Another edition of mortgage match-ups: “FHA vs. conventional loan.”
In recent years, FHA loans surged in popularity, largely because subprime (and Alt-A) lending was all but extinguished as a result of the ongoing mortgage crisis.
Simply put, the FHA stepped in to fill the void after private lenders closed up shop.
Some even claim FHA loans are the “new subprime” due to the dubious mix of low down payment and credit score requirements, despite originally being geared toward low and moderate-income borrowers.
But you don’t have to be a subprime borrower to take advantage of an FHA loan. In fact, some borrowers may have excellent credit and still go the FHA route because it makes more financial sense.
FHA and Conventional Loans Both Offer a Great Low Down Payment Option
- You can get an FHA loan with a 3.5% down payment and a 580 FICO score
- Or a conventional loan with just 3% down and a 620 FICO score
- FHA is more flexible in terms of credit score
- But be sure to consider the cost of mortgage insurance when comparing the two loan programs
First off, whether you go FHA or conventional, know that the down payment requirement is minimal. So you don’t need much in your bank account to get approved.
As noted, FHA home loans have become insanely popular. The main selling point of an FHA loan is the 3.5% minimum down payment requirement coupled with a low credit score requirement. That’s a one-two punch.
However, in order to qualify for the government loan program’s flagship low down payment option, you need a minimum credit score of 580. A score below 580 requires a 10% down payment, which most home buyers don’t have.
And 580 is just the FHA’s guideline – individual banks and mortgage lenders still need to agree to offer such loans. So there’s a very good chance you’ll need an even higher credit score with many lenders.
Of course, a 580 credit score is pretty dismal…and you should certainly strive for better, even if you are able to qualify for an FHA loan.
Along with that, an eligible donor can provide gift funds for 100% of the borrower’s closing costs and down payment. And no reserves are required if it’s a 1-2 unit property. In other words, you don’t need much if any cash to finance your home purchase with an FHA mortgage.
But thanks to new guidelines issued by Fannie Mae and Freddie Mac, you can now get a conventional loan with just 3% down .
That means the FHA is no longer winning in the down payment category if you ignore credit score. Both FHA and conventional loans can be had for very little down!
However, the FHA vs. conventional loan battle doesn’t end there. We need to consider other factors, such as credit score.
FHA Loans Good for Those with Poor Credit
- There’s not one clear winner for all loan scenarios
- It will depend largely on your credit score
- FHA loans tend to benefit those with low credit scores
- While conventional loans are often cheaper for those with better credit
While FHA mortgages require a slightly higher minimum down payment, you only need a 580 FICO score for approval.
Meanwhile, conventional mortgage loans require a minimum 620 FICO score. So it might be easier to go FHA vs. conventional if you’re struggling credit score-wise.
The screenshot above from the Urban Institute details when FHA wins out over conventional lending, and it tends to happen if credit scores fall below 720. The gray shaded sections show when FHA financing is the better deal.
We can see that FHA financing is remarkably cheaper for borrowers with credit scores between 620-679, and marginally cheaper for scores between 680-719.
The blue shaded sections show when you’re better off going with a conventional home loan. The biggest benefit seems to be for borrowers with credit scores of 760+.
Of course, you’ll need to plug in your actual numbers into a mortgage calculator to see what works for you.
The other major selling point to an FHA loan is that the minimum credit score is 500. Again, this is subject to lenders actually offering programs for scores this low.
And as mentioned, scores between 500 and 579 require a higher minimum down payment of 10%.
But FHA loans can be a good option for those with bad credit and little set aside for down payment who are determined to get a mortgage.
FHA Loans Hugely Popular with First-Time Buyers
Chances are if you’re a first-time home buyer, you’ll use an FHA loan over a conventional loan.
Just look at the chart above from the Urban Institute, which details the FTHB share of purchase mortgages by loan type.
As you can see, the FHA was dominated by FTHB with an 82.8% share in October 2018. Yes, nearly 83% of those who used an FHA loan for a home purchase were first-timers.
Meanwhile, only 47.8% share of purchase loans backed by the GSEs (Fannie Mae and Freddie Mac) went to first-timers.
The reason this might be the case is due to the low credit score requirement coupled with the low down payment requirement.
Since first-timers are often short on down payment funds (because they aren’t selling a prior residence and using the proceeds toward the new home), FHA tends to be a good fit.
FHA borrowers also generally have higher DTI ratios, higher LTVs, smaller loan amounts, and lower credit scores relative to GSE borrowers.
However, if you have student loans, which a lot of first-timers probably do, the FHA can treat them unfavorably when qualifying you for a mortgage.
If you’re in an income-driven repayment (IDR) plan, the FHA uses 1% of the entire balance as the monthly payment for DTI purposes.
Meanwhile, Fannie Mae will allow the actual income-based repayment, even if it’s $0. This can make qualifying for a conventional loan easier.
Are FHA Mortgage Rates Lower than Conventional?
- FHA rates are typically lower than conventional rates
- But the spread can vary and not be all that different
- You also have to consider the entire housing payment
- Factoring in mortgage insurance and closing costs
Speaking of mortgage rates, FHA loans tend to come with slightly lower interest rates, though one has to consider the entire payment (with mortgage insurance included) to determine what’s the better deal.
The box above actually assumes an interest rate of 4.70% for an FHA loan and 4.66% for a similar conventional one, though you’ll need to consider actual and current mortgage rates. This is somewhat unusual since it’s usually the other way around.
This spread can vary over time and there’s a good chance FHA mortgage rates will be lower than conventional ones in the future, so pay attention to current rates on both products as well.
I wouldn’t bank on FHA rates being higher, so if reality turns out to be different, it can certainly change the outcomes in the table above.
FHA Loans Subject to Mortgage Insurance
- Mortgage insurance is unavoidable on an FHA loan
- And will often remain in force for the entire loan term
- Conventional loans allow you to drop MI at 80% LTV
- Which is a huge advantage
We’ve talked about some benefits of FHA loans, but there are drawbacks as well.
The major one is the mortgage insurance requirement. Those who opt for FHA loans are subject to both upfront and annual mortgage insurance premiums, often for the life of the loan.
The upfront mortgage insurance requirement is unavoidable, and nearly doubled from 1% to 1.75% back in 2012. And the annual premium can no longer be avoided.
Since 2013, many FHA loans now require mortgage insurance for life, making them a lot less attractive and expensive long-term! The never-ending FHA MIP could be the tipping point for some.
Additionally, it’s possible to execute an FHA to conventional refinance to dump the MIP once you have the necessary home equity. So it doesn’t really need to stay in-force for life.
Keep in mind that FHA loan offerings are also pretty basic. They offer both purchase mortgages and refinance loans, including a streamlined refinance, but the choices are slim.
At the same time, the max loan-to-value ratio for a cash out refinance is a very low 85%, which makes them a poor choice for tapping equity. But they’re mostly used for home buying anyway.
Conventional Loans Offer Many More Options and Just 3% Down!
- Access to more loans programs (fixed, ARMs, etc.)
- And you can get financing on more property types
- Including vacation homes and investment properties
- And the minimum down payment requirement is lower!
Now let’s discuss conventional loans, an alternative to FHA loans that tend to offer a lot more variety.
With a conventional loan, which includes both conforming and non-conforming loans, you can get your hands on pretty much any home loan program from a 1-month ARM to a 30-year fixed, and everything in between.
So if you want a 10-year fixed mortgage, or a 7-year ARM, a conventional loan will surely be the way to go.
And now you can get a conventional loan with just 3% down, which actually beats the FHA’s down payment requirement slightly!
Another benefit of going with a conventional loan vs. an FHA loan is the higher loan limit, which can be as high as $765,600 in certain parts of the nation.
This can be a real lifesaver for those living in high-cost regions of the country (or even expensive areas in a given metro). With an FHA loan, you might be stuck with a maximum loan amount just above $300,000.
For example, it caps out at $331,760 in Phoenix, Arizona. That pretty much ends the discussion if you’re planning to buy even semi-expensive real estate there. Your only option will be a conventional mortgage loan.
Anything above the FHA loan limit is considered a jumbo loan, and will often come with a higher mortgage rate and tougher underwriting criteria, such as a higher down payment requirement and more limited debt-to-income ratios.
However, jumbos are still technically considered conventional mortgages because they aren’t government loans. And more importantly, they aren’t capped at a certain loan limit because they live outside the requirements of Fannie Mae and Freddie Mac.
For those who need a true jumbo loan, a conventional mortgage will be the only way to obtain financing.
Are Fannie Mae and FHA the same thing?
People seem to confuse these two, so let’s put it to rest. The answer is NO.
Fannie Mae is one of the two government-sponsored enterprises (a quasi-public company) along with Freddie Mac that issues conforming mortgages.
The FHA stands for Federal Housing Administration, a government housing agency that insures mortgages.
They have a similar mission to promote homeownership and compete with one another, but they are two completely different entities.
No Mortgage Insurance Requirement on Conventional Loans
- If you put down 20% or have 20% equity
- You won’t have to pay mortgage insurance
- Some lenders may even waive MI regardless of the LTV
- By offering a slightly higher interest rate
You won’t be subject to mortgage insurance premiums if you go with a conventional loan, assuming you put 20% down, or have at least 20% home equity when refinancing.
Even if you’re unable to put 20% down, there are low down payment loan programs that don’t require private mortgage insurance to be paid out of pocket.
In fact, the Fannie Mae Homepath program only requires a three percent down payment with no minimum borrower contribution (and you can get up to a 3% credit for closing costs).
Additionally, there are select lender programs that offer 3% down with no MI, so in some cases you can put down even less than an FHA loan without being subject to that pesky mortgage insurance.
Of course, you can argue that the PMI is built into the rate when putting down less than 20%, even if it isn’t paid explicitly.
So you might get stuck with a higher interest rate if you make a small down payment and don’t have to pay PMI.
As noted, conventional mortgages require a down payment as low as three percent, so low down payment borrowers with good credit may want to consider conventional loans first.
You Can Get Conventional Loans Anywhere
- All mortgage lenders offer conventional loans
- Whereas only some banks originate FHA loans
- Not all condos are approved for FHA financing
- And you can’t get an FHA loan on second homes or non-owner occupied properties
Another plus to conventional mortgages is that they’re available at pretty much every bank and lender in the nation.
That means you can use any bank you wish and/or shop your rate quite a bit more. Not all lenders offer FHA mortgage loans, so you might be limited in that respect.
Additionally, conventional loans can be used to finance just about any property, whereas some condo complexes (and some houses) aren’t approved for FHA financing. If you’re actively shopping, real estate agents will probably point this out to you.
The FHA has minimum property standards that must be met, so even if you’re a great borrower, the property itself could hold you back from obtaining financing. In other words, you might have no choice but to go the conventional route.
The same goes for second homes and non-owner investment properties. If you don’t intend to occupy the property, you will have no choice but to go with a conventional loan.
Let me make it very clear; the FHA home loan program is only good for owner-occupied properties!
Final Word: Is an FHA Loan Better than a Conventional One?
- There is no definitive yes or no answer
- You have to look at your loan scenario specifically
- Consider how long you’ll keep the loan and what your goals are
- Compare and contrast and do the math, there are no shortcuts!
These days, both FHA and conventional loans could make sense depending on your unique loan scenario. You can’t really say one is better than the other without knowing all the particulars.
And as noted, you or the property may not even qualify for an FHA loan to begin with, so the choice might be made out of necessity.
Both loan programs offer competitive mortgage rates and closing costs, and flexible underwriting guidelines, so you’ll really have to do the math to determine which is best for your particular situation.
Even with mortgage insurance factored in, it may be cheaper to go with an FHA loan if you receive a lender credit and/or a lower mortgage rate as a result.
Conversely, a slightly higher mortgage rate on a conventional loan may make sense to avoid the costly mortgage insurance tied to FHA loans.
Generally speaking, those with low credit scores and little set aside for down payment may do better with an FHA loan, whereas those with higher credit scores and more sizable down payments could save money with a conventional loan.
Also consider the long term picture. While an FHA loan might be cheaper early on, you could be stuck paying the mortgage insurance for life. With a conventional loan, you’ll eventually be able to drop the PMI and save some dough.
What a lot of folks tend to do is start with an FHA loan, build some equity (typically through regular mortgage payments and home price appreciation), and then refinance to a conventional loan.
In that sense, both loan types could serve one borrower over time.
Ask for a side-by-side cost analysis, but also make sure you understand why one is better than the other. Don’t just take their word for it! They might be inclined to sell you one over the other…
Lastly, be sure to consider the property as well, as both types of financing may not even be an option.
Tip: If you want a zero down loan, aka have nothing in your savings account, consider VA loans or USDA home loans instead, both of which don’t require a down payment.
There is also the FHA 203k loan program, which allows you to make home improvements and get long-term financing in one loan.
Now let’s sum it all up by taking a look at a condensed list of pros and cons for FHA and conventional loan programs.
FHA Loan Pros
- Low down payment requirement (3.5% down)
- Lower credit score needed (580 for max financing)
- Lower mortgage rates
- May be easier to qualify for than a conventional loan (higher DTIs allowed)
- Shorter waiting period to get approved after foreclosure, short sale, etc.
- No prepayment penalty
- No asset reserve requirement (for 1-2 unit properties)
- Gift funds can cover 100% of closing costs and down payment
- Streamlined FHA refinances are fast, cheap, and easy
FHA Loan Cons
- Slightly higher minimum down payment requirement (3.5% vs. 3%)
- Subject to mortgage insurance (for full term of mortgage in many cases)
- Must pay upfront and monthly mortgage insurance premiums
- Mortgage insurance harder to cancel
- Fewer loan type options than conventional loans
- Only available on owner-occupied properties
- Many condominium complexes aren’t approved for FHA financing
- Loan limits are lower in more affordable regions of the country
- Generally only allowed to have one FHA loan at a time
Conventional Loan Pros
- Lower minimum down payment requirement (3%)
- No mortgage insurance requirement if 80% LTV or lower
- Can cancel existing mortgage insurance at 80% LTV
- Can be used on all property and occupancy types
- Many more loan program options
- Can hold numerous conventional loans
- No maximum loan limit and conforming limit higher than the FHA floor
- More lenders to choose from (nearly every bank offers conventional loans)
- Easier qualifying guidelines for those with student loans
- Might be able to close your loan faster
Conventional Loan Cons
- Higher credit score requirements (minimum 620 credit score)
- Higher mortgage rates
- May be more difficult to qualify than FHA loan
- Mortgage insurance still required for loans above 80% LTV
- Reserves may be required to qualify
- Possible prepayment penalty (not common these days)