FHA Vs. Conventional Loans: Definition And Differences

If you’re just starting the process of buying a house, you’ll have to decide early on what kind of mortgage loan you’ll use to pay the home seller. The first thing to know is that there are several types of home loans, each with its own advantages and disadvantages.

Let’s take a look at two broad categories of loans: conventional loans versus those offered through the FHA loan program.

An FHA loan is a government-backed home loan insured by the Federal Housing Administration. This 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.

Government-backed loans are a type of nonconforming loan. That means that borrowers don’t need to meet conventional lending standards – generally set by Fannie Mae and Freddie Mac, though government agencies can set their own qualification standards.

FHA loans are available as fixed-rate or adjustable-rate mortgages (ARMs).

Conventional loans are home loans offered by private lenders without any direct government backing. In other words, unlike FHA loans, they aren’t insured or guaranteed by a government agency. You need to have a higher credit score, lower debt-to-income (DTI) ratio and usually a slightly higher down payment to qualify.

Conventional loans can be either conforming or nonconforming loans. Conforming loans meet Fannie Mae and Freddie Mac standards, which includes many consumer protections.

Conforming loans can’t exceed conforming loan limits.

Nonconforming loans – most commonly, jumbo loans – are offered to those who wish to buy a home that exceeds conforming loan limits. Here at Rocket Mortgage®, we offer Jumbo Smart loans. Our jumbo loans are processed just like our conforming loans, so you get the same consumer protections with a much higher loan limit.

Like FHA loans, conventional loans are available as fixed-rate or adjustable-rate mortgages (ARMs). Commonly, loan repayment terms for home loans are 15 or 30 years, however conventional loans are available for any term from 8 – 30 years.

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 based on your credit history, among other factors. The higher your credit score, the less of a risk you are and the lower rate you’ll qualify for.

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 may also use VantageScore®, another type of credit scoring model. Your credit score and information are reported by each of the three major credit bureaus: Experian™, Equifax® and TransUnion®. Your score may vary between credit bureaus.

If you're applying as a sole borrower, the median score between the three is considered the qualifying score. If you're applying with another borrower, the score that’s generally considered is the lowest median score between multiple clients. There’s one notable exception we'll get to below.

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 credit score do you need 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 to qualify for a conventional mortgage. This is based on your median score as an individual. If you have a co-borrower, Fannie Mae often looks at things a little differently than other mortgage investors. They take the average median score of all borrowers on the loan rather than the lowest median score. This can make it easier to qualify.

If your co-borrower has a median score of 580 and you have the median score of 720, in the past, both incomes couldn't be used to qualify for a conventional loan. Now Fannie Mae averages the two, making the qualifying score 650. It's important to note that for your interest in mortgage insurance cost, the lowest median score is still what counts, so you could have a slightly higher rate. Additionally, this doesn't apply to every loan option offered by Fannie Mae.

FHA Loan Credit Score Requirements

You can qualify for an FHA home 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 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 Rocket Mortgage) require borrowers to have a credit score of 580 and above. The qualifying credit score is the lowest median score if you have a co-borrower. If you're an individual, it's your middle score.

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

To qualify for some conventional loans, you’ll need a minimum 3% down payment. For most conventional loans, a 5% down payment is required.

It’s a popular misconception that home buyers must have a 20% down payment to get a mortgage loan. A 20% down payment is an optimal down payment because it allows home buyers to avoid private mortgage insurance (PMI) premiums, which we’ll look at in more detail below.

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

For an FHA loan, a 3.5% down payment is sufficient if your credit score is 580 or above. If your credit score is between 500 and 579, you’ll be asked to make a 10% down payment.

Here’s an example of how much you’d pay for a down payment on both types of loans:

• Conventional loan down payment of 3% on a $400,000 house: $12,000
  
  
• FHA loan down payment of 3.5% on a $400,000 house: $14,000

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 initial fixed-rate period expires. Fixed-rate mortgages keep the same interest amount and payment until you pay off the mortgage.

Discount points are prepaid 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 (LTV) ratio. 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 more 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.

In many respects, the appraisal process is the biggest difference between the two types of loans, and it can lead sellers in a tight housing market to avoid offers backed by FHA loans.

Conventional Appraisals

If you’re buying a home with a conventional loan, your lender will require a home appraisal. That’s because they want to be sure the house you want to buy with the loan has sufficient value so if they are forced to sell after a foreclosure, they’ll recoup their losses.

FHA Appraisals

FHA appraisal standards – also used by VA and USDA loan programs – are more demanding than those required by conventional lenders.

Listing agents – those who represent sellers – may advise their clients to avoid offers backed by FHA loans because of its strict appraisal standards. Because the appraisal approval and value comes late in the process, sellers will have lost a lot of time on the home sale. They’ll have to start all over again, and sellers will have to disclose to future home buyers any conditions identified by the FHA appraisal process.

Both conventional and FHA loans have loan limits, which means you can’t go over the loan limit amount for either type.

Conventional Loan Limit

The 2023 conforming loan limit will be $726,200, with higher cost areas at $1,089,300.

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 a jumbo loan mentioned above. They usually have stricter underwriting guidelines because of the larger loan size.

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 $472,030, such as in rural Missouri, and the upper limit in high-cost counties is $1,089,300, 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.

Mortgage insurance protects the lender if 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 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 another option, in which the lender includes your mortgage insurance in you monthly principal and interest payment by giving you a slightly higher interest rate. This can have advantages for many borrowers, but keep in mind that you can’t cancel lender-paid PMI unless you refinance or sell your home.

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 0.15% – 0.75% of the base loan amount, all based on the term (length) of your mortgage, your LTV ratio, your total mortgage amount and the size of your down payment.

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 of at least 3%, or 20% if you want to avoid PMI.
  
  
• You have a low DTI, which compares your monthly debt payments to your monthly gross income.
  
  
• You want flexible repayment terms.

An FHA loan makes the most sense if the following applies to you:

• 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. You should directly weigh the pros and cons and your own qualifications, so you take your next steps in the right direction.

Are you ready to get started on your home loan approval process? Apply online now and let us help you decide which option will work best for you.