Deciding which type of loan to get is an important step when buying a home. The two most popular options for first-time homebuyers are conventional and Federal Housing Administration (FHA) loans. Each loan has advantages and drawbacks to consider.
What is an FHA loan?
FHA-approved lenders can issue loans that are insured by the Federal Housing Administration and are ideal for buyers looking for low down payment options, flexible income and credit guidelines.
Conventional loans aren't insured or guaranteed by government agencies. They are usually available with fixed or adjustable-rate terms, and may require higher credit scores and down payments than FHA loans.
Differences between FHA and conventional loans
There are several key differences between conventional and FHA loans. Consider the following when choosing the right mortgage for your situation:
- Qualifying for loans
- Property standards
- Property types
- Down payment requirements
- Private mortgage insurance
- Loan limits
Qualifying for loans
While lenders look at many things when reviewing applications, credit score and debt-to-income (DTI) are two important factors.
It’s often easier to qualify for an FHA loan than for a conventional loan because buyers can have a lower credit score and a higher debt-to-income (DTI) ratio compared to a conventional loan. However, applicants with a lower credit score and higher DTI ratio may still qualify for a conventional loan. In this case, lenders would consider additional factors such as income and down payment.
Property appraisals for FHA loans are similar to conventional loans. Appraisers assess the property for value, soundness of construction and safety. FHA appraisers must make sure it meets FHA Minimum Property Standards. For conventional loans the Home Valuation Code of Conduct regulates the standards, protecting appraisers from realtor and lender influence.
For either loan type, the appraisal is not a home inspection.
Lenders also look at what buyers plan to use the home for. FHA loans require the borrower to live in the home as their primary residence, so they can’t invest in or flip properties. With conventional loans, individuals can buy a variety of property types including private homes, investment properties and vacation houses.
Down payment requirements
FHA loans are appealing for homebuyers who can’t make a large down payment. With FHA loans, buyers may be able to put as little as 3.5% down. Conventional loans used to require a minimum down payment of 20%. However, some lenders now offer conventional loans with as little as 3% down.
When homebuyers put less than 20% down on a conventional loan, they also need private mortgage insurance (PMI). For FHA loans, borrowers have to pay mortgage insurance premiums (MIP) regardless of how much they put down. PMI and MIP protect lenders from financial losses should the borrower default on their loan. Premiums are calculated and applied differently depending on whether the loan is conventional or FHA.
Individuals with an FHA loan will pay both upfront and monthly premiums. FHA loans use a one-size-fits-all premium rate calculation, which may stay in effect for the life of the loan.
With conventional loans, borrowers usually pay a monthly or single PMI premium. Factors such as credit score and down payment help determine the PMI rate. PMI ends for conventional loans when the borrower reaches 78% loan-to-value ratio.
When comparing FHA and conventional loans, it's important to note that both types of loans limit the amount you can borrow. Maximum loan amounts vary by county, and these limits usually change each year.
Conventional mortgages must meet loan limits set by the Federal Housing Finance Agency. These limits are usually the same regardless of where you're buying a home, except for some higher cost counties.
FHA mortgage limits vary by the county where the property you’re buying is located and tend to be lower than conventional limits.
FHA loan requirements
Homebuyers may qualify for an FHA loan if they:
- Meet the minimum credit score requirement, which varies by lender
- Will use the home as their primary residence
- Can provide proof of employment and steady income
Lenders will review your credit history during the underwriting process, so making payments on time will improve your chances of being approved. However, some things can make getting a loan more difficult, including:
- No credit history: Lenders need to determine creditworthiness. For anyone without a credit history, they may be able to do this with non-traditional, merged credit reports or other means.
- Bankruptcy: Bankruptcies don't automatically disqualify individuals from qualifying for an FHA loan. Buyers with a Chapter 7 bankruptcy must typically wait at least two years from discharge of the bankruptcy before applying for an FHA loan. They also may be required to show they have re-established good credit.
- Late payments: Generally, applicants should have 12 months of on-time payments before applying for an FHA loan, although you may be able to provide a reasonable explanation.
- Foreclosure: Foreclosures don't necessarily disqualify someone from an FHA loan if at least three years have passed. Lenders will consider applications with foreclosures on a case-by-case basis.
Federal debt, collections and judgments: FHA loans usually require these to be paid off either before or by closing, or have an existing repayment plan with a satisfactory payment history. It's important to choose a mortgage that meets your financial situation and future goals. Our home lending advisors can answer any questions and help you find the right loan for your needs.