March 26, 2024
Written by Jordan Bishop
Financial Writer
Financial Writer
Jordan Bishop is the founder of Yore Oyster and the author of Unperfect: Innovators, Trendsetters, and the Art of Problem Solving. He writes about investing, money psychology, crypto, and luxury travel. In his free time, he likes to run and eat kimchi.
When financing a home, navigating the maze of mortgage options can be intimidating. Among all the choices, FHA and conventional loans stand out as two of the most popular pathways to homeownership.
Each of these two types of loans carries its unique set of pros and cons, so prospective buyers should learn about each before deciding. We'll demystify these mortgage options and offer a comprehensive comparison to help you choose the right loan for your financial situation and homeownership goals.
Federal Housing Administration (FHA) loans are a government-backed method of achieving homeownership that helps people with lower credit scores or limited funds for down payments. These loans have more lenient eligibility requirements than conventional loans, which makes them particularly enticing for first-time homeowners.
Borrowers with credit scores as low as 500 may qualify for an FHA loan, provided they can make a down payment of at least 10%. For those with credit scores of 580 and above, the down payment requirement is just 3.5%.1
However, there are additional costs that come with FHA loans.
Borrowers are required to pay an upfront mortgage insurance premium (MIP) and an annual mortgage insurance premium, which can significantly add to the overall cost of the loan.
FHA loans also come with borrowing limits that may restrict you from buying a higher-priced property.
Despite these drawbacks, FHA loans continue to be a popular way to finance the purchase of a home, especially for those who find it challenging to qualify for conventional financing due to credit or financial constraints.
In contrast to FHA loans, conventional loans are not backed by the government. Instead, they're offered by private lenders like banks and mortgage companies.
Since the private sector offers conventional loans, lenders have more leeway in establishing eligibility requirements, including credit scores, down payment amounts, and debt-to-income ratios. Borrowers with strong credit profiles may benefit from more favorable terms, including lower interest rates and reduced fees.
While FHA loans are generally intended for owner-occupied residences, conventional loans can also finance second homes and investment properties. Conventional loans don't impose the same property condition requirements as FHA loans, giving borrowers more flexibility in choosing the homes they wish to purchase.
However, conventional loans generally require higher credit scores and larger down payments than FHA loans. Most lenders require a minimum credit score of 620.2
When weighing the differences between FHA and conventional loans, there are a few factors you should consider to choose the best fit for your individual circumstances. Let's take a look:
FHA loans typically have more lenient eligibility requirements than conventional loans. They're known for accepting lower credit scores and allowing for smaller down payments, making homeownership more accessible to people with less-than-perfect credit or limited savings.
In contrast, conventional loans usually require higher credit scores and larger down payments. While this will pose challenges for some borrowers, it also result in more favorable terms for those with strong credit profiles. Lenders typically favor borrowers with credit scores of 620 or above, and down payment obligations can vary depending on the borrower's creditworthiness and the specific type of mortgage loan.2
FHA loans offer down payment options as low as 3.5% for borrowers with credit scores of 580 or higher. For those with scores between 500 and 579, a minimum down payment of 10% is required. These smaller down payments may result in higher monthly mortgage payments and increased overall costs over the life of the loan, but they also allow people with lower savings to become homeowners sooner rather than later.3
Conventional loans, on the other hand, may require larger down payments ranging from 5% to 20% of the home's purchase price. The benefit of making a larger down payment is that it normally leads to lower monthly mortgage payments and reduced overall interest costs.2
FHA loans require both an upfront mortgage insurance premium (MIP) and an annual mortgage insurance premium, which adds to the overall cost of the loan. The upfront MIP can be financed into the loan amount, but the annual MIP (which protects the lender in case the borrower defaults on the loan) is an ongoing expense that borrowers need to budget for over the life of the loan.4
Conventional loans may also require private mortgage insurance (PMI) if the down payment is less than 20% of the home's purchase price.5 However, unlike FHA loans, PMI can typically be canceled once the borrower reaches a certain level of equity in the home. This can result in lower monthly mortgage payments over time and reduced overall costs, making conventional loans an attractive option for borrowers who can afford the larger required down payment.
FHA loans often have slightly higher interest rates compared to conventional loans, particularly for borrowers with weaker credit profiles. While the difference may seem minimal, even a slight difference in interest rates can have a significant impact on the amount paid over the long-term.
Borrowers with excellent credit may be able to secure more favorable interest rates with conventional loans, saving them a substantial amount of money over the life of the loan. With that said, consider all aspects of the loan, including fees and closing costs, to determine the most cost-effective option based on your individual situation.
FHA loans have borrowing limits that vary by location and are set by the Federal Housing Administration. These limits may restrict borrowers who want to purchase a higher-priced property, especially in areas with high housing costs.6
Conventional loans generally have higher borrowing limits than FHA loans, allowing borrowers to finance more expensive homes. However, loan limits may still apply depending on the specifics of the loan and the borrower's financial situation.
In addition to FHA and conventional loans, there are a few other government-backed programs that offer alternative paths to homeownership.
VA loans: Available to eligible veterans, active-duty service members, and their spouses, VA loans often require no down payment and offer competitive interest rates. They also eliminate the need for private mortgage insurance (PMI), reducing the overall costs for qualified borrowers.7
USDA loans: Aimed at rural and suburban homebuyers, USDA loans offer 100% financing and lower interest rates, making homeownership more accessible in rural communities.8
State and local housing agency programs: Many states provide housing assistance and down payment grants to first-time buyers and low-to-moderate-income families.
Exploring these options alongside FHA and conventional loans will help you determine which is better for you.
Choosing between an FHA and a conventional loan hinges on your credit score, down payment capacity, and long-term financial goals.
FHA loans and conventional loans each have their own advantages and considerations. FHA loans offer more accessible eligibility criteria and lower down payment requirements, making them suitable for individuals with lower credit scores or limited savings.
On the other hand, conventional loans offer more flexibility and potentially lower costs for borrowers with strong credit profiles and larger down payments.
Find out more about how to get a mortgage.
An FHA loan is a mortgage insured by the Federal Housing Administration, designed to make homeownership more accessible to borrowers with lower credit scores and smaller down payments.
While FHA loans carry lower upfront costs in the form of a lower down payment, they also come with higher ongoing costs in the form of mortgage insurance premiums and higher interest rates, which cost the borrower more over the lifetime of the loan.
There's no one-size-fits-all loan since the best loan option depends on your financial situation, credit history, and homeownership goals. Instead, evaluate the characteristics and pros and cons of each loan type to make the decision that's best for you.
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