What Is a Conventional Loan vs. FHA?

Conventional loans and FHA loans are two widely used mortgage options. Understanding their distinctions is important for prospective homeowners as they navigate their financing choices.

Understanding Conventional Loans

A conventional loan is a mortgage not insured or guaranteed by a government agency. These loans are originated and serviced by private lenders such as banks, credit unions, and other financial institutions. They represent the most common type of mortgage available.

Eligibility for a conventional loan involves specific financial criteria. Lenders look for a minimum credit score of 620; scores of 680 or above can lead to more favorable interest rates. Borrowers’ debt-to-income (DTI) ratio is a factor, with many lenders preferring a DTI of 43% or lower, though some may accept up to 50% depending on other financial strengths.

Conventional loans can allow for down payments as low as 3% or 5% of the home’s purchase price. A 20% down payment avoids private mortgage insurance (PMI). When a down payment is less than 20%, PMI is required. This insurance protects the lender if the borrower defaults. PMI can be removed once the loan-to-value (LTV) ratio reaches 80% of the home’s original value, and is automatically terminated at 78% LTV.

Property standards for conventional loans focus on the home’s appraised market value. A licensed appraiser evaluates the property’s size, condition, location, and features, comparing it to similar, recently sold homes. The appraisal ensures the property’s value supports the loan amount, protecting both the lender and the borrower.

Understanding FHA Loans

An FHA loan is a mortgage insured by the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development (HUD). This government backing reduces risk for lenders, making FHA loans a more accessible option for a broader range of homebuyers, particularly those with limited savings or lower credit scores. FHA loans are available through private, FHA-approved lenders.

Eligibility requirements for FHA loans are more flexible than those for conventional loans. Borrowers can qualify with a minimum credit score of 580 for a 3.5% down payment. If a credit score is between 500 and 579, a 10% down payment may be required. Debt-to-income ratios are more lenient, allowing for a total DTI of up to 43%, depending on other compensating factors.

Mortgage Insurance Premium (MIP) is required for all FHA loans, regardless of the down payment amount. MIP consists of an upfront mortgage insurance premium (UFMIP) and an annual mortgage insurance premium. The UFMIP is 1.75% of the loan amount and can be paid at closing or financed into the loan. The annual MIP varies but ranges from 0.15% to 0.75% of the loan amount and is paid monthly. For most FHA loans with down payments less than 10%, MIP remains for the entire loan term. With a 10% or greater down payment, it may be removed after 11 years.

FHA loans impose specific property standards, which are more stringent than those for conventional loans. An FHA-approved appraiser evaluates the property to ensure it meets HUD’s standards for safety, soundness, and security. This includes checking for functional major systems, a sound roof, and freedom from health hazards. If the property does not meet these standards, repairs may be required before loan approval.

Comparing Conventional and FHA Loans

The fundamental difference between conventional and FHA loans lies in their government backing. FHA loans are insured by the Federal Housing Administration, offering protection to lenders and making them more accessible to borrowers who might not qualify for other financing. Conventional loans, conversely, are not government-insured and are instead offered by private lenders, often requiring stricter borrower qualifications.

Credit score requirements differ significantly. Conventional loans necessitate a minimum credit score of 620. FHA loans offer more leniency, allowing for credit scores as low as 580 with a 3.5% down payment, or 500 with a 10% down payment.

Down payment minimums vary. Conventional loans can offer down payments as low as 3%, though a 20% down payment avoids private mortgage insurance. FHA loans permit a minimum down payment of 3.5%.

Mortgage insurance varies considerably between these loan products. Conventional loans may require Private Mortgage Insurance (PMI) if the down payment is less than 20%, but PMI can be canceled once sufficient equity is built. FHA loans, however, mandate a Mortgage Insurance Premium (MIP) for all loans, consisting of both an upfront and an annual component. For most FHA loans, this MIP remains for the entire loan term, regardless of equity, unless the loan is refinanced into a conventional mortgage.

Property requirements are more rigorous for FHA loans. FHA appraisals assess the home for market value and adherence to specific health, safety, and structural standards set by HUD. Conventional loan appraisals focus on market value and structural integrity.

Loan limits vary. Both conventional and FHA loans have maximum loan amounts, which differ and are adjusted annually based on housing market conditions. FHA loan limits are lower than conventional loan limits in many areas.

Regarding interest rates, FHA loans can have lower interest rates due to their government insurance, especially for borrowers with lower credit scores. However, the mandatory MIP on FHA loans can make the overall cost higher than a conventional loan for borrowers with strong credit who can avoid PMI or have it removed quickly.

Debt-to-income (DTI) ratios differ. FHA loans are more flexible with higher DTI ratios, allowing up to 43%. Conventional loans have stricter DTI limits, preferring ratios below 45%, though some programs may allow up to 50% for well-qualified borrowers.