What is the difference between a conventional loan and FHA loan?

Summary: There are different considerations between a conventional and FHA loan. It is important to understand each one to help you decide the kind of loan that may be right for you.

What is a conventional loan?

A conventional mortgage is a loan that originates from a private lender and is not backed by the government. Conventional loans are either conforming or non-conforming.

Conforming loans can be sold to other lenders, typically government-sponsored entities (GSEs) such as Fannie Mae and Freddie Mac, because the loan “conforms” to their guidelines.

Nonconforming loans don’t conform to GSE guidelines. They’re typically large loans, sometimes called “jumbo” mortgages. While GSEs won’t buy these jumbo loans, they may be sold to other lenders. Depending on the state of the market and your credit profile, jumbo loans may be difficult to obtain.

Conventional mortgage loans are typically have fewer hurdles than FHA loans. They offer competitive interest rates and loan terms, which may result in a lower monthly payment compared to FHA loans. However, if your down payment is less than 20% of the loan, private mortgage insurance (PMI) is required and therefore may increase your monthly payment until 20% equity is reached.

What is an FHA loan?

FHA loans are provided by the Federal Housing Administration (FHA) and are typically easier to qualify for than a conventional loan as they are backed by the U.S. government. This means there is a lower risk for lenders, as a defaulted loan is paid off and ownership transfered by the FHA.

Unlike most conventional loans, the Federal Housing Administration only requires 3.5% of the purchase price of the home as a down payment as long as it is your primary residence. Keep in mind that 100% of the down payment may be in gift form, though some restrictions may apply and sufficient documentation is required.

Since a lower down payment is possible, FHA loans can save a lot of money upfront. However, mortgage insurance premium (MIP) for loans below 20% of the purchase price can increase monthly payments. It can also result in paying far more for the home than you would with a conventional loan. The upfront mortgage insurance premium (UFMIP) also needs to be paid at the time of closing, which is normally 1.75% of the loan amount.

An FHA loan can offer incredible benefits to first-time homebuyers, families with low- to moderate-incomes, and buyers with lower credit scores. An FHA loan can sometimes make the difference between buying your dream home now versus several years from now. You can always refinance to a conventional loan once you strengthen your financial health.

Keep in mind that FHA loans often have strict standards for the minimum property condition that you are trying to buy. As such, FHA loans that do not meet these minimal conditions may require the seller to make improvements and request a re-inspection prior to loan approval and closing. Due to these more strict eligibility requirements, some sellers may choose not to support FHA loans, limiting your buying options.

Which type of loan is right for me?

Selecting the type of home loan requires careful consideration and research. Below are some points to consider before selecting a home loan.

Here are the pros of a conventional mortgage:

  • Allows down payments as low as 3%, based on lender requirements and your credit risk profile
  • No PMI is added with down payments of 20% or more
  • PMI can be removed from your monthly payment once you reach 20% equity
  • Conventional mortgage loans may be used to buy primary residences, vacation homes, and investment properties
  • Often have a higher loan limit than FHA loans (check your county loan limits)
  • More buying options compared to sellers that may not accept FHA loans

Below are the pros of an FHA loan:

  • Relaxed credit score requirements (currently 640 or higher as a result of COVID, but it has been as low as 560 in recent history)
  • Lower debt-to-income (DTI) ratios are required to secure the loan compared to a conventional loan
  • Low down payment options, allowing for the purchase sooner than with a conventional loan
  • May be used to purchase single-family homes, multi-family homes, condos, and manufactured homes - check with your lender on what may qualify

Are you a veteran looking for VA loan limits?

Additional details about VA loan limits can be found on the VA website.