When you wade into the homebuying pool, it can be tricky to decide which type of mortgage loan is best for you.
Two of the most popular loan options are conventional and FHA loans, and they both offer big advantages to homebuyers — depending on your finances.
While it’s easy to fall into black-and-white thinking — “conventional loans are good, FHA loans are bad” — think of it as the question: which one makes the most sense for you?
What’s the Difference Between FHA and Conventional Loans?
FHA loans defined
FHA loans are government-backed loans insured by the Federal Housing Administration (FHA), a division of the U.S. Department of Housing and Urban Development (HUD). The FHA created this loan program to help those who didn’t meet traditional lending criteria become homeowners.
The government backing reduces the risk for lenders and encourages flexibility in approving borrowers with lower credit scores and down payments. That’s why it’s possible to qualify for an FHA loan with a 580 credit score and a 3.5% down payment.
The home must also be your primary residence. You cannot buy a vacation home or investment property with an FHA loan. However, you can buy a multifamily home with an FHA loan (up to four units), live in one unit, and rent out the others for income.
So that’s FHA. But what is a conventional home loan?
Conventional loans are the most common mortgages. They’re not insured by the government, but rather by the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. You may have heard the terms “conventional loans” and “conforming loans” used interchangeably, but there’s an important difference.
Conventional loans refer broadly to non-government-backed loans, and there are several different types of conventional loans. What most people probably mean when they refer to conventional loans is conforming loans.
A conforming loan meets Fannie Mae and Freddie Mac borrower guidelines and loan limits. Conforming loan limits are updated each year based on housing prices in a given area. A loan limit represents the maximum amount a lender can approve on a conforming loan. But we’ll explain more further down.
Generally speaking, you’ll need a credit score of at least 620 to qualify for a conventional loan and a debt-to-income ratio of 45% or less. Unlike FHA loans, conventional loans may be used for primary residences, vacation properties or second homes, and investment properties. That gives you more flexibility in how you use the home.
FHA loan vs. conventional loan eligibility
One way to figure out if an FHA or conventional loan is better for you is to compare the eligibility requirements.
|Credit Score||580 with a 3.5% down payment Borrowers with scores between 500 to 579 must put at least 10% down||620|
|Minimum down Payment||3.5%||3%|
|Debt-to-Income (DTI) Ratio||50% or less, though some lenders will approve higher DTIs||43% or less|
|Property Requirements||Primary residence only||Can be a primary residence, second home, or investment property|
It’s important to note, though, that these are just guidelines. Lenders often set their own standards, and some are able to offer more flexibility than others. The best way to find out what loan types you qualify for is to get preapproved. Then you’ll know which loan types are on the table for you and how much you can likely borrow.
FHA vs. Conventional Loan Cost
When considering conventional loans vs. FHA loans, you want to make sure you understand each loan’s requirements. Knowing how different factors affect your total loan costs can help clarify your choice.
One of the major differences between FHA and conventional loans is the minimum credit score requirement. Why? Credit score indicates how much risk your lender will take on when it comes to your ability to repay. Higher credit scores indicate a history of on-time payments and good credit management, which signals lower risk.
The minimum credit score to qualify for an FHA loan with a 3.5% down payment is 580. You’ll need a score of 620 or higher to qualify for a conventional loan.
|Here’s a tip, though: If your credit score is 680 or less, you may want to opt for an FHA loan even if you can get a conventional mortgage. Why? Because Fannie Mae and Freddie Mac add loan level price adjustments (LLPAs), which increase interest rates for borrowers with scores below 680. You could end up paying significantly more interest on the loan because of the LLPAs. Plus, mortgage insurance will likely be more expensive for conventional with a lower score. It’s important to get a side-by-side comparison if you’re eligible for both loan programs.|
Below is an example comparison for two applicants, one with a 640 score and one with 740.
|Borrower 1: 640 score||Borrower 1: 640 score||Borrower 2: 740 score||Borrower 2: 740 score|
|Principal & interest payment*||$1,183||$1,327||$1,164||$1,247|
|Taxes & insurance*||$300||$300||$300||$300|
For FHA or conventional loans, the higher your credit score, the better your chances of qualifying and receiving a competitive interest rate.
FHA and conventional loans also diverge when it comes to down payment amounts and rules.
FHA loans require a minimum 3.5% down payment, while conventional loans require at least 3%. You might think conventional loans have the edge in this area, but consider this.
The FHA allows borrowers to use gift funds to cover their entire down payment and closing cost amounts. That means you could buy a house with no money out of pocket if you have a relative or friend who wants to give you a financial gift.
Depending on the type of conventional loan you’re using, gift funds may not be an option or you may still have to contribute some of the costs.
Something else to account for when comparing these loans is mortgage insurance. We’ll cover mortgage insurance in depth in just a minute, but with a conventional loan, you only need private mortgage insurance (PMI) if you put down less than 20%.
If you can put down a traditional 20% down payment, you avoid mortgage insurance altogether. But even if you put down a smaller amount, the PMI requirement ends once you reach 20% equity in the home.
FHA loans, on the other hand, require an upfront and annual FHA mortgage insurance premium (MIP). If you put down less than 10%, which most FHA borrowers do, you’ll owe the annual MIP for the life of the loan. Put down more than 10% and you’ll only pay the annual MIP for the first 11 years of the loan.
Another big consideration in the conventional home loan vs. FHA comparison is that they have different debt-to-income ratio (DTI) requirements. Your DTI is calculated by dividing your total monthly debts (such as credit card payments, student loans, and car loan payments) by your gross monthly income (income before taxes and deductions).
The higher your DTI, the more risk a lender sees, since so much of your income is allotted to debts. Low DTIs can indicate less risk, and therefore increase your borrowing power and can put you in the range of a more competitive interest rate.
FHA loans typically require a DTI of 50% or less, though some mortgage lenders will approve borrowers with higher ratios. For a conventional loan, you’ll likely need a DTI of 45% or less.
As we discussed above, both loan types have the possibility of a mortgage insurance requirement.
FHA mortgage insurance premium (MIP)
All FHA loans are subject to an upfront mortgage insurance premium of 1.75%. The annual MIP rate depends on your down payment, but most FHA borrowers opt for the 3.5% down option with annual MIP of 0.85%.
The annual MIP is broken down into monthly payments that are included in your mortgage payment. The upfront MIP can be paid at closing or rolled into your mortgage.
If you put 10% or more down on your FHA loan, your MIP requirement ends after 11 years. However, putting down less than 10% means having monthly MIP payments as long as the home loan exists. The only way to remove your MIP in this case is to refinance your FHA loan to a conventional loan when you reach 20% home equity.
Conventional private mortgage insurance (PMI)
If you put down less than 20% on a conventional loan, you will have to pay private mortgage insurance (PMI), but only until you hit that 20% mark. Once that happens, you can request that the PMI be removed from your loan; lenders won’t remove it automatically until you have 22% equity.
Your down payment and mortgage insurance costs are closely linked, since the more you put down, the less you’ll pay in PMI or MIP over time.
You can also get a better mortgage insurance rate with a lower loan-to-value ratio (LTV) — that just means how much you still owe on the home. So if you buy a home with 3% down, your LTV is 97%.
Putting even a little more money down can help you save. In the chart below, you’ll see that bumping up your down payment from 3% to 5% on a conventional loan could mean $80 a month in savings. And with the FHA option, the monthly mortgage insurance payment in this case works out to be even less, making the overall mortgage payment lower.
FHA vs conventional 3% down vs conventional 5% down on a $250,000 home
|FHA 3.5% down||Conventional 3% down||Conventional 5% down|
|Monthly mortgage insurance||$174||$240||$181|
|Final loan amount||$245,472||$242,500||$237,500|
|Final monthly payment||$1,486||$1,539||$1,459|
FHA guidelines require that the home must be your primary residence, though you can buy a house, townhouse, multifamily home, condo, or manufactured home. Conventional loans, on the other hand, may be used to buy primary homes, second or vacation homes, and investment properties.
The FHA also has strict property and appraisal requirements, and an FHA appraiser will need to view the house before the loan can close. Lenders cannot approve an FHA loan for more than the home’s appraised value, and the appraiser may note areas of the home that must be fixed before the sale can go ahead.
For this reason, some sellers do not want to accept offers with FHA loans. They worry that if the property does not pass the appraisal, they will be responsible for making repairs before they can sell the home. But while FHA appraisal requirements are stricter than other loan types, most houses will pass just fine. The appraiser is looking for overall safety and livability to ensure that the property is suitable to live in. And if you have enough savings, you can make up the difference between the appraisal and sale price with a larger down payment, if the appraisal comes in lower.
FHA and conventional loans both have loan limits on the amount of money a lender can approve for a borrower. Loan limits change annually, and your limit will depend on where you live, since they’re set based on the median area housing price in a given county.
In 2021, the FHA loan limit for a single-family residence is $356,362 for lower-cost areas and $822,375 for high-cost areas. Loan limits increase based on the number of units in the home.
The conforming loan limits for a single family home are $548,250 in most areas, but up to $822,375 in high-cost areas. If you want to buy a home above that amount, you’ll need to explore jumbo loans. These accommodate high-value properties but are only offered by certain lenders and are not insured by a government agency, Fannie Mae, or Freddie Mac. Jumbo loans often require higher credit scores and down payments, though guidelines vary by lender.
Although FHA and conventional loans have the same limit in high-cost areas, their differences in low-cost areas can make a big difference in the type of home you can buy, depending on which loan program you choose.
OK, but I still want to know. FHA or conventional loan: which is better?
Choosing between an FHA or conventional loan may seem overwhelming when you’re comparing loan features and eligibility criteria. That’s why the best way to move forward is to get preapproved by a lender.
A preapproval tells you not only how much you can borrow, but which loan programs you qualify for. If it turns out you’re eligible for both, ask your lender to walk you through the pros and cons based on your financial situation and homebuying goals.
A good rule of thumb is to go with a conventional loan if you have high credit and at least 5% down. But you still might do better with FHA, so don’t disregard it automatically.
If you’re a homebuyer with excellent credit, a low DTI ratio, and plenty of savings for a down payment, conventional may be the best option, especially if you qualify for a competitive interest rate and can avoid or limit your PMI.
FHA may be the right track if your credit score is low or DTI is on the high end, or you plan to use gift money to cover all of your upfront mortgage costs.
Ultimately, FHA and conventional loans are both great programs. So again, it’s not so much about which is better, but about which is best for you and which one will help you buy your home sooner.
Conventional loans vs. FHA FAQs
It depends on your homebuying goals and financial situation. Homebuyers with high credit scores may benefit from a conventional loan because they may receive low rates and non-permanent mortgage insurance.
FHA loans can be great options for borrowers who have the income to afford a home but have lower credit scores or a high DTI. An FHA loan can provide an affordable path to homeownership even for folks whose credit has taken a hit in the past.
FHA loans are backed by the federal government, which means they can offer more flexibility in borrower qualifications. It can be easier to qualify for an FHA loan because the minimum credit score requirement is 580 to buy with a 3.5% down payment. FHA lenders can also sometimes approve borrowers with debt-to-income ratios above 50%.
Conventional loans are insured not by the federal government, but by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. The minimum credit score requirement is 620, and the maximum debt-to-income ratio is typically 45%.
Not all sellers prefer conventional, but if they’re looking to sell quickly, they may look more favorably on conventional offers because of the FHA’s appraisal requirements. The FHA requires that an FHA-approved appraiser inspect the property and determine its value. If the property doesn’t meet FHA property standards, they could require repairs to be made before the loan can close. Additionally, lenders cannot approve loans for more than the home’s appraised value. Additionally, some sellers view FHA buyers as less qualified, which isn’t the case if the buyer has a preapproval. A conventional preapproval is the same as an FHA one: both state that the buyer can finance the home.
The right loan for you
Although there’s a lot to think about when considering conventional loans vs. FHA, remember that the goal is always to find the best loan type for your specific financial situation and homebuying experience.
Learning about FHA and conventional loans is helping you and your family make an informed decision about what fits you best when it comes to their eligibility requirements, terms, and flexibility.
Start with your goals and finances — and get preapproved — and you’ll find the right loan for you.
Fairway is not affiliated with any government agencies. These materials are not from HUD or FHA, and were not approved by a government agency.