What Is the Difference Between a Conventional and FHA Loan?

The mortgage landscape offers various paths to homeownership. Deciding on the right loan type is a significant step for prospective buyers, influencing long-term financial commitments. Among the most common options available are conventional loans and those backed by the Federal Housing Administration (FHA). These two choices cater to distinct borrower profiles and property types, reflecting varied requirements and benefits. Understanding their fundamental differences is essential for making an informed decision.

Key Eligibility and Borrower Profile Differences

Conventional loans, which are not insured by a government agency, generally require borrowers to demonstrate a stronger financial standing. Lenders typically look for a credit score of at least 620, though scores of 680 or higher often result in more competitive interest rates. The down payment for conventional loans can be flexible, ranging from as low as 3% for certain programs up to 20% or more, with a larger down payment helping to avoid private mortgage insurance. Lenders also assess the borrower’s debt-to-income (DTI) ratio, preferring it to be below 45% to ensure repayment capacity.

In contrast, FHA loans are government-insured, making them accessible to a broader range of borrowers, particularly those with less-than-perfect credit or limited savings. A minimum credit score of 580 is typically required for the lowest 3.5% down payment option. Borrowers with credit scores between 500 and 579 may still qualify but generally need a higher down payment of 10%. FHA guidelines are also more lenient regarding debt-to-income ratios, often allowing ratios up to 43%. These relaxed criteria make FHA loans a viable option for first-time homebuyers or individuals rebuilding their credit.

Mortgage Insurance and Loan Costs

Mortgage insurance is a significant cost factor that differs between conventional and FHA loans. For conventional loans, Private Mortgage Insurance (PMI) is typically required when the borrower makes a down payment of less than 20% of the home’s purchase price. PMI protects the lender in case the borrower defaults. This insurance is usually paid monthly and is added to the regular mortgage payment.

PMI is removable; it can often be canceled once the loan-to-value (LTV) ratio reaches 80% of the home’s original value, either through principal payments or increased home equity. Borrowers can generally request cancellation when their equity reaches 20%, and it is automatically terminated when the LTV reaches 78% based on the original loan amount, provided the borrower is current on payments.

FHA loans, conversely, require a Mortgage Insurance Premium (MIP) for all borrowers, regardless of the down payment amount. This includes an Upfront Mortgage Insurance Premium (UFMIP), which is 1.75% of the loan amount and is typically financed into the loan, meaning it’s added to the principal balance rather than paid out-of-pocket at closing. Additionally, FHA loans have an Annual Mortgage Insurance Premium (Annual MIP), paid monthly, which varies based on the loan amount, term, and LTV.

For most FHA loans with the minimum 3.5% down payment, the Annual MIP is required for the entire life of the loan. If a borrower puts down 10% or more, the Annual MIP may be canceled after 11 years. Unlike conventional PMI, FHA MIP cannot be removed based on reaching a certain equity percentage; the only way to eliminate it is generally by refinancing into a conventional loan.

Property Requirements and Loan Limits

Property requirements and loan limits also present distinct differences between conventional and FHA loans, influencing the types of homes buyers can purchase. Conventional loans generally have less stringent property condition requirements. Appraisals for conventional loans primarily focus on determining the market value of the property to ensure it adequately secures the loan. While basic habitability, safety, and structural soundness are expected, cosmetic issues or minor repairs typically do not prevent a property from qualifying.

Loan limits for conventional loans are set by government-sponsored enterprises like Fannie Mae and Freddie Mac. These “conforming loan limits” are generally higher than FHA limits, allowing borrowers to finance more expensive properties, especially in high-cost housing markets. These limits are adjusted annually and can vary by county.

FHA loans, however, are subject to Minimum Property Requirements (MPRs) and Minimum Property Standards (MPS). These standards ensure the property is safe, sound, and secure, aiming to protect the borrower and the FHA’s insurance fund. FHA appraisers conduct a thorough inspection to confirm that the home meets these criteria, which can include checking for lead-based paint hazards, structural defects, adequate roofing life, and proper drainage. If a property does not meet these standards, mandatory repairs may be required before the loan can close, potentially delaying the purchase.

FHA loan limits are determined by the Department of Housing and Urban Development (HUD) and are typically lower than conventional loan limits. These limits vary significantly by county. This means that in some high-cost areas, the FHA loan limit might restrict a buyer’s ability to purchase a more expensive home compared to what a conventional loan might offer.