FHA vs. Conventional Loan: What’s the Difference?

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Creditworthiness requirements

Traditional loans require a minimum FICO® Score of 620 according to the latest Fannie Mae Eligibility Matrix. This is generally considered a fair to good credit rating. Lenders can set their own minimum amounts, but 620 is the minimum.

Also, not all borrowers qualify for a conventional 620 credit rating. Suppose you have a debt-to-income ratio of between 36% and 45% (your monthly debt payments are roughly one-third to one-half of your monthly income). You want a deposit of less than 25%. To do this, you need a score of at least 720. The minimum creditworthiness requirements for conventional loans can be between 640 and 700, depending on the loan details.

On the other hand,FHA loan requirements are straightforward. With a minimum deposit, which we’ll cover in the next section, you’ll need a credit score of 580 or greater. With a down payment of 10% or more, you can get an FHA loan with a credit score of only 500.

Deposit requirements

The down payment for a conventional loan depends on the lender, the type of property and the qualifications of the borrower.

There are conventional mortgage loans with a down payment of only 3%. To qualify, a borrower must have strong credit ratings and other factors. Traditional minimum loan deposit requirements range from 3% up to 25%, depending on the situation. Part of your down payment can come from a down payment gift (and in certain circumstances all of your down payment can come from a gift).

On the other hand, FHA loan down payment requirements depend on the creditworthiness of the borrower. If the borrower has 580 or higher, a minimum 3.5% deposit is required. With a score in the range of 500 to 579, the borrower needs at least 10% less. One hundred percent of your down payment can come from a down payment gift.

interest charges

Interest rates vary depending on the qualifications of the borrower, but this is more of a factor with conventional loans. Borrowers with excellent credit ratings can get conventional mortgage rates well below the market average. Unfortunately, borrowers with mediocre credit often have to pay significantly more.

As of this writing, the national average for a conventional 30 year fixed-rate mortgage is around 2.8%. If you have an excellent credit rating (760 to 850), the average interest rate is only 2.42%. However, if you have the minimum FICO® Score of 620 required for a traditional loan, you can expect a rate of around 4.0%.

When you calculate your monthly payment, the interest rate can make a huge difference. Also, these prices change over time. Before you start budgeting, compare current mortgage rates.

Interest rates can vary somewhat on FHA loans. In general, all FHA borrowers receive FHA mortgage rates close to the national average – even with marginal credit. Higher interest rates are intended to compensate mortgage lenders for bad credit borrowers and the associated additional risk of default. However, because the government guarantees all FHA loans, there is no additional risk associated with low credit borrowers.

Used

Both FHA and conventional loans can be used to purchase properties with up to four residential units. But there are some subtle differences.

FHA loans are available only for owner-occupied properties. So you can buy an apartment building like a triplex, but you have to live in one of the residential units. The same 3.5% down payment and credit rating requirements also apply to apartment buildings. FHA loans are great for a popular investment strategy called “house hacking”. Then buy your first investment property with an FHA loan and rent out the units you don’t live in. (This was my own first type of real estate investment.)

Conventional loans allow the purchase of real estate with up to four units, but not with a small down payment. Duplex properties require a minimum of 15%, while three- to four-unit properties require a deposit of 25% or more.

Another difference is that conventional loans are not subject to personal use and can therefore be used to purchase a vacation home or investment property that you do not live in.

Credit limits

Both FHA and conventional loans have size restrictions.

FHA loans are designed to help low- to middle-income Americans become homeowners. Their requirements are correspondingly stricter. In most parts of the United States, the FHA loan limit for a single family home is $ 331,760 as of the time of this writing. However, this can be as high as $ 765,600 in more expensive real estate markets and is even higher in Alaska and Hawaii. There are also higher limits that apply to borrowers buying apartment buildings.

For conventional loans that meet Fannie Mae and Freddie Mac lending standards, the default credit limit is $ 510,400 (at the time of this writing). High cost markets have the same cap of $ 765,600 as FHA loans.

It is worth noting that for an amount that exceeds these limits, you can get a conventional loan – a so-called jumbo loan. However, stricter credit and down payment standards may apply to these loans.

costs

The main disadvantage of an FHA loan over a traditional loan is the cost.

For an FHA loan, you must get FHA mortgage insurance. This is where the state guarantee comes from. It has an upfront premium and ongoing premium and in most cases is impossible to get rid of during the life of the loan.

Conventional mortgages with a discount of at least 20%, on the other hand, are not subject to any compulsory mortgage insurance. If you have lower down payments, you will need to take out private mortgage insurance (PMI). However, this usually only has annual premiums (with no upfront costs). And you can get rid of it if your loan is repaid the same amount that you would have borrowed with a 20% down payment

FHA vs. Conventional Loan: Which Is Better?

There is no one-size-fits-all answer here. Some borrowers are better off pursuing an FHA loan while others consider a conventional mortgage loan to be the better option.

In general, an FHA loan is better if:

  • You have a below average credit score.
  • You don’t have a lot of money to file.
  • You want to buy a property with two to four units for a small down payment.

On the other hand, conventional loans are better suited for:

  • Borrowers with good credit
  • Borrowers who have larger down payments available
  • Borrowers looking to buy a vacation home or investment property

The final result? Find out about both loan types, then get pre-approvals and interest rate quotes from some of the best FHA lenders and the best conventional mortgage lenders. This way, not only can you compare mortgage lenders, but you can also see which type of mortgage is the better option for you.

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