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Overall, FHA loans tend to be more expensive than conventional loans due to fees and other costs, but they are still a good option for borrowers with less than perfect credit.
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Conventional loans are the most popular type of mortgage product and for good reason. These types of loans allow you to buy a home with just 3% down, which makes them an attractive option for many homebuyers. But while conventional loans are good for some homebuyers, it’s important to ask yourself whether conventional loans the right choice for you, or if you be better served by a government-backed FHA loan.
It’s important to understand the difference between conventional vs. FHA loans so you can find the best mortgage for your financial situation. Understanding your options will help you save the most money during your home purchase.
Defining FHA and conventional loans
FHA loans are government-insured mortgages designed to help borrowers with low-to-moderate incomes afford homes. They have flexible debt-to-income and credit score requirements, which means they’re a good option for homebuyers who have bad credit or large debt loads.
However, if you’re looking to purchase a fixer-upper or second home, an FHA loan may not work for you. To qualify for financing, homes need to meet strict health and safety standards. If the property you want to buy is in rough shape, it may not pass inspection.
FHA loans can also only be used to purchase primary residences, so if you’re looking to buy an investment property or vacation home, a conventional loan may be the better choice.
Conventional mortgages aren’t insured by the Federal Housing Administration, so your lender won’t get money from the government if you default. This makes conventional loans riskier than FHA loans for lenders, which is why they have stricter requirements. To qualify, you’ll need a credit score of at least 620 and a debt-to-income ratio of 43% or less. But if you have strong enough finances to get approved, conventional loans are a great option because they tend to be cheaper than FHA loans.
Tip: If you put down 10% or more, you may only need a 500 credit score to get approved for an FHA loan. Otherwise, you’ll need a credit score of 580 or higher, but it will depend on your lender requirements.
Comparing FHA and conventional loans
Having trouble deciding which type of loan is right for you? Here are some factors you should consider when comparing FHA vs. conventional loans.
Mortgage insurance
FHA loans require upfront mortgage insurance, which costs 1.75% of the total loan amount. You’ll also have to pay an annual mortgage insurance premium (broken up into monthly payments), and the total amount will depend on the base loan amount, LTV ratio and mortgage term.
Conventional loans, on the other hand, don’t require extra mortgage insurance if you put 20% or more down. The cost of your annual premium depends on your credit score and down payment amount, but in general, premiums cost between 0.5% and 1% of your loan amount. If you have good credit and can get a low rate, you may pay less mortgage insurance on a conventional loan vs. FHA.
Closing costs
FHA loans tend to have higher closing costs than conventional loans, but because FHA loans allow the seller to pay for more of your closing costs than conventional loans, they may actually be cheaper. Conventional loans only allow outside parties to contribute 3% of your closing costs if you’re making a down payment of 10% or less. FHA loans, on the other hand, allow the seller to pay for 6% of your closing costs regardless of your down payment amount, so they may be better for buyers with low cash reserves.
Down payment
FHA loans require a minimum down payment of 3.5%. Conventional loans allow you to put as little as 3% down, which makes them a better option for buyers with minimal savings. However, you’ll need good credit to be able to qualify for low down payment mortgages.
FHA vs. conventional loans: pros and cons
FHA loans come with more lenient credit score and DTI requirements than conventional mortgages, making them easier to qualify for. You may be able to get approved for an FHA loan with a credit score as low as 500 and a debt-to-income ratio as high as 50%. Most conventional loans require a credit score of 620 and a DTI of 43% or less, so they may be out of reach for borrowers with bad credit.
Another advantage of FHA loans is that they tend to have lower interest rates than conventional mortgage rates. They also come with higher closing costs, though, as well as higher down payment requirements and non-cancellable mortgage insurance, so they may be more expensive than conventional loans in the long run.
Borrowers pay an average of $7,402 in closing costs when taking out FHA loans. If you get a conventional mortgage, you’ll only pay, on average, about $3,745 in closing costs. FHA loans also have higher down payment requirements. You may be able to put as little as 3% down on your conventional loan depending on the lender, whereas FHA loans require a down payment of at least 3.5%.
Another drawback of FHA loans is that mortgage insurance is more difficult to cancel. If you put less than 10% down, you’ll have to pay mortgage insurance for the life of your loan in most cases. If you make a down payment of 10% or more, you’ll still be required to pay mortgage insurance for 11 years.
Conventional loans only require private mortgage insurance if you put less than 20% down, and you can cancel it as soon as you have 22% equity in your home.
The final word
When thinking about an FHA vs. conventional loan, it all comes down to your personal circ*mstances. FHA loans have lower credit score requirements than conventional loans, which makes them a good option for borrowers with bad credit. But if you have good credit and can qualify for conventional loans, they may be the better choice because they tend to be cheaper.
