FHA vs. Conventional Loans
You have a lot of financing options available to you as a homebuyer. The trouble is most people either aren’t aware of the various loan types that exist out there or don’t know what separates one from another.
Well, we’re going to sort that out right now.
Arguably the most important loan options that prospective homebuyers should consider are conventional and government-backed loans — in particular, FHA loans.
When comparing FHA vs. conventional loans, what separates the two? And how do you know when one is a better fit than the other? Let’s break down the pros and cons of each so you can make the best financing decision for your circumstances.
Conventional loan vs. FHA: What’s the difference?
What are conventional loans?
Think of a conventional home loan as your standard mortgage. If you called up your loan officer and asked for the typical 30-year fixed rate loan, then you’d be getting a conventional mortgage. More specifically, though, conventional loans are mortgages that are not insured or backed by government agencies in any way. Private lenders and mortgage companies extend them to borrowers, using the home as collateral and charging interest in exchange for the loan.
Conventional home loans can come with a variety of lending terms:
- The aforementioned 30-year fixed rate loan
- 15-year fixed rate loan
- 5-year adjustable rate mortgage (ARM)
- 7-year ARM
- 10-year ARM
- Jumbo loan
- Interest-only mortgage
Is Fannie Mae a conventional loan?
Mortgages provided through either Fannie Mae or Freddie Mac’s lending programs are considered conventional loans. Although Fannie and Freddie are government-sponsored enterprises, they are not part of the federal government itself. Because of that distinction, Fannie Mae and Freddie Mac loans fall under the umbrella of conventional mortgages.
FHA loan meaning: What are FHA loans?
As the name suggests, an FHA loan is a mortgage that’s insured by the Federal Housing Administration. If the borrower defaults on the mortgage, the FHA agrees to repay the lender a percentage of the remaining balance on the loan.
The goal here is to increase homeownership and encourage more people to buy homes. By repaying a portion of the defaulted loan balance to the lender, the FHA reduces the amount of risk mortgage companies take on. That, in turn, encourages lenders to extend FHA loans to applicants who otherwise may not qualify for a mortgage. As such, FHA loans often feature enticing loan terms like flexible down payment options and relatively lenient eligibility requirements. Even if you are unable to secure a conventional mortgage due to credit score, income, debt-to-income (DTI) ratio or other criteria, you may be able to get an FHA loan.
Conventional vs. FHA loans
Conventional loans | FHA loans | ||
Credit score requirements | 620 or above | May be as low as 500-570 in some cases | |
Down payment options | Varies by lender, but 20% is preferred | 3.5% to 10% of sale price, depending on credit score | |
Mortgage rates | Depends on loan terms, borrower profile and market activity, but may be higher than FHA loans | Also dependent on loan terms, borrower profile and market activity, but may be lower than conventional loans | |
Mortgage insurance | Required with down payment options less than 20% of sale price, but can be removed when 20% equity is accumulated | Required with down payment options less than 20% of sale price and can never be removed | |
Loan limits | As of 2022, conforming loan limits for most of the country are $647,200. Above that is considered a jumbo loan. | Varies by county, can range from $420,680 to $970,800. | |
DTI requirements | Variable, but less than 43% is preferred | Up to 50% may be acceptable |
Do sellers prefer conventional or FHA loans?
If you have the only offer on the table, a seller probably won’t care too much what type of financing you’re using, just as long as you check all the right boxes (offer amount, earnest money, etc.). After all, once the deal goes through, why would a seller worry about the type of home loan you have?
It’s a different story if they’re weighing multiple offers, though. In that scenario, sellers will likely lean toward offers that seem like a sure thing. That can mean they’ll favor homebuyers who have more cash on hand to cover a large down payment or have fewer hoops to jump through to secure their financing. Rightly or wrongly, sellers may view FHA loans as a bigger headache to deal with or a bigger risk to take on. With that in mind, you may find that sellers prefer offers with conventional loans when there are several offers being considered.
FHA or conventional loan: Which is better?
The truth is neither loan is inherently better than the other. There are pros and cons to think about when comparing an FHA vs. conventional mortgage. It really comes down to your specific circumstances and what you need from a mortgage.
What is the downside of a conventional loan?
Looking at the table above, you probably noticed that lending requirements are much stricter for conventional mortgages. Compared with an FHA loan, you’ll likely need a higher credit score, lower DTI ratio and larger down payment to qualify for a conventional loan. Depending on your financial status, those could all be major hurdles to clear.
Another potential downside — although this is by no means set in stone — is the interest rate. With a conventional fixed rate loan, you may be looking at a slightly higher mortgage rate — again, that’s not necessarily always true. Things are even murkier when comparing adjustable rate mortgages (ARMs), because interest rates are so variable depending on the length of the loan and fixed rate term.
What is the downside of an FHA loan?
FHA loans usually have conventional mortgages beat on eligibility standards, but there are other trade offs to consider. The two biggest drawbacks: mortgage insurance and APR.
Mortgage insurance never goes away
Aside from specialized financing vehicles like VA loans, mortgage lenders will require mortgage insurance whenever a borrower puts forward less than 10% of the sale price as a down payment. If you use a conventional mortgage, regulatory requirements dictate that lenders automatically remove private mortgage insurance (PMI) once your loan balance reaches 78% of the original loan to value (LTV). That means you can say goodbye to mortgage insurance once you’ve accumulated 22% equity in the property.
But with an FHA loan, that mortgage insurance will be applied to the entire life of the loan. You could own 90% equity in your home, and you’ll still owe mortgage insurance premiums on your monthly payments. The only workaround is to refinance your mortgage into a different type of loan — like a conventional mortgage — without that requirement.
Higher APR can reflect larger monthly costs
Mortgage insurance premiums directly impact your monthly housing costs, which brings us to your annual percentage rate (APR). Your APR is often a more telling figure when determining the total cost of your mortgage because it accounts for additional fees beyond the principal and interest. These costs include origination fees, closing costs, money spent on discount points and, most notably, mortgage insurance.
Take a look at one of our daily mortgage updates, and you may see that even when FHA loans have lower interest rates than conventional mortgages, they often have higher APRs. That’s because published mortgage rates typically assume that the buyer has 20% equity in the home, which means no mortgage insurance on conventional loans.
But APRs on FHA loans always need to build in mortgage insurance premiums, leading to higher rates and additional monthly costs.
When should you pick an FHA loan vs. conventional loan?
FHA loans can be great financing options if you’re not confident you’ll be able to meet your lender’s qualifications on a standard mortgage. That may be because you’re carrying a lot of debt, you need more time to improve your credit score or you’re unable to afford a large down payment. These are all perfectly understandable financial situations to be in, by the way. Saving up tens of thousands of dollars to pay for a 20% down payment can be, frankly, unfeasible for many prospective homebuyers. That’s why the FHA loan program exists: to boost homeownership in this country.
That being said, if you’re on strong financial footing and you can afford to make a dent on your purchase with a down payment (doesn’t have to be 20% — many lenders have flexible down payment options), a conventional home loan may be a better fit. You won’t be tethered to mortgage insurance that runs the entire length of the loan, for one. And you’ll have fewer parties involved in the mortgage process, which could speed things along so you can close on your new home more quickly.
In conclusion
FHA loans and conventional mortgages both have plenty to offer potential homebuyers. With their more lenient lending qualifications, FHA mortgages may be more appealing to first-time homebuyers and anyone trying to dig out of debt or turn their financial prospects around.
On the other hand, conventional mortgages are basically the default financing option for many, if not most, borrowers. You’ll work directly with your lender and don’t need to worry about third-party agencies or organizations making additional requests. And with today’s streamlined digital mortgage platforms, going from pre-approval to closing is a pretty straightforward process. You’ll be picking up the keys to your new home before you know it.