Advantages and Disadvantages: Conventional vs. FHA Loans
Conventional and FHA Loans Both Have Pros and Cons for Home Buyers
Ready to buy a home? One of the first things to consider is what type of mortgage you need. Conventional loans and FHA loans are two popular options for first-time and repeat home buyers, or for current homeowners who want to refinance their mortgage.
The main distinction between the two is that FHA loans are backed by the full faith and credit of the U.S. government, while conventional loans are not. The differences don't end there, however. Choosing the right mortgage matters because the path you follow can ultimately influence the cost of owning your home over the long-term.
As you being your home buying journey, here are the most important things to weigh when comparing conventional vs. FHA loans.
Conventional vs. FHA Loans: Down Payment Requirements
FHA loans have long been touted as the go-to option for home buyers who don't have a significant amount of cash for a down payment. It's possible to buy a home with as little as 3.5 percent of the purchase price down through the FHA loan program.
Traditionally, a 20 percent down payment has been the standard for conventional loans. But, it's now possible to get a mortgage through Fannie Mae or Freddie Mac with a down payment of 3 percent. That could make a conventional loan slightly more attractive for qualified buyers.
Private Mortgage Insurance
Private mortgage insurance or PMI applies when you put less than 20 percent down on a home using a conventional loan. PMI is an insurance policy for the lender that allows them to recoup any financial losses if you default on your mortgage. FHA loans also carry private mortgage insurance, but it goes by a different name: mortgage insurance premiums (MIP).
Conventional vs. FHA loans diverge in how these premiums are calculated and applied. With an FHA loan, you have both an upfront premium and a monthly premium. The upfront premium can be rolled into your mortgage or paid at closing; the monthly premium is included as part of your mortgage payment.
With a conventional mortgage, you typically only pay a monthly or single premium for PMI. Your PMI rates are determined by the size of your down payment and your credit score. An FHA loan uses a one-size-fits-all premium rate calculation.
Where conventional vs. FHA loans have the advantage is that PMI ends automatically once you achieve a 78 percent loan-to-value ratio. (Technically, you can ask your lender to remove it once you reach 80 percent LTV.) With an FHA loan, the mortgage insurance premium stays in effect for life. The only way to remove it is to refinance to a conventional loan with a 20 percent down payment.
Conventional vs. FHA Loan Limits
How much you can borrow matters when you're comparing conventional vs. FHA loans. FHA loan limits are determined based on where you plan to buy and the median home prices in that area. Conventional loans typically adhere to the same limit, regardless of the market you're buying in. For 2018, most buyers are subjected to a limit of $453,100 for a conventional loan.
Conventional and FHA loans also differ in the types of property you can use them for. A conventional loan, for instance, could be used to buy a primary residence, vacation home or rental property. If you're applying for an FHA loan, it's assumed that you'll be living in that home full-time. Homes purchased through the FHA loan program also have to meet stricter appraisal standards to qualify for a mortgage. In that sense, a conventional loan can have fewer obstacles to buying.
Qualifying for Conventional vs. FHA Loans
Conventional and FHA loans use different standards for borrower approval. From a credit scoring perspective, FHA loans are easier to qualify for. As of 2018, the minimum credit score you need to qualify for an FHA loan with a 3.5 percent down payment is 580. It's possible to get an FHA loan with a credit score below that cutoff, but you'll need to bump up your down payment to 10 percent of the purchase price.
Conventional loans raise the bar on credit standards. A score of 620 or better is generally recommended to get approved for a conventional mortgage but individual banks can require an even higher score. Borrowers for both types of loans will also look at your income and how much of that goes to debt repayment each month. With an FHA loan, you may be able to get approved with a higher debt-to-income ratio but conventional mortgages typically cap the acceptable DTI at 43 percent.
Your credit score and DTI matter for approval because they influence the interest rate you'll pay on your loan. Generally, FHA loans tend to offer better rates for borrowers than conventional loans. A lower rate means less your mortgage costs overall, which is especially important when interest rates rise.
Which Type of Mortgage Loan Is Right for You?
Both FHA and conventional loans can offer low down payments but FHA loans can be beneficial for borrowers who may have a lower credit score. The downside is that you won't be able to eliminate private mortgage insurance with an FHA loan unless you refinance. Calculating the upfront and overall cost of buying with a conventional vs. FHA loan can help you decide which one is the best fit for your home buying situation.