If you’re a first-time homebuyer, you may be wondering whether an FHA or conventional loan is the right choice for you. The loan that is best for you ultimately depends on your financial situation and the type of home you are hoping to buy.
Understanding the difference between these two types of loans can make it easier to determine which is the right fit for you. This article will explain what FHA and conventional loans are, the difference between the two, and what the pros and cons are of each.
What is an FHA Loan?
An FHA loan is a government-backed loan for first-time homebuyers. The Federal Housing Administration backs the loan but the loan itself is given by an approved mortgage lender.
FHA loans typically have lower credit and down payment requirements. They are available in fixed-rate terms for 15 or 30 years. Here is a brief list of the requirements to qualify for an FHA loan:
- A minimum FICO score of at least 500
- Mortgage insurance is required
- Borrower’s debt-to-income ratio must be lower than 43%
- The property must be the borrower’s primary residence
- The borrower must be able to provide proof of employment
What is a Conventional Loan?
A conventional loan is any loan that isn’t backed by a government agency such as the FHA or the Veterans Administration (VA). Conventional loans are offered through a private lender and account for roughly two-thirds of the mortgages taken out in the U.S.
Here are the requirements to qualify for a conventional mortgage:
- Fill out your mortgage application
- Provide any necessary documentation
- Have a credit report run
- Provide proof of employment
Conforming vs Non-Conforming Loans
There are two different types of conventional loans you can apply for:
- Conforming loans: These loans have terms and conditions that comply with the guidelines set by Fannie Mae and Freddie Mac. However, individual lenders can set stricter requirements if they choose. To qualify for a conforming loan, you must be able to meet the following guidelines:
- Credit score
- Down payment
- Debt-to-income ratio
- Loan limit
- Non-conforming loans: A non-conforming loan is above the maximum loan amount set by Fannie Mae and Freddie Mac. These are also referred to as jumbo loans. Non-conforming loans tend to have higher interest rates and are less common than conforming loans.
What is the Difference Between a Conventional and FHA Loan?
The main difference between the two loans is that FHA loans tend to be easier to qualify for. Conventional loans will require a higher credit score and a larger down payment.
But this doesn’t necessarily mean than an FHA loan is always the best choice. If you choose an FHA loan, you will have more provisions to deal with. Listed below is a more detailed explanation of how the two loans match up.
Credit Scores
- FHA loans: If you have a minimum credit score of 500, you can qualify for an FHA loan with a 10% down payment. Borrowers with a minimum credit score of 580 can qualify with a 3.5% down payment.
- Conventional loans: Conventional loans typically require a minimum credit score of 620. But this can vary depending on the lender.
Down Payment
- FHA loans: FHA loans require a minimum down payment of either 3.5% or 10%, depending on the borrower’s credit score. And with an FHA loan, 100% of the down payment can be a gift from someone else.
- Conventional loans: It is possible to find a conventional loan that will accept a down payment as low as 3%. However, you’ll need to have a very good credit score to qualify for this. Conventional loans allow a portion of the down payment to be a gift.
Borrowing Limits
- FHA loans: The borrowing limit on FHA loans varies depending on the county you live in. However, the new loan limitsdid take effect on January 1, 2021. For high-income areas, the borrowing limit is $822,375. The lowest borrowing limit is $356,362.
- Conventional loans: For conforming loans, the borrowing limit also depends on where you live. Fannie Mae updated the 2021 guidelines and the loan limits increased across all but 47 counties in the U.S.
For a one-unit home, the borrowing limit is $548,250. For a one-unit home in a high-cost area, the limit is $822,375.
Debt-to-Income Ratio
- FHA loans: For 2021, a borrower’s debt-to-income ratio must be below 43%. Their total housing debt can’t exceed 31%. However, some borrowers are granted an exception so don’t get discouraged if you fall short on this guideline.
- Conventional loans: The maximum debt-to-income ratio will depend on the lender you work with. But some lenders will allow debt-to-income ratios between 40% and 50%.
Eligible Properties
- FHA loans: Single-family homes, approved condos or townhomes, detached and semi-detached homes, and manufactured homes are all eligible for FHA loans. An FHA loan cannot be used to purchase a rental property or vacation home. The house must be used as your primary residence.
- Conventional loans: Single-family homes, condos and townhomes, detached and semi-detached homes, and home in need of serious upgrades are all eligible for conventional loans. Conventional loans can be used to purchase your primary residence, a rental property, or a vacation home.
Mortgage Insurance
- FHA loans: You will have to take out mortgage insurance with an FHA loan. And if your down payment is lower than 10%, you’ll have to keep it for the life of the loan. However, if you choose to refinance to a conventional loan at a later date, you can ditch the mortgage insurance.
- Conventional loans: No mortgage insurance is required if you provide a 20% down payment. If your down payment is less than that, you’ll have to take out mortgage insurance. But your mortgage insurance is canceled once you reached 80% equity in your home.
Refinancing
- FHA loans: As long as you meet the lender’s requirements, you can refinance your FHA loan down the road. And it may be easier to refinance an FHA loan thanks to a program known as streamline refinance.
This program is offered by the Department of Housing and Urban Development. It allows you to refinance your existing FHA loan but avoid the home appraisal process.
It also requires less documentation and underwriting. To qualify, you must be current on your mortgage payments.
- Conventional loans: You can refinance a conventional loan as long as you meet your lender’s requirements. Borrowers who took out a loan from Fannie Mae or Freddie Mac are also eligible for the Home Affordable Refinance Program (HARP).
This program allows all borrowers to refinance their home, regardless of how much equity you have in your house. This is available for borrowers who took out a loan on or before May 31, 2009 and are current on their monthly payments.
Are FHA Loans Better than Conventional Loans?
If you’re still unsure whether an FHA loan or conventional loan is the right choice for you, here are some of the pros and cons of each.
Advantages of FHA Loans
- These loans are easier to qualify for
- Better for borrowers with low credit scores
- Low down payment requirements
- Comes with better refinancing options
Disadvantages of FHA Loans
- Requires mortgage insurance
- If your down payment is less than 10%, the mortgage insurance is required for the life of the loan
- Puts limits on certain types of properties
- May come with high interest rates
- It usually takes longer to process FHA loans
Advantages of Conventional Loans
- Offers higher borrowing limits than FHA loans
- Mortgage insurance isn’t required with a 20% down payment
- You can take out loans for investment properties
- Some loans accept down payments as low as 3%
Disadvantages of Conventional Loans
- To apply, borrowers need at least a 620 credit score
- It may be harder for low-income borrowers to qualify
- A higher down payment is required to avoid mortgage insurance
How to Decide Between the Two
If you’re a low-income borrower or have a low credit score, then an FHA loan may be the right choice for you. Just make sure you can afford the mortgage insurance and monthly mortgage payments.
If you have a credit score of 620 or higher and can afford a bigger down payment, a conventional mortgage is probably the best option for you. And if your credit score is 720 or higher, you’ll likely find that conventional mortgages are the more affordable option.
The best place to start is by talking to a mortgage broker and having them walk you through your options. Or if you’re interested in learning more, you can check out the following resources:
Source: crediful.com