generally required.

FHA loans require both an Upfront Mortgage Insurance Premium (UFMIP) and an annual Mortgage Insurance Premium (MIP). The UFMIP is a one-time fee of 1.75% of the loan amount, which can be paid at closing or financed. The annual MIP is paid monthly, typically ranging from 0.15% to 0.75% of the loan amount, depending on the loan-to-value (LTV) ratio and loan term.

Properties financed with an FHA loan must meet minimum property standards (MPS) during appraisal. These standards ensure the home is safe, secure, and structurally sound, addressing potential health and safety hazards. An FHA-approved appraiser confirms the property meets these requirements.

Key Differences and Comparative Factors

Key distinctions between conventional and FHA loans influence which loan type suits a borrower’s circumstances.

Down Payment

Conventional loans typically require a minimum of 3% to 5% down, with 20% often preferred to avoid PMI. FHA loans allow lower down payments, starting at 3.5% for credit scores of 580 or higher, and 10% for scores between 500 and 579.

Credit Score

Conventional loans generally require a minimum credit score of 620, with higher scores often leading to more favorable terms. FHA loans are more flexible, allowing scores as low as 500, though a score of 580 or above is needed for the lowest down payment.

Mortgage Insurance

Conventional loans require PMI for down payments under 20%, which can be canceled once 20% equity is reached or automatically terminates at 78% LTV. FHA loans mandate both an Upfront Mortgage Insurance Premium (UFMIP) and an annual Mortgage Insurance Premium (MIP) regardless of down payment. The annual MIP generally continues for the loan term unless 10% or more was put down, allowing cancellation after 11 years.

Property Requirements

While both loan types require an appraisal, FHA loans have more stringent minimum property standards focusing on safety, security, and structural soundness. This can lead to required repairs before closing, unlike conventional appraisals primarily concerned with market value.

Loan Limits

Both conventional and FHA loans have maximum borrowing limits that vary by location and housing costs. Conventional limits are set by the Federal Housing Finance Agency (FHFA) for conforming loans, while FHA limits are determined by HUD. These limits adjust periodically and can be higher in high-cost areas.

Debt-to-Income (DTI) Ratios

Conventional loan guidelines typically prefer a DTI ratio below 45% to 50%, depending on other compensating factors. FHA loans offer more flexibility, allowing DTI ratios up to 50% or higher with strong compensating factors, such as significant cash reserves or a strong credit history.

Assumability

FHA loans are generally assumable, allowing a qualified buyer to take over the seller’s existing loan with lender approval. This can be an advantage in a rising interest rate environment. Conventional loans are typically not assumable due to “due-on-sale” clauses requiring the loan to be paid in full upon property sale.

Funding Fees and Closing Costs

FHA loans include a mandatory Upfront Mortgage Insurance Premium (UFMIP) of 1.75% of the loan amount, often financed but adding to the total cost. While both loan types have closing costs, the UFMIP is unique to FHA loans and impacts the amount needed at closing.