FHA vs. Conventional Mortgages: The Basics

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FHA and conventional mortgages differ mostly in the types of borrowers they qualify, as well as in the costs of the loan.

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With the exception of VA loans for U.S. veterans, mortgage loans typically fall into two distinct categories: Federal Housing Administration (FHA) and conventional mortgages.

The biggest difference between FHA and conventional mortgages is their qualification requirements, with FHA loans having the loosest requirements for qualifying borrowers. FHA and conventional mortgages also carry differing costs for borrowers. To choose the best mortgage option for your home purchase, you’ll want to be sure you understand these costs completely.

Both FHA and conventional mortgages limit the amount you can borrow. Regulators update these limits annually and they vary by region, so check Fannie Mae for current loan limits in your area.

FHA Mortgages

FHA loans are backed by the government, so lenders can assume more risk for these loans and loosen the qualification requirements.

FHA loans are insured by the Federal Housing Administration. As a result, FHA loans generally have less stringent requirements than conventional mortgages do.

Because these loans are backed by the government, lenders can assume more risk for these loans and loosen the qualification requirements as a result. This may make FHA loans the best option for first-time homebuyers or anyone with a low credit score, a high debt-to-income ratio, or a previous short sale or foreclosure.

These lower qualification requirements can often translate into higher borrowing costs though, so you should carefully weigh your options.

Requirements

All borrowers are required to pay a mortgage insurance premium (MIP) for FHA loans regardless of how much money they put toward a down payment.

If you put more than 10% down, you should be able to remove the MIP in 11 years. If you put less than 10% down at closing, the MIP is permanent for the life of the loan. You can refinance out of FHA into a conventional mortgage to remove this premium, as long as you are able to qualify for and pay the costs of a refinance.

FHA appraisals must also adhere to strict safety and code regulations and may be more extensive than with conventional mortgages. This can pose issues for you if you are considering buying a "fixer-upper" property, since it may not qualify for FHA financing.

In order to qualify for an FHA mortgage, you will need:

• A credit score of at least 500
• A 3.5% down payment for a credit score of 580 or higher
• A 10% down payment for a credit score of 500 to 579
• A debt-to-income ratio lower than 57%
• A loan size below the annual limit set by regulators for FHA loans
• To live in the house as your primary residence for 90 days or longer (you can’t use an FHA loan to flip a sale)
• A stringent appraisal that assesses safety, structural integrity, and adherence to local building codes in addition to home value

Pros

FHA loans may offer significant benefits, especially to first-time home buyers.

These benefits include:

• They provide access to home ownership for borrowers with credit scores as low as 500, or borrowers who have recently foreclosed on a home.
• FHA loans allow borrowers to make down payments of only 3.5% (provided their credit score is 580 or higher) allowing those with smaller savings access to homeownership.
• Borrowers with a debt-to-income ratio close to 57% can qualify for FHA loans.
• You can refinance out of an FHA loan into a conventional mortgage later on to remove MIP.
• Interest rates for FHA loans are usually lower than those for conventional mortgages.

Cons

FHA loans do carry more costs than conventional mortgages, and there are aspects of FHA loans you should look out for.

Downsides of FHA mortgages include:

• MIP payments can be considerable and add significantly to the monthly payment on the mortgage.
• If you put less than 10% down on the mortgage, you cannot remove MIP for the entire life of the loan.
• MIP is mandatory regardless of the size of the down payment.
• Because the loans are federally insured, appraisals must show that the property meets strict requirements for safety and structural integrity and adheres to local building codes, which means you may not be able to buy and renovate a fixer-upper.
• Although you can refinance into a conventional mortgage, refinancing requires you to pay closing costs, which may be cost-prohibitive without sufficient cash savings.
• Loan limits for FHA mortgages tend to be lower than for conventional mortgages.

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Who should get an FHA mortgage?

You may be best suited for an FHA loan if you are a first-time homebuyer, your credit score is low, you have a high debt-to-income ratio, you have little equity or cash savings to use for a down payment, or you have previously foreclosed on a home loan.

Conventional Mortgages

Qualification requirements are stricter for conventional mortgages, but they often cost less over the life of the loan.

Because conventional mortgages are uninsured by the federal government, the private lender issuing the loan takes on all the risk. They usually seek to minimize this risk by carefully vetting borrowers and charging private mortgage insurance (PMI) for loans with less than a 20% down payment.

If your credit is good, the PMI is usually lower than the mortgage insurance premium that accompanies an FHA loan, and it is automatically removed once the loan is reduced to 78%.

Requirements

In order to qualify for a conventional mortgage loan, you will need:

• A credit score of 620 or higher, with better rates available at scores of 720 or higher
• A down payment as low as 3% if you plan to pay private mortgage insurance, or 20% if you don’t
• With good credit and sufficient savings, you can put as low as 3% down, but your will have to pay private mortgage insurance
• A debt-to-income ratio below 50%, although 43% and below will make you more likely to be approved and qualify you for the best rates
• A loan size below the conforming loan limit set by the Federal Housing Finance Agency

Pros

If you qualify, conventional mortgages offer several benefits, including:

• Depending on your credit score, private mortgage insurance payments can be much smaller than mortgage insurance premiums on an FHA loan. This makes your monthly payment smaller, allowing you to pay more toward the principal on your loan, as well as save more money over the life of the loan.
• Private mortgage insurance on a conventional loan is automatically removed once you pay it down to 78%, without the need to refinance.
• If you can show that you are otherwise a low-risk borrower, you may be able to put as little as 3% down.
• The loan sizes for conventional mortgages are usually higher than for FHA loans.
• Appraisals for conventional mortgages assess the value of the home without the stringent safety standards required for FHA loans.
• You can use a conventional mortgage to finance a vacation home or investment property as well as a primary residence.

Cons

There are, however, some down sides to conventional mortgages:

• Because the qualifying requirements on a conventional mortgage are stricter than with an FHA loan, you may not have access to this type of loan depending on your financial situation.
• Interest rates for conventional mortgages tend to be higher compared to FHA loans.
• Although you may still be able to qualify for a conventional mortgage after a negative credit event like a foreclosure or short sale, the wait time for approval after the event will be longer than for an FHA loan.

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Who should get a conventional mortgage?

You may be best suited for a conventional mortgage if you have a credit score of 620 or above and are able to make a down payment of at least 5%. If you are looking to buy a vacation home or investment property rather than a primary residence, you will only be able to use  a conventional mortgage.

How to Find the Best Mortgage For You

By comparison shopping for low interest rates and loan costs, you can be sure that your mortgage loan, just like your new home, is the best fit for you.

A mortgage is a long-term commitment, so you will want to find the best rate and terms possible. Doing some research to understand mortgage options, the current market, and your own level of risk as a borrower can help you find (and even negotiate) better terms for your loan.

If you are currently searching for a home to buy, knowing how to qualify for the best mortgage rates and options can help you prepare for the purchase process. There are steps you can take now to improve your chances of qualifying for the lowest-cost loans.

Understand your credit.

The first step to determine which loan options are right for you is to check your credit score. Many first time home buyers start filling out loan applications without checking their credit scores, which can be a costly mistake.

You can pull a free credit report once every year from the Federal Trade Commission. Be sure to check your report before beginning the home loan application process to find any errors or discrepancies. If you do find issues on your report, do what you can to repair those errors now. Contact businesses and financial institutions to remove fraudulent charges or incorrect late payments.

Keep in mind that a credit score below 620 may limit the types of mortgages you qualify for. The lower your credit score, the higher your mortgage interest rate will be too. The best rates in the market are reserved for borrowers with scores of 720 and above.

The fees associated with your loan will also be lower if your credit score is 720 or higher. This can save you thousands of dollars over the life of your mortgage.

With lower interest payments and smaller costs for the loan, you may even be able to afford a more expensive home. That’s because your payments will go toward the actual value of the home rather than costs for the mortgage. As a result, you will also build equity in your home more quickly.

Review your finances.

Before seeking out mortgage options, you will also want to review your finances to determine how much of a down payment you can afford to make, and ensure that you have enough additional funds to cover closing costs. Closing costs generally amount to between 3% and 5% of the total cost of the loan.

To qualify for a mortgage, you will also need to show that you have an emergency cash fund in addition to the down payment and closing costs. This will reassure lenders that you are not likely to default on the loan. If coming up with enough cash is an issue for you (as it is for most first-time home buyers), an FHA loan may be the right fit. With a lower down payment on an FHA loan, you will have more liquid funds to close. Just keep in mind that the MIP payments may be high as a result.

You should also consider your debt-to-income ratio. This number calculates how much of your monthly income is committed to paying down debt obligations, including mortgage, student or personal loan payments, and credit cards. Bringing your debt-to-income ratio below 36% can help you qualify for a lower mortgage rate.

If you can, pay off smaller debts and pay down larger ones before you start applying for mortgages. Just make sure that you leave yourself enough cash for down payment, closing costs, and reserves.

Compare your options.

Once you have gathered this information, you can begin applying for mortgage loans. It is in your best interest to apply for as many mortgage options as you can, so that you can comparison shop for the best mortgage rate and mortgage loan products overall. Even if you have good or excellent credit already, it’s in your best interest to gather as many options as possible.

These applications don’t have to damage your credit score either. All loan applications filed within a 45 day period will only count as a single pull on your credit. As long as you file all of the loan applications within those 45 days, the effect on your credit will be insignificant.

The result of all of those applications will be a range of pre-approval letters, outlining the rates available to you. You’ll also get information about the monthly payments, terms, and fees you can expect for each loan.

As a basis for comparison, look up the current national averages for mortgage interest rates. Freddie Mac reports on national rates regularly and can give you an overview of the market as well as whether it is trending up or down. Next, find the average rates for your region. The Consumer Financial Protection Bureau offers an online tool to check mortgage rates in your area.

Once you receive your pre-approvals, ask questions. A mortgage is a long-term commitment, and you want to be sure you understand all aspects of your loan before signing.

Make informed decisions.

Equipped with the knowledge of your options, you are in the best possible position to make an educated decision about which mortgage loan product is right for you. You can move forward with your home purchase knowing that you are paying the lowest cost mortgage available to you, whether that turns out to be an FHA or conventional mortgage. By finding the best rate and monthly payments you can comfortably afford, you will save thousands over the loan term.

You may even find that knowing your options drives your costs down further. Mortgage rates are difficult to negotiate and you may not qualify for a conventional mortgage. But if you can show lenders that you have been offered a better deal elsewhere, they may sweeten the deal for you to undercut the other offer. This might mean reduced closing costs and other lending fees, which may make a big difference for you as you start out in your new home.

Consider the fees and closing costs for each loan offer you receive. These are likely to vary by lender and may impact your ability to close if you are using most of your savings for the down payment.

Especially when considering FHA loans, look at how much you will be paying each month on mortgage insurance. Remember that for some FHA mortgages, mortgage insurance premiums last for the entire life of the loan and don’t count toward your principal. Over time, that monthly premium adds up to quite a bit of money.

When considering mortgage loan products, pay careful attention to the second page of each loan disclosure, which shows the five-year projection for the loan. This is the best metric to compare each loan, because you can see how much you will have paid in total and toward the principal in five years. All other factors considered, the better loan is the one that allows you to pay down more principal within five years and therefore build equity more quickly.

By comparison shopping for a low interest rate and loan costs, you can be sure that your mortgage loan, just like your new home, is the best fit for you.

Which Mortgage Option Is Right for You?

Whichever mortgage option you choose, seeking out several mortgage loan offers from a variety of lenders can help you rest assured that your mortgage is the best one available to you.

Ultimately, the mortgage option that fits you best depends on your current financial situation, the type of home you are buying, and whether you plan to refinance or sell in the near future.

An FHA loan may offer you the opportunity to access homeownership even if your credit is low, you don’t have much money to put toward a down payment, or you have recently experienced a negative credit event.

On the other hand, you may find a conventional mortgage comes at a much lower overall cost. The more you pay in mortgage insurance, the less you pay toward the principal of your mortgage. Since private mortgage insurance is typically lower than FHA mortgage insurance premiums, this is one big reason to choose a conventional mortgage if you qualify. You will build equity more quickly with a lower cost loan.

Whichever mortgage option you choose, seeking out several mortgage loan offers from a variety of lenders can help you rest assured that your mortgage is the best one available to you with the lowest costs over the long term.

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