What Is the Difference Between a Conventional and FHA Loan?

Securing a mortgage represents a significant step toward homeownership, and understanding the various financing options available is a primary consideration for many prospective buyers. Among the most common choices encountered are conventional loans and those insured by the Federal Housing Administration (FHA). Each type carries distinct characteristics that can significantly influence a borrower’s eligibility, financial obligations, and overall homebuying experience. This article aims to clarify the specific attributes of conventional and FHA loans, providing a clear understanding of their differences to assist individuals in making informed decisions.

Understanding Conventional Loans

Conventional loans are a common form of mortgage financing not insured or guaranteed by a government agency. Instead, these loans are offered and backed by private lenders, such as banks, credit unions, and mortgage companies. Eligibility for a conventional loan depends on a borrower’s financial strength, including their credit history and debt obligations.

Lenders seek applicants with strong credit profiles, often requiring a minimum credit score of 620 or higher, with better rates available for scores above 700. Down payment expectations for conventional loans can vary, ranging from as little as 3% for some programs to 20% or more. A larger down payment can reduce the loan amount and may eliminate the need for private mortgage insurance.

When a borrower puts down less than 20% of the home’s purchase price, private mortgage insurance (PMI) is required. PMI protects the lender in case the borrower defaults on the loan. Property eligibility for conventional loans focuses primarily on the home’s market value and condition. Debt-to-income (DTI) ratios, which compare a borrower’s monthly debt payments to their gross monthly income, are also considered, with lenders often preferring a total DTI below 43% for conventional financing.

Understanding FHA Loans

FHA loans are a type of mortgage insured by the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development (HUD). This government backing makes FHA loans appealing to a broader range of borrowers, particularly those who may have lower credit scores or less money saved for a down payment. The FHA does not directly lend money; instead, it insures loans made by FHA-approved private lenders.

These loans are designed to make homeownership more accessible, often featuring more flexible qualification criteria than conventional loans. The minimum credit score requirement for an FHA loan can be as low as 580 to qualify for the minimum down payment of 3.5%. Borrowers with credit scores between 500 and 579 may still qualify with a larger down payment, typically 10% or more.

A mandatory mortgage insurance premium (MIP) is a distinguishing feature of FHA loans, required for all FHA-insured mortgages regardless of the down payment amount. This premium includes both an upfront payment and annual premiums. Property eligibility for FHA loans is based on strict HUD minimum property standards, ensuring the home is safe, sound, and secure. FHA loans also offer more flexible debt-to-income ratio guidelines, sometimes allowing for higher ratios compared to conventional loan programs.

Comparing Key Loan Features

The choice between a conventional and FHA loan hinges on several key differences, each impacting a borrower’s financial situation and eligibility. Understanding these distinctions is important for prospective homebuyers.

Down Payment Requirements

Minimum down payment expectations vary between these loan types. Conventional loans, particularly those offered by Fannie Mae and Freddie Mac, can require as little as 3% down for eligible borrowers. However, putting less than 20% down necessitates private mortgage insurance (PMI). FHA loans permit a minimum down payment of 3.5% for borrowers with a credit score of 580 or higher, making them accessible with a small upfront investment.

Credit Score Standards

Credit score requirements represent another differentiator. Conventional lenders look for a minimum FICO score of 620 for standard loan programs, with higher scores often leading to more favorable interest rates. FHA loans are more lenient, allowing borrowers with credit scores as low as 580 to qualify for the minimum 3.5% down payment. Borrowers with scores between 500 and 579 may still be eligible but are required to make a 10% down payment.

Mortgage Insurance

Mortgage insurance requirements differ between conventional and FHA loans. For conventional loans, private mortgage insurance (PMI) is required if the down payment is less than 20% of the home’s purchase price. PMI can be canceled once the borrower’s equity reaches 20% of the original home value, either through appreciation or consistent principal payments. Borrowers can request cancellation once the loan-to-value (LTV) ratio reaches 80% and it is automatically terminated when the LTV reaches 78%, provided payments are current.

FHA loans require a Mortgage Insurance Premium (MIP), which consists of both an upfront premium and annual premiums. The upfront MIP is 1.75% of the loan amount, which can be financed into the loan. Annual MIP is paid monthly and varies based on the loan term, loan-to-value (LTV) ratio, and original loan amount, ranging from 0.45% to 1.05% of the loan balance annually. For most FHA loans with a loan term greater than 15 years and an original loan-to-value (LTV) ratio greater than 90%, the annual MIP is required for the entire loan term, making it a longer-lasting cost compared to conventional PMI.

Loan Limits

Both conventional and FHA loans are subject to loan limits, but their determination and amounts differ. Conventional loan limits are set by the Federal Housing Finance Agency (FHFA) and apply to loans eligible for purchase by Fannie Mae and Freddie Mac. For most of the United States, the conforming loan limit for a single-unit property is $766,550 in 2024, though higher limits apply in designated high-cost areas. FHA loan limits are determined by HUD and vary by county, based on a percentage of the conforming loan limits for that area, ranging from 65% to 150% of the conforming loan limit, with a national floor and ceiling.

Property Eligibility and Appraisal Standards

Property eligibility and appraisal standards present distinctions. Conventional loan appraisals primarily focus on determining the home’s market value to ensure it adequately secures the loan amount. While appraisers note obvious defects, the emphasis is on valuation. FHA loans, conversely, require appraisals that adhere to strict HUD minimum property standards, ensuring the home is safe, structurally sound, and sanitary. This means FHA appraisals examine aspects like proper ventilation, safe access, and functioning utilities, potentially requiring repairs before the loan can close if deficiencies are found.

Debt-to-Income Ratio Guidelines

Debt-to-income (DTI) ratio guidelines are considered by both loan types to assess a borrower’s ability to manage monthly payments. Conventional lenders prefer a total DTI ratio below 43%, though some programs may allow for slightly higher ratios with strong compensating factors, such as a large down payment or significant reserves. FHA loans offer more flexibility regarding DTI ratios, allowing for total DTI ratios up to 50% or even higher in some cases, particularly for borrowers with strong credit scores or significant cash reserves. This flexibility can be beneficial for borrowers with higher debt burdens relative to their income.