November 10, 2017 by 1 Comment

Unless you’re already a mortgage expert, picking between an FHA loan and a conventional loan can be tricky. Luckily, we’re about to lay it all out for you—the advantages, the disadvantages, the requirements, and how to choose.

If you just want to sit back and relax, our mortgage blogger, Carter Wessman, can walk you through the basics in this short video. For a deep dive into FHA vs conventional loans, read on.

FHA vs. Conventional Loans from Total Mortgage on Vimeo.

Know what you want? Jump ahead.

What are FHA and Conventional Mortgage Loans?

First, let’s take a quick overview of the whole FHA vs. conventional loan debate.

FHA stands for Federal Housing Administration, which means that FHA loans are backed by the government. Originally, they were created to help make homeownership more accessible to buyers with damaged credit or minimal savings. After the housing market crashed, they became popular across all income levels and especially with first time buyers.

Conventional loans, meanwhile, are your plain vanilla loans. They aren’t backed by the government, but they must conform to specific guidelines in order to be sold to Fannie Mae and Freddie Mac and then resold to investors—as most mortgage loans are, one way or another. They, too, are widely popular.

Both loans offer you flexibility in type (fixed rate vs adjustable rate) as well as term length (30 years is typical, though 15 years is another popular choice). There are a couple exceptions, but we’ll get to those later.

Overall, there are 7 key points of difference between conventional and FHA loans. They are down payments, private mortgage insurance, income requirements, interest rates, property qualifiers, and refinancing. If that sounds like a lot, don’t worry. For a quick overview, you can check out the chart below. Otherwise, we’ll walk through them all step by step.

FHA vs Conventional Comparison Chart

fha vs conventional comparison chart

FHA vs Conventional Credit Guidelines

Let’s start with the biggest difference between FHA loans and conventional loans: the credit score.

FHA loan credit score requirement 580FHA Credit Score Requirements

Since FHA loans were created specifically to provide an option to buyers with low and recovering credit scores, it’s no surprise that they have the lowest credit score requirements available. That makes FHA loans a great option for first time homebuyers who haven’t had the chance to build up their credit.

A credit score of 580 or over allows you to make a down payment of just 3.5%. Between 500-579, and you’ll need to put down at least 10%. Under 500, and you likely won’t be able to qualify. If you’re leaning toward an FHA home loan, it’s worth it to shoot for over 580, though.

conventional loan credit score requirement 620

Conventional Credit Score Requirements

Conventional mortgage credit scores, meanwhile, are typically required to be higher. It’s difficult to guarantee an exact number, since requirements vary from lender to lender and can also be contingent upon other financial factors.

620 is generally the lower limit of conventional credit requirements. Remember, though, that credit impacts interest rate. While you may be able to go as low as 620 if the rest of your loan application is spotless, the best possible rates are reserved for higher credit scores. If your credit score is under 680, it will probably make more sense for you to opt for an FHA mortgage loan, for reasons we’ll get into later.

Winner: both. Which is the true winner for you will depend on your credit score. 680 or over: conventional. Under 680: FHA.

Down Payment Requirements

When most people hear “large loan,” they think “large down payment.” That isn’t necessarily the case with a mortgage, though.

“The majority of clients and Realtors I speak with assume you need 10-20% down to buy a home,” said Terry Hastings, Manager of Total Mortgage’s Ridgefield branch. “Many are opting to rent because they don’t know that they could buy—and probably pay less than renting.”

In reality, you don’t even have to put down 10%. Or even 5%.

FHA Loan 3.5% Down Payment

With an FHA loan, you can put as little as 3.5% down on a house, putting the cost of buying a house more in range with the cost of a security deposit for a new rental. You just need to have a credit score of at least 580 and meet all other FHA guidelines (which we’ll get into later).

Conventional Loan 3% Down Payment

With a conventional home loan, you can go as low as 3%—something that’s actually called a conventional 97 loan. Since a conventional 97 loan is technically a different program than a standard conventional loan, it has a few extra restrictions:

  • The loan must be a 30-year fixed-rate loan
  • The property must be a one-unit, single family home, co-op, PUD, or condo.
  • The property will be the buyer’s primary residence
  • The buyer (or one of the buyers) can’t have owned a house in the last 3 years
  • The loan amount is at or under $453,100

Of course, many first-time homebuyers meet these restrictions automatically, so not all will find them an obstacle. For those that do, there’s still the option to put 5% down.

Winner:  Conventional. If you want to go low, it doesn’t get any better than 3%.

Private Mortgage Insurance for FHA and Conventional

Of course, the FHA vs conventional loan debate doesn’t end there. If you put less than 20% down using any loan except for a VA loan, that means you’ll have to get private mortgage insurance. Private mortgage insurance (or PMI) protects lenders in the event that borrowers with low equity default on their loans—and the borrower gets to pick up the tab.

Conventional Loan PMI

When it comes to conventional loans, PMI is simple: make it to 20% equity, and you’re free and clear. That can either mean putting 20% down on the house initially, or paying PMI until you hit 20% equity with your monthly mortgage payments. Your lender is legally required to drop your PMI automatically at 22%, or per your request at 20%.

FHA Loan PMI

For FHA loans, though, the story is different. You’ll have to pay PMI for the life of the loan if you initially make a down payment of less than 10%. To get out of paying PMI, you’ll have to refinance once you build enough equity.

One more downside? PMI tends to be higher for FHA loans than it is for conventional loans, since FHA have slightly more relaxed credit and debt requirements. The difference isn’t dramatic, but it’s something to keep in mind.

Winner: Conventional. Being able to get rid of PMI as soon as possible is a huge plus.

Income Requirements

Debt to income (or DTI) ratio is another factor you’re going to need to consider when choosing conventional vs FHA loans.

DTI is exactly what it sounds like—the percentage of your gross monthly income that will go toward paying off debt (this includes your new mortgage). Lenders use the following formula to work out this number, and you can too:

monthly expenses ÷ pre-tax monthly income =  DTI %

While the exact requirements can (again) vary from lender to lender, most will require a 45% or lower DTI ratio for conventional loans.

FHA Debt to Income Requirements

With FHA home loans, however, lenders will often offer a bit more flexibility if the borrower is in otherwise good shape. In some cases, you might see DTI ratios as high as 55% accepted.

“I just did a loan this summer for a buyer who had a student loan,” Hastings said. ”Even though the parent paid for the loan, the buyer’s ratios were too high for Fannie or Freddie. FHA approved the loan and without it, she would not have been able to buy a home. As it stands, her monthly payment is less than it would cost to rent.”

Winner: FHA. If you have a lot of debt, an FHA might just be your ticket to a mortgage.

Interest Rates

fha mortgage loan interest rateHere’s an interesting difference between conventional and FHA loans that you don’t hear about very often: FHA loans tend to come with lower interest rates than conventional loans.

For the most part, this due to the fact that FHA borrowers have historically been less likely to pay off their mortgage early than conventional borrowers. This makes the servicing of these loans more valuable, and incentivizes banks to offer lower rates.

However, if  FHA interest rates are the only factor that’s tipping you over the edge to an FHA, you might want to think again. The difference between the two has historically been fairly minor, and since rates vary from lender to lender anyway, the savings that come with an FHA could easily be offset by having to pay PMI for the life of the loan.

If you’re concerned with getting the lowest interest rate possible, there are other ways to get a lower rate, like opting for an adjustable rate mortgage (ARM), or paying points ahead of time.

Winner: FHA. But only by a hair.

Click here to get today’s latest mortgage rates (Jul. 16, 2018).

Property Eligibility for FHA and Conventional Loans

Just because you qualify for a mortgage doesn’t necessarily mean your future house will.

Because FHA home loans are backed by the government and meant to help families, they place more restrictions on the sort of house that qualifies.

FHA Property Guidelines

  • Must be occupied by the buyer
  • Must be your primary residence (i.e. not a vacation or investment property)
  • Must be occupied within 60 days of closing
  • Must be assessed for safety with an additional home inspection
  • Must be under the capped lending amount (this varies depending on location and property size)

Conventional Mortgage Property Qualifiers

Conventional loans have fewer restrictions. Second homes and investment properties both qualify, and you won’t need special inspections. They, too, have a capped loan amount called the conforming loan limit. The limit is $453,100 in most areas, though that number increases in high-cost areas and for multi-unit properties. If you need more financing than that, a jumbo loan is your next step.

Conventional 97 Property Qualifiers

Of course, it’s a different story if you’re planning on taking advantage of a conventional 97 loan to put just 3% down. As we outlined in our section on down payments, the requirements also dictate that:

  • The property must be a one-unit, single family home, co-op, PUD, or condo.
  • The property will be the buyer’s primary residence
  • The buyer (or one of the buyers) can’t have owned a house in the last 3 years
  • The loan amount is at or under $$453,100

Winner: Conventional. When it comes to flexibility, conventional takes it, easily.

Conventional vs FHA Refinancing

Here’s one thing you might not have considered yet: what happens if you want to refinance 5 or 10 years down the line? Luckily, with both loans you’ll be able to refinance into virtually any loan you want, changing term length, interest rate, and even taking cash out. But that’s where the two diverge.

Refinancing a Conventional Loan

For a conventional loan, this will require more or less the same process that got you the loan in the first place, though it should be much less stressful now that you’re not also trying to juggle a move. That means you’ll have to apply, provide financial documentation, get approved by an underwriter, and go through a less involved closing process.

FHA Streamline Refinance

However, if you’re refinancing from an FHA loan to another FHA loan, you do so using a special program, called FHA streamline refinance. It generally allows you to refinance with:

  • no new credit score
  • no new appraisal
  • no new income verification

As you can imagine, that cuts way down on the time and hassle involved in refinancing.

Cash-Out Refinances: Conventional vs FHA

If you’re opting for a cash-out refinance, there are a few extra things to take into consideration. Cash-out refinances allow homeowners to tap into the equity they’ve built up in their home, effectively increasing their remaining loan amount in exchange for liquid cash. This is great option for owners looking for a way to finance renovations, investments, or an education.

Conventional refinances allow homeowners to take a new loan for up to 80% of what their property is worth (this process requires a new home appraisal). Here’s an example. Let’s say your property is worth $100,000 and you have 60% equity, or $60,000 paid off. With a conventional cash-out refinance, you’ll be able to take out a refinance loan for up to $80,000, and once you pay off the remaining loan balance of $40,000, you’ll be left with $40,000 in cash and a new mortgage for $80,000.

FHA loans, meanwhile, allow for a loan-to-value ratio (or LTV) of up to 85%, giving owners the opportunity to take more out of their equity.

Winner: FHA. Simple and fast is always nice.

Which Mortgage Loan Should You Choose?

When we get down to it, neither loan is objectively better than the other.  It all ultimately depends on you, your financial situation, and your plans for the future.

Choose an FHA loan if:

  • You have lower or no credit
  • You have a lot of debt already
  • You already have an FHA loan and want to refinance
  • You don’t plan on staying in the home long enough to hit 20% equity (meaning you’ll be paying PMI either way)
  • You have a bankruptcy or foreclosure in your past

Choose a conventional loan if:

  • You have fair to excellent credit
  • You have a reasonably low DTI ratio
  • You need to be able to make the smallest possible down payment
  • You want to be able to dump PMI without having to refinance
  • You’re buying an investment property or second home

If you want a personalized loan recommendation, check out our MyMortgage Builder. By answering a few simple questions about your goals and status, you’ll receive a short list of loans that make sense for you.

 


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1 Comment

  • gagerobertsonhathaway@yahoo.com' Gage says:

    This was a great video. It was short, easy, and informative. One thing I would like to touch on is the reference to F.H.A loans having P.M.I. F.H.A loans do not have P.M.I; rather they have M.I.P (Mortgage Insurance Premium).

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