FHA vs. conventional loans

What is a conventional loan?

Conventional loans are the most common type of mortgage loans in the U.S. However, they’re generally only accessible to applicants with decent credit. They also require a more significant down payment.

There are two types of conventional loans:

• Conforming mortgages: These loans follow specific dollar-amount limits set by Fannie Mae and Freddie Mac, the two government-sponsored agencies that buy mortgages from lenders and sell them as investments while guaranteeing the underlying loans.
• Nonconforming mortgages: Also known as jumbo loans, these are loans in dollar amounts too big to be guaranteed by Fannie and Freddie. They’re common with luxury homes or in red-hot housing markets.

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What is an FHA loan?

A Federal Housing Administration loan is a type of mortgage loan that makes homeownership possible for individuals who wouldn’t qualify for a conventional loan.

The FHA was created by Congress in 1934 and became part of the Department of Housing and Urban Development in 1965.

As the FHA itself puts it, when the agency came along during the Great Depression, the housing industry was flat on its back.

• 2 million construction workers had lost their jobs.
• Terms were difficult to meet for homebuyers seeking mortgages.
• Mortgages were limited to 50% of a property's market value, with a repayment schedule spread over three to five years and ending with a balloon payment.
• America was primarily a nation of renters. Only 4 in 10 households owned homes.

Since its inception, the FHA has insured more than 46 million mortgages.

What's the difference between FHA and conventional loans?

The major difference comes down to your financial standing.

If you have excellent credit and enough saved for a significant down payment, a conventional loan would be the right option for you. But if you don’t have the financial resources, an FHA loan could put the American dream of homeownership within reach.

While conventional mortgages are regulated by Fannie Mae and Freddie Mac, the government insures FHA loans. This means if you can’t make your mortgage payments, the Federal Housing Administration will step in.

FHA and conventional loans share some similarities but fundamentally differ when it comes to the application process, requirements, limits and associated fees and costs.

Interest rates

Both FHA and conventional mortgages offer fixed- and adjustable-rate loan options.

With fixed-rate loans, your interest rate isn’t subject to change, meaning you’ll pay the same rate over the life of the loan. Adjustable-rate mortgages, or ARMs, will adjust over time, moving in sync with a benchmark interest rate. So while you may start out with a low rate on an ARM, you’re likely to see your rate increase over time.

Until 1983, the FHA set its own interest rates, until the Housing and Rural Recovery Act mandated that the rates should be determined by the market. As things stand now, your credit score will have a bigger impact on the mortgage rates you’re offered than your type of loan.

Down payments

Lenders typically will require you to put down a minimum of 5% on the purchase price of the home to secure a conventional loan. But if your down payment is less than 20%, you’ll be required to pay extra for private mortgage insurance, known as PMI, which could increase your annual costs by up to another 1% of your total loan amount.

You’ll need far less in the bank for a minimum down payment on an FHA. You’ll have to offer up at least 3.5%; if your payment is less than 10% of the total loan amount, you’ll be required to pay an upfront mortgage insurance premium (MIP) of 1.75%.

Whichever loan you go with, the more you put down initially, the lower your monthly payment will be over the life of the loan.

Mortgage limits

With conventional mortgages, the government sets an annual limit that establishes a maximum balance for conforming loans. A permanent formula for the conforming loan limit was established under the Housing and Economic Recovery Act of 2008.

The limits for single-unit homes in 2022 are:

• $647,200 in most states. This is an increase of $98,950 from $548,250 in 2021.
• $970,800 in high-cost areas, plus Alaska, Hawaii, Guam and the U.S. Virgin Islands. This limit is up from $822,375 in 2021.

With an FHA loan, you’ll be more limited in how much you can borrow. The limits vary based on the region where you live.

• The maximum FHA loan for a single-family home in a low-cost county is $420,680 — an increase from $356,362 in 2021.
• In more expensive housing markets, that number will rise higher, toward the upper limit of $970,800.

The Department of Housing and Urban Development website has a search engine prospective homebuyers can use to look up the limit in their region.

Credit score requirements

When deciding which type of mortgage you’ll be eligible for, your credit score will be one of the most important factors lenders consider. For a conventional loan, they’ll want to see you have at least a score of 620.

To qualify for an FHA loan, ideally you’ll have a credit score around 580. But lenders will accept a score as low as 500 if you make a down payment of more than 10% of the purchase price of the house.

The reason lenders feel comfortable being more permissive with FHA loans is they know that if you fail to make your payments, the government will step in.

Insurance

With a conventional loan, you’ll have to pay private mortgage insurance if you put down less than 20% of the home’s purchase price. PMI is arranged by your mortgage lender and provided by private insurance companies.

You can pay your PMI either as a monthly premium, where it’s added to your mortgage payment, or upfront. A lender may offer you more than one option. The Consumer Financial Protection Bureau recommends you ask your loan officer to help you calculate the total costs of the different options to determine your best fit.

With FHA mortgages, the trade-off you get with the government backing your loan is that you’ll be required to pay a mortgage insurance premium (MIP), which does make the overall price of your loan higher than it first seemed.

In fact, you’ll have to pay two insurance premiums: a one-time upfront MIP and an annual premium.

• Upfront: The one-time premium is typically equal to 1.75% of the purchase price and can be paid in cash or financed in the mortgage.
• Annual: The annual insurance is collected in monthly installments and added to your mortgage. It’s common to pay 0.85% per year, but the charge can vary from 0.45% to 1.05%, depending on the loan amount and whether the term is 15 or 30 years.

If you put down less than 10% on your loan initially, you’ll have to pay premiums for the entire life of your loan, or at least until you refinance or sell your home. Otherwise, you’ll be expected to pay the annual premiums for the first 11 years of your loan.

It should be noted that mortgage insurance of all types doesn’t protect you if you fail to make your mortgage payments. It’s only there to protect the lender.

Appraisal

A home appraisal is typically required when you’re applying for a mortgage. An appraisal is simply an unbiased assessment of a home’s value, to reassure lenders that they’re not lending you more than the home is reasonably worth.

With a conventional loan, your appraiser will simply be looking at the home’s market value. However, with FHA loans, a HUD-approved appraiser is required to look at both the value and whether the property meets the department’s minimum health and safety standards.

Issues that may be flagged to HUD in this process include peeling paint, loose handrails, or issues with ventilation, heating and electrical systems. If anything is flagged as a health or safety issue in the appraisal process, it will need to be corrected before the loan can be approved.

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Summary: FHA loan vs. conventional loan

FHA vs. conventional: Pros and cons

There are advantages and disadvantages to both these types of loans.

With conventional loans, the biggest plus is if you lock in at fixed interest rate, your monthly payments will always be consistent. And if you’re fortunate enough to be in good financial standing with a solid down payment and excellent credit, you’ll save yourself all the additional fees that can add up.

The most significant downside to conventional loans is that the requirements keep the dream of homeownership out of range for many Americans.

With FHA loans, a major “pro” is that you can still buy a home, even with a less-than-great credit score and a small down payment.

But in the “con” column, paying less upfront will likely mean you’ll have to deal with more fees and potentially end up paying more each month than you expected at the outset.

Frequently asked questions

It’s a big decision taking on a 15- or 30-year financial commitment. Still have questions? Here, we tackle some of the most common questions about these two types of loans.

Can a first-time homebuyer get a conventional loan?

Yes, first-time homebuyers absolutely can apply and qualify for a conventional loan. If you’ve maintained a good credit score, you’re ready with your down payment and you’ve got a regular source of income, you should have no issue securing a conventional loan, whether or not you’ve had a mortgage before.

Is an FHA loan better than a conventional?

When it comes to picking a mortgage, deciding which type of loan to go with is ultimately a personal choice. With conventional loans, you might have a more straightforward application process. And depending on your income, you’re more likely to be granted a larger loan and are less likely to have add-on fees come up throughout the process.

But a conventional loan isn’t always within reach for everyone.

If you’ve always dreamed of owning your own home and you don’t have a nest egg set aside for your down payment, or if your credit score is nothing to write home about, an FHA loan is a great way of making your dream come true.

Are FHA closing costs higher than for a conventional loan?

Closing on both types of mortgages, you’ll pay property taxes and title fees. With the exception of your lawyer fees, which will be charged based on hourly services, your fees will generally reflect a percentage of the overall sale price.

The major difference you’ll find between the closing costs of FHA and conventional loans is the MIP. While you may pay PMI on a conventional loan, the 1.75% upfront MIP may end up costing you a little more at closing.

What are the benefits of a conventional home loan?

With a conventional loan, if you’re able to make that 20% down payment upfront, you’ll end up saving yourself a lot of money in fees over the long run. Another upside to these loans is that sellers tend to prefer them over FHA loans.

Why do sellers prefer conventional over FHA loans?

There are a few factors at play here. The first is that conventional loans tend to indicate (fairly or not) that buyers have access to more funds, since they’re able to make larger down payments. Sellers may assume the deal is less likely to fall apart because of that.

And there’s also the matter of the home inspection. With an inspection for an FHA mortgage, assessors are specifically looking for issues with the property that may need to be resolved before the loan can be approved. That may also hold up or even put an end to the deal.

What will fail an FHA inspection?

According to HUD, an FHA inspection seeks to make sure a home is safe, secure and sound. Some of the major concerns HUD expects an appraiser to look for are:

• Standing water against the foundation and/or excessively damp basements.
• Hazardous materials on the site or within the improvements.
• Faulty or defective mechanical systems (electrical, plumbing or heating/cooling).
• Evidence of possible structural failure (such as settlement or bulging foundation wall, unsupported floor joists, cracked masonry walls or foundation).
• Signs of possible pest infestation.
• Leaking or worn-out roofs.
• Any other condition that in the professional judgment of the appraiser warrants inspection.

Do FHA loans take longer to close?

If your appraiser finds any issues, like those listed above, your FHA loan may take longer to close since the problems will need to be addressed before moving forward.

There’s also usually a little bit more paperwork involved in the application process for an FHA loan, so you may find the underwriting process (where your lender goes through your assets, credit score and tax records before granting you the loan) does take a little more time.

If you want to speed up the process, it’s best to submit your documentation in an organized way, so your underwriter won’t have to return to you with any questions or follow-up.

What credit score is needed for a conventional loan?

To secure a conventional loan, you’ll need a credit score of 620 or higher. You can check your credit score for free.

And if you’re not happy with your number, you can always work on building your credit score with some straightforward steps, such as becoming an authorized user on a family member's card and paying your minimum credit card payments each month.