FHA vs. Conventional Loan: Everything You Need to Know

October 20th, 2023  / Author: Zachariah Peterson
Essential Guides

A home is typically the most significant investment a person makes in their life, and the majority of people require a loan to finance the purchase. The type of mortgage you get impacts your interest rate, conditions, qualification requirements, and, finally, the kind of home you can afford.

Usually, FHA and conventional loans are two of the most commonly used types of loans. But what's the difference between an FHA vs. a conventional loan? This article uncovers the intricacies of these two types of mortgages so you can determine which one is the option that meets your requirements and circumstances.

What Is an FHA Loan?

Federal Housing Administration (FHA) loans are guaranteed by the United States government and made available by FHA-approved lenders such as banks, credit unions, and other lending institutions. FHA loans are intended for borrowers who have limited available funds or a low credit score. There are also particular FHA loan categories that can be used to fund future construction or the renovation of a current home.

Since FHA loans are federally insured, they can offer more favorable conditions, such as lower interest rates, to borrowers who wouldn't be able to get a home loan in any other way. This means that it is easier to qualify for an FHA loan in comparison to a conventional loan.

Some of the advantages of FHA loans are decreased down payments, easier lending requirements, and reduced interest rates. The disadvantages of FHA loans are that mortgage insurance is required, it is used only for primary residences, and it has limited loan amounts.

What Is a Conventional Loan?

Conventional loans are mortgages that are not guaranteed by the United States government. Typically, conventional mortgages are available to borrowers with established, excellent credit standing and stable finances.

Private mortgage lenders, including banks, credit unions, and other financial organizations, are financing conventional loans. Because the federal government does not guarantee conventional loans, they present a higher risk to lenders, and that's why they offer conventional mortgages only to clients with the best financial profiles.

The down payment, the user's preferred mortgage type, and the state of the market all affect the interest rate on a conventional loan. A large percentage of conventional loans have fixed interest rates, which implies that they remain constant during the loan.

Conventional loan advantages are that mortgage insurance is based on equity, it is not just for primary residences, and there is the possibility of lending more.

The disadvantages of conventional loans are stricter lending criteria, the fact that you must have a higher credit score to qualify, and a lower debt-to-income ratio is required.

Moreover, conventional loans are classified into two types: conforming and non-conforming.

How to Qualify for FHA vs. Conventional Loan

Debt-to-Income Ratios

Your debt-to-income (DTI) ratio is the percentage of your monthly pre-tax income that you spend on debt repayment, which includes your mortgage. The higher your DTI, the more probable it is that you will have difficulty paying your expenses.

To qualify for an FHA loan, your debt-to-income ratio must be 50% or less. Conventional loans, in some cases, allow debt-to-income ratios of up to 50%, but DTIs of 43% or less are more likely to be approved.

Credit Scores

FHA loans are typically easier to qualify for, requiring only a credit score of 580. On the other hand, a credit score of 620 or higher is usually required for conventional loans.

The lender will determine the credit score required for either type of loan. Even though the FHA sets minimum scores, lenders may require a higher minimum. Note that with a higher credit score, you'll be offered a lower interest rate on both conventional and FHA loans.

Mortgage Insurance

Mortgage insurance may be required based on the conditions of your loan and the size of your down payment. Mortgage insurance, unlike other types of insurance, doesn't protect you. It secures the lender in case you are unable to make payments.

Despite the amount of the down payment, FHA loan borrowers must pay the required mortgage insurance premiums. In addition, if you put down less than 20% on a conventional loan, you must pay private mortgage insurance.

Minimum Down Payments

If your credit score is 580 or higher, FHA loans require a 3.5% down payment. Those with scores between 500 and 579, however, must pay 10%. Only a primary house may be purchased using an FHA loan.

Loan Limitations

You can only borrow a certain amount with conventional and FHA loans, and county-specific maximum loan amounts apply. Loan limits are adjusted on an annual basis.

What Is the Difference Between an FHA vs. Conventional Loan?

Here are some key differences to take into account when looking for a mortgage for your next home. Keep in mind that both types of loans have benefits, but qualification criteria vary.

In general, FHA loans are easier to qualify for and allow for lower credit scores than conventional loans, but conventional loans are typically less expensive.

The government does not insure or guarantee conventional loans. Because of that, these loans have stricter lending criteria and require a higher down payment than FHA loans. In comparison to conventional loans, FHA loans are easier to get. A conventional loan requires a higher credit score, a lower debt-to-income ratio, and a higher down payment.

On the other hand, it's important to know - FHA loans can only finance a primary residence, while conventional loans can finance a primary residence, a vacation home, rental property, etc.

So, it all depends on the circumstances. Every lender is different, as is every financial situation. Accordingly, each loan has advantages. FHA loans are easier to apply for, but if you meet the criteria for a conventional loan, it will probably be more cost-effective.

Why Do Sellers Favor Conventional Loans over FHA Loans?

Homebuyers who obtain conventional financing are viewed as more secure by some sellers than borrowers who qualify for an FHA loan. This is because some may regard FHA loans as a last resort for lenders who are unable to qualify for another loan. In reality, getting an FHA loan may make more financial sense than getting a conventional loan, although the borrower qualifies for both.

It All Comes Down to Your Financial Situation

You can finance home purchases with FHA loans and conventional loans, but there are differences between them. In the end, your financial situation will probably determine whether you choose an FHA loan or a conventional loan.

If you have a relatively low credit score or less money saved for a deposit, an FHA loan may be a wiser choice. A conventional loan, on the other hand, might be more suitable if your funds are in order and you can meet the criteria for desirable loan terms.

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