Conventional vs FHA loans
You’re ready to buy a house, but face the question – which mortgage is right for you? The two most common programs are conventional and FHA loans. Are conventional loan rates better than FHA loan rates? Is one program more flexible than the other?
We answer these questions and more in this guide.
Check to see if you qualify first
Are you refinancing or purchasing?
Best bet is to see if you qualify first then see whether it makes sense to proceed.
A Quick Conventional Loan Rundown
Let’s take a quick look at conventional loans. You probably assume you need a 20% down payment with conventional loans as that’s their reputation – it’s not true though. Conventional loans have come a long way in recent years. Today, they require:
- 3% – 5% down payment
- 620 or higher credit score
- Maximum 28% housing ratio and 50% total debt ratio
- No recent bankruptcies or foreclosures
- Stable income and employment
If you put less than 20% down on a conventional loan, you’ll pay slightly higher interest rates and you’ll pay Private Mortgage Insurance until you owe less than 80% of the home’s value. But conventional rates are often low to begin with if you have good credit, so even if you have a lower down payment, it’s still an affordable option.
3% Down programs are limited to first time home buyers or have limitations on your annual income (must be 80% of area median income or less) and/or geolocation of subject property.
A Quick FHA Loan Rundown
FHA loans have that government guarantee, so the FHA sets the guidelines and lenders can add their ‘overlays’ or other requirements. FHA loans do have flexible guidelines which are great for first-time and subsequent homebuyers. FHA loans require:
- Minimum 3.5% down payment
- 580 credit score or higher (500 credit score may be allowed with 10% down payment)
- Maximum 31% housing ratio and 55% total debt ratio
- No recent bankruptcies or foreclosures
- Stable income and employment
FHA loans require mortgage insurance for the life of the loan. Even when you owe less than 80% of the home’s value, you still pay the insurance unless you refinance into a conventional loan. FHA loan rates are often competitive with conventional loan rates, making it a viable choice for those that don’t qualify for conventional financing.
Even though FHA loans are more lenient on credit scores, why credit scores are low matters. For example, if you have multiple recent lates on non-medical accounts/collections, AUS (Automated Underwriting System) may not approve your loan without improving your overall credit profile.
Pros and Cons of Conventional Loans
Now that you know the breakdown, let’s look at the ‘good and bad’ of the conventional loan program.
- Low down payment requirements as long as you pay PMI
- Higher loan limits of $510,400 in most areas (up to $765,600 in high cost areas)
- Your down payment and closing costs funds can be 100% gift funds
- You can cancel PMI once you owe less than 80% of the home’s value without refinancing
- There’s no upfront mortgage insurance fee
- You don’t pay any PMI if you put down 20% or more
- Appraisal requirements are a little more relaxed than FHA loans
- You can use a conventional loan on an owner-occupied, investment, or vacation property
- Higher conventional loan rate adjustments for low credit scores
- The debt ratio maximums are tight, which limits how much you can borrow
- Credit score minimums are higher for conventional loans
- PMI rates are driven by your credit score and loan-to-value ratio; the lower your credit score and the higher your LTV, the higher your PMI rate
- There isn’t a ‘streamline’ refinance program that would save you money on closing costs or streamline the process
Pros and Cons of FHA Loans
FHA loans have their own pros and cons, as they are the right loan for some, but not all.
- Low down payment requirement of just 3.5% with a credit score as low as 580
- 100% of your down payment and closing costs may be gift funds
- Annual mortgage insurance rates are often lower than PMI rates if your credit score is low
- Allows credit scores as low as 580 (or 500 in certain cases), which is great for those with a blemished credit history
- Higher debt-to-income ratio allowances for both the housing ratio and total debt ratio, making it easier to qualify with existing debts or to afford a more expensive home
- Mortgage insurance rates don’t vary based on your credit score –most people pay 0.85% (but it ranges from 0.45% – 1.05% depending on loan terms and loan amounts)
- FHA loan rates start lower than conventional loans and as long as you have ‘good credit’ you may get those low rates
- FHA loans offer a streamline refinance program that saves you money on closing costs and offers a simple approval process
- Lower loan limits of $331,760 in low-cost areas and a ceiling of $765,600 in high-cost areas, with most areas falling in between and lower than conventional loan limits
- You pay mortgage insurance for the life of the loan or until you pay it off in full or refinance it
- The FHA charges an upfront mortgage insurance fee of 1.75% of the loan amount
- You must use 3.5% of your own funds if you have a credit score lower than 580, which means only 7.5% can be gift funds
- Lenders often add overlays or their own requirements on top of the FHA’s requirements making it harder to qualify
More: FHA Loan Requirements
How to Choose Between the Conventional and FHA Loan
How do you choose between the conventional and FHA loan? It comes down to how well you qualify for the conventional loan and what you’ll pay for each loan. Consider the following:
Do you have a credit score below 680?
If so, consider the FHA loan as it offers lower FHA loan rates than conventional loan rates. Conventional loans base your interest rate on your credit score.
The lower your credit score falls from 680, the higher your conventional interest rate climbs including mortgage insurance rate. This means a higher and possibly unaffordable payment.
Do you have a high debt ratio?
Even though some conventional lenders may approve a DTI as high as 50%, you’ll pay for it in the interest rate and mortgage insurance rate.
FHA loans have more flexible guidelines and don’t penalize you for higher debt ratios, which may result in a more affordable payment.
Do you have a large down payment?
Even if you don’t quite have a 20% down payment, but it’s at least 10% or more, a conventional loan may make more sense. While you’ll pay PMI, you won’t pay it for long.
Once you owe less than 80% of the home’s value, you can request PMI cancellation right away. You don’t have to refinance or spend money to get out of the PMI like you would with an FHA loan.
Do you have great credit?
Even if you have a low down payment, but have great credit, the conventional loan may save you more money since conventional loan rates are based on your credit score. Even your PMI will be lower because of the great credit score, giving you access to a great loan program that doesn’t charge upfront mortgage insurance or annual mortgage insurance for the life of the loan.
Are you buying an investment or a second home?
FHA loans are only for owner-occupied homes. The FHA only guarantees the loans for those that need a home to live in, not one to make money off of.
If you are increasing your investment portfolio by buying an investment property or a second home, you’ll need a conventional loan.
Will you stay in the home long-term?
If this is your ‘forever’ home or at least your long-term home, a conventional loan may make more sense if you have the credit to qualify. If you choose the FHA loan, you pay mortgage insurance for the life of the loan.
If you want out of it, you have to pay to refinance into a conventional loan. If you qualify for the conventional loan right off the bat, you can get by with just as low of a down payment, but you’ll save over the life of the loan when you don’t have to refinance to get out of the mortgage insurance.
Do you like to refinance?
Some homeowners just like to refinance. They like knowing they have the lowest possible interest rates available at any given time.
The FHA loan offers a streamline refinance program that enables you to refinance without verifying your income, credit score, or home value.
As long as you have a good payment history and the refinance will save you money, you may qualify. Conventional loans don’t offer this option.
Choose the right mortgage the first time
Choosing between a conventional and FHA loan is an important decision. Remember, your mortgage could be with you for the next 30 years depending on your plans.
While conventional loan rates and FHA loan rates may look vastly different on paper, find out what rates you qualify for as they may be much different than what you see advertised.
Before you decide, look at both options. Look not only at the monthly payment, but at the big picture. What will each loan cost you over the life of the loan? Will you keep the loan for its duration or will you refinance? Do you want the option to stop paying mortgage insurance? Do you need the FHA loan for its flexibility?
Answering these questions and comparing your options should help you reach the decision that is right for your home purchase or refinance. As always, feel free to ask us questions or let us help you choose the right mortgage for you.