Are you ready to take the plunge and buy a house, but aren’t sure of all the different loan types available? Let’s kick off your research in the right direction and take a look at two types of loans, conventional and FHA loans – and the pros and cons of each.
What Is An FHA Loan?
An FHA loan is a government-backed home loan insured by the Federal Housing Administration. An FHA loan has less-restrictive qualifications which can make it a good choice if you’re worried about coming up with a down payment and/or have a lower credit score.
What Is A Conventional Loan?
Conventional loans aren’t insured or guaranteed by a government agency, they’re insured by private lenders. You need to have a higher credit score, lower debt-to-income (DTI) ratio and down payment to qualify.
Conventional loans are also called conforming loans because they conform to Fannie Mae and Freddie Mac standards. Fannie Mae and Freddie Mac are government-created enterprises that buy mortgages from lenders and hold the mortgages or turn them into mortgage-backed securities. Conventional loans are also available in fixed rates and ARMs. Common loan terms range from 10 – 30 years.
FHA Vs. Conventional Loans: Credit Score
Lenders take a look at your credit score whether you pursue an FHA loan or a conventional loan. Your credit score is a three-digit number that represents the amount of risk a lender takes on when you borrow money. Your credit score could range from excellent (800 and above) to poor (350 – 579) and it’s all based on your credit history. The higher your credit score, the less risky you are to a lender.
Most lenders look at your FICO® Score, a credit scoring model developed by the Fair Isaac Corporation, which ranges from 350 points (low) to 850 points (high). Lenders also use VantageScore®, another type of credit scoring model. You also have a score that comes from each of the three major credit bureaus: Experian®, Equifax® and TransUnion®.
The following factors are taken into consideration to build your score:
- Whether you make payments on time
- How you use your credit
- Length of your credit history
- Your new credit accounts
- Types of credit you use
So, what does your credit score need to be to get a loan? That depends on the type of loan you’re after.
Conventional Loan Credit Score Requirements
Credit score requirements for a conventional loan vary depending on the lender. However, you generally need a minimum credit score of 620 or higher in order to qualify for a conventional loan. The credit score requirement is higher for conventional loans compared to FHA loans because the lender takes on more risk, and conventional loans don’t have the backing of a government agency.
FHA Loan Credit Score Requirements
You can qualify for an FHA loan with a credit score as low as 500, but it does come with strings attached. For example, you need to be able to put 10% down in order to get an FHA loan with a credit score of 500.
The higher your credit score, the lower your down payment needs to be for an FHA loan. Generally, most FHA loan lenders (including Quicken Loans®) require a credit score of 580 and above.
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FHA Vs. Conventional Loans: Down Payment
Let’s dig into the specifics of exactly how much of a down payment you’ll need for each type of loan.
Conventional Loan Down Payment
Contrary to popular belief, a 20% down payment is not a requirement for a conventional loan. However, if you can’t come up with a 20% down payment, you pay private mortgage insurance (PMI), which is a lender’s protection in case you default on your loan.
A smaller down payment equals more risk, so you mitigate that risk for the lender when you pay for mortgage insurance. PMI payments are built directly into your monthly mortgage payments.
FHA Loan Down Payment
You can put down as low as 3.5% for an FHA loan, but you need to have a credit score of at least 580. You’re required to put 10% down if your credit score is lower, in the 500 – 579 range.
Here’s an example of how much you’d pay for a down payment on both types of loans:
- Conventional loan down payment of 20% on a $200,000 house: $40,000
- FHA loan down payment of 3.5% on a $200,000 house: $7,000
FHA Vs. Conventional Loans: Interest Rates
Mortgage interest rates are affected by the following high-level factors:
- The state of the economy
- Investor demand
- The Federal Reserve
Though these factors do play a role, it’s important to focus on the financial factors you can control. Lenders will take into account your credit score, the amount you borrow, your down payment amount, whether you choose an adjustable or fixed-rate mortgage and discount points.
Monthly payments on adjustable rate mortgages (ARMs) change periodically depending on the prevailing interest rate after the fixed-rate period expires. Fixed-rate mortgages keep the same interest amount and payment until you pay off the mortgage.
Discount points are fees paid to a lender to get a lower interest rate. You pay for discount points to enjoy lower monthly mortgage payments over the life of the loan.
Conventional Loan Interest Rates
Again, conventional loan interest rates depend on the factors you can influence. They also include your credit score and loan-to-value ratio (LTV). LTV ratio refers to the amount of loan you take out relative to the value of the property that secures a loan.
FHA Loan Interest Rates
FHA interest rates can be competitive compared to conventional mortgages because the government backs the loan and decreases the risk for your lender. Your interest rate depends on several factors, including market interest rates, your income, credit score, the amount you plan to borrow, your down payment amount and more.
FHA Vs. Conventional Loans: Loan Limit
Both conventional and FHA loans have loan limits, which means you cannot go over the loan limit amount for either type.
Conventional Loan Limit
In 2019, conventional loan limits for one-unit family homes in the lower 48 states is $484,350, and for Alaska and Hawaii, it’s $726,525. For high cost areas, it’s also $726,525. High-cost areas exist in the District of Columbia and the following states: California, Colorado, Connecticut, Florida, Georgia, Idaho, Maryland, Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Tennessee, Utah, Virginia, Washington, West Virginia and Wyoming. If you need a loan for a home that exceeds these loan limits, you need to consider something called a jumbo loan. Jumbo loans are non-conforming loans because they aren’t backed by Fannie Mae or Freddie Mac. They usually have stricter underwriting guidelines because they’re riskier for a lender.
FHA Loan Limit
New loan limits are set on FHA loans every year. These limits depend on where in the U.S. you consider a home purchase. The upper limit in low-cost counties is $314,827, such as in rural Missouri, and the upper limit in high-cost counties is $726,525, such as Orange County, California. The easiest way to determine the upper limit in your county is to visit the HUD website for FHA mortgage limits. If you choose to go with an FHA loan over a conventional loan, it’s important to remember that these loan limits might cap the amount of home you can purchase.
FHA Vs. Conventional Loans: Mortgage Insurance
Mortgage insurance protects the lender in the event that you default on your loan.
Conventional Loan Mortgage Insurance
If you don’t put at least 20% down for a down payment, you’re required to pay for private mortgage insurance (PMI), which can come in several forms:
- The most common is that you pay a monthly premium, which is an annual rate divided by 12.
- A single premium policy is another option, which involves an upfront payment.
- A split premium is an upfront payment as well as a monthly premium, and ideally, a seller will pay the upfront premium.
- Lender-paid PMI is also another option, in which the lender purchases the insurance and you pay it back at a higher interest rate. You cannot cancel lender-paid PMI.
FHA Loan Mortgage Insurance
A mortgage insurance premium (MIP) is a required payment for an FHA loan. FHA loan mortgage insurance is typically paid for the life of your loan, unless you make a down payment of 10% or more, in which case MIP comes off after 11 years. You’ll pay an upfront mortgage premium (UFMIP), which normally amounts to 1.75% of your base loan amount.
You also pay MIP payments of approximately 0.45% – 1.05% of the base loan amount, all based on the term (length) of your mortgage, your loan-to-value ratio (LTV), your total mortgage amount and the size of your down payment.
When A Conventional Loan Makes Sense
Each situation is flexible, but your qualifications or preferences should be close to these if you want to try for a conventional loan:
- Your credit score is at least 620.
- You have a down payment equal to at least 3%, or 20% if you want to avoid PMI.
- You have a low debt-to-income ratio, or DTI, which compares your monthly debt payments to your monthly gross income.
- You want flexible repayment terms.
When An FHA Loan Makes Sense
An FHA loan makes the most sense if you have these preferences or meet the following:
- You don’t have a high credit score.
- You don’t have much money for a down payment.
- You have a higher DTI.
Ultimately, understanding which loan is right for you is a matter of understanding your financial situation and needs.
An FHA loan is a government-backed home loan insured by the Federal Housing Administration. An FHA loan has less-restrictive qualifications compared to a conventional loan, which is not backed by a government agency. You need to have a higher credit score, lower debt-to-income (DTI) ratio and down payment to qualify for a conventional loan.
There are specific loan limits for both FHA and conventional loans and you may need to pay mortgage insurance for conventional loans but must pay a MIP for an FHA loan. Directly weigh the pros and cons and your own qualifications so you take your next steps in the right direction.
If you want to consult with an expert, Rocket Mortgage® by Quicken Loans® has Home Loan Experts available to help you weigh the pros and cons of each.
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