Conventional loans vs. FHA loans

Woman with a prosthetic leg reclines on a sofa and researches conventional loan vs. FHA loans on a laptop.Image: Woman with a prosthetic leg reclines on a sofa and researches conventional loan vs. FHA loans on a laptop.

In a Nutshell

Some borrowers need conventional loans — others want FHA mortgages. What’s the difference? Down payments, credit score requirements and mortgage insurance may vary greatly between conventional loans and FHA mortgages.
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There’s a lot that goes into buying a home, from saving for a down payment and finding the perfect place to lining up your financing.

And one of the biggest decisions you’ll have to make is what type of mortgage to use. In this article, we’ll look at conventional mortgages and FHA loans, what their major differences are and how to choose the right one for you.

What is a conventional loan?

Conventional loan is a broad term that describes a mortgage that isn’t guaranteed or insured by a government agency or program. Conventional loans can generally fall into one of two categories: conforming loans and nonconforming loans.

Conforming loans are those that fall within the loan limit set by the Federal Housing Finance Agency and meet requirements set by Fannie Mae and Freddie Mac. Nonconforming loans aren’t bound by those requirements, so there can be a lot of variation in costs and who qualifies, depending on the lender.

What is an FHA loan?

An FHA loan is one that is backed by the Federal Housing Administration. The FHA doesn’t directly lend money to homebuyers. Instead, it guarantees the loans that private lenders provide. The requirements to qualify for an FHA loan are generally more flexible than some conventional loans, which can help to make homeownership more accessible.

Basic differences between conventional loans and FHA loans

Let’s take a look at the key differences between conventional and FHA loans so you can better evaluate what might be best for your next home purchase.

Minimum down payment

FHA borrowers with a credit score of at least 580 may qualify for a loan with as little as 3.5% down. With a credit score below 580, you’ll need a down payment of at least 10%. These are the FHA minimums — additional lender requirements may apply.

In the case of a conforming conventional loan, the down payment must meet the requirements set by Fannie Mae and Freddie Mac. They generally require a minimum down payment of 3% to 5%.

But in the case of nonconforming loans, lenders may set their own down payment requirements. For example, with a nonconforming jumbo loan, lenders may require a larger down payment to compensate for the additional risk they’re taking on.

Credit qualification

To qualify for an FHA loan, FHA guidelines state you’ll need a credit score of at least 500, but it’s important to note that with this credit score, you’ll need a down payment of at least 10%.

To qualify for the maximum financing with a down payment of 3.5%, you’ll need a credit score of at least 580. As mentioned above, these are the FHA standards, and additional lender “overlays,” including FICO® score requirements, may apply depending on the lender.

As with other features of conventional loans, the credit score required depends on whether it’s a conforming or nonconforming loan. To borrow using a Fannie Mae or Freddie Mac conventional conforming loan, you’ll generally need a credit score of at least 620. The rules for nonconforming loans are likely to vary more from one lender to the next and will depend on the type of nonconforming loan.

Mortgage insurance

Regardless of what type of loan you apply for, you may find yourself paying mortgage insurance. On an FHA loan, the insurance is known as a mortgage insurance premium, or MIP.

First, you’ll pay an upfront MIP of 1.75% of the base loan amount. Then you’ll pay an annual MIP, with an amount that depends on the base loan amount and your loan-to-value ratio, or LTV. Annual MIPs range from 0.45% to 1.05% of the base loan amount and last for either 11 years or the entire mortgage term, depending on your down payment.

Conventional mortgages may also require insurance, but in the case of these loans, it’s something known as private mortgage insurance, or PMI. PMI is generally required for conventional loans with a down payment of less than 20%.

Borrowers may only be required to pay PMI until they reach 20% equity in their homes. You can generally avoid it in two ways. First, you can request that your loan servicer cancel PMI once your LTV falls below 80%. Otherwise, PMI should automatically fall off when you’re scheduled to reach 78% LTV as long as you are current on your payments.

Loan uses

Both FHA loans and conventional conforming loans can be used for properties with one, two, three or four units. In the case of an FHA mortgage, FHA loans are only for owners who occupy their homes. You cannot purchase investment property with an FHA single-family home loan. The house you buy must be the one you intend to live in as your primary residence.

Conventional loans can be more flexible, depending on the lender. FHA loans require you to be an owner-occupier using the home as your main address — but with a conventional loan,  government-backed loan requirements like this may not apply. It depends on the lender, the loan and other factors. Some requirements may apply if you seek a conforming loan, but nonconforming loans may offer more options.

Which loan is right for you?

Both conventional loan and FHA loans have their advantages, but there are some general rules of thumb you can think about as you prepare to buy your next home.

FHA loans may be the better option for borrowers without credit scores that qualify for a conventional mortgage or those who don’t have a large down payment. In these cases, an FHA loan may be more affordable and could even be the only option available to you.

But for borrowers with good credit who can afford a larger down payment, a conventional loan is likely a choice worth exploring.

What’s next?

If you’re starting the homebuying process, a mortgage loan officer, mortgage broker or real estate agent can help you compare different loan options and decide which is right for you.

Keep in mind that various loan products have different requirements for down payments, credit scores, debt-to-income ratios and more. Understanding ahead of time what standards you’ll have to meet will help ease the decision-making process.   

About the author: Erin Gobler is a freelance personal finance writer based in Madison, Wisconsin. Erin studied journalism and political science at the University of Wisconsin-Oshkosh and began writing full-time after a seven-year caree… Read more.