FHA vs. conventional loans: pros and cons
When you’re weighing an FHA vs. conventional loan, looking at the pros and cons side by side can help to make things a lot clearer. Each option has its strengths, depending on your credit score, savings and long-term plans. Here’s a quick breakdown to help you compare.
FHA loan pros
- More flexible credit score requirements
- More flexible debt-to-income ratio (DTI) requirements
FHA loan cons
- Mortgage insurance is required
- Lower loan limits
- Stricter property rules
Conventional loan pros
- No mortgage insurance with 20% down
- Higher loan limits
- More flexibility with property types
Conventional loan cons
- Higher credit score requirements
- Not assumable
FHA vs. conventional loans: what's the difference?
When you’re looking at these popular loan types—conventional or FHA—think about what matters most to you in a home loan. Are you looking for a lower down payment, or is a great interest rate more important? How might these details affect your bigger financial goals?
Whether you’re a first-time home buyer or looking to refinance, understanding the nuances will affect your wallet and your stress level. Let’s keep that last one to a minimum.
Down payments and credit scores
FHA loans are often a go-to for first-time buyers, and with good reason. They require a down payment as low as 3.5% and are more forgiving of a credit history that has a few dings, requiring a credit score of just 580. Even if you don't have traditional credit, FHA loans have options for alternative credit documentation.
As for conventional loans, these are a bit more by-the-book. They typically require a down payment at a minimum of 3%, and a credit score of at least 620. This makes them an option for those who have a good credit history and some extra cash ready for upfront costs.
Debt-to-income ratios
Both loan types look at your DTI ratio because lenders need to know where you stand financially. DTI is just an easy way to assess how much money you owe compared to how much you make. FHA is a bit more lenient, allowing a higher percentage of your income to go towards debts.
For conventional loans, lenders generally prefer that you have a DTI of 36% or less. In some cases, they may allow DTIs up to 50% but typically not above that. The maximum allowable DTI ratio for most conventional mortgages is 50%. For a conforming conventional loan, the maximum DTI ratio is 43%. However, your income and down payment are also considered, so it never hurts to check with your lender.
Mortgage insurance
Here’s where it gets a bit tricky, so let’s break it down into bullets. (I mean, whose favorite topic is mortgage insurance?)
| FHA Loans | Conventional Loans | |
|---|---|---|
When Required | Always required. | Required if down payment is less than 20%. |
Upfront Payment | 1.75% of loan amount at closing (UFMIP – Upfront Mortgage Insurance Premium) | None |
Annual Payment | 0.15% to 0.75% of the loan amount annually; varies by down payment, loan amount and term. | Added to monthly mortgage payment until 20% equity is reached. |
Cancellation | Can't cancel unless down payment is at least 10%; then, it ends after 11 years. Otherwise, refinancing is necessary. | Can cancel once 20% equity is achieved through payments, extra payments or increase in home value. Automatically cancelled when loan balance falls to 78% of home's original value. |
Interest rates
FHA loans often come with lower interest rates, which helps keep affordability front and center. But here's the twist: those pesky mortgage insurance premiums might just nibble away at the savings you thought you were getting. It's a bit of a balancing act—lower rates, but with a side of extra fees, making it a sweet-and-sour financial deal.
Conventional loans, meanwhile, might not start out as the cheapest option if your credit score isn’t top-notch. However, if you’ve got a solid credit history, you could snag a lower rate, which is sweet for your wallet. Plus, there's no mandatory mortgage insurance if you put down 20% or more, which means no extra fees added to your monthly payments.
Loan limits
FHA loans have limits that depend on where you live, but they’re generally lower than conventional loan limits. This might limit your choices if you’re looking at a pricier property. Think of it as a budget cap in a high-end market—you can shop, but your options might be limited.
On the flip side, conventional loans offer higher limits, which can be a game-changer if you're eyeing a more expensive home. They give you freedom to explore pricier properties (and maybe even a jumbo loan) without hitting the financial ceiling too quickly, offering a bit more room to chase after that dream home.
Property standards
When it comes to the property itself, FHA loans have stricter property standards. The reason is that they're government-backed loans. Understandably, the property can't be in disrepair. But, hey—it’s like having someone who’s looking out for you, helping to make sure your home easily passes inspection. Yes, it can make the buying process a bit cumbersome if the property has issues that need fixing, but it also helps protect the program for buyers who come after you.
Conventional loans have more flexible standards, which can be a relief if you're buying a home that has some character (or even a few quirks). Your appraisal may still call out major issues, but smaller problems, like a missing handrail, may not need to be fixed for the loan to move forward.
Refinancing
Maybe you’re already on the property ladder and the moment you’ve been waiting for has arrived: a healthy dip in interest rates. If you're in an FHA loan, check out its streamline refinancing option—it’s typically straightforward with minimal hassle because it requires less paperwork. It's your fast pass to better loan terms, making the whole process smoother and quicker.
For those with conventional loans, refinancing can be an option to secure lower interest rates or better terms. Plus, once you've built up enough equity, you can say goodbye to PMI, removing one more financial burden.
Are they assumable?
FHA mortgages come with a pretty cool feature: they're assumable. This is a huge perk, especially in a high-interest rate environment. If someone is selling a home with an FHA mortgage locked in at a low rate, the buyer can take it over, which is great for both the seller and the buyer.
Conventional loans typically aren't assumable. If you're going this route, you'll have to secure your own financing, likely at current, and possibly higher, market rates. This helps to make FHA loans a bit more attractive in scenarios where saving on interest is a priority.
