Comparing FHA Loans to Conventional Mortgages

Jun 30, 2023 | Mortgage Guides

Choosing Wisely: Comparing FHA Loans to Conventional Mortgages

Picking a home loan can be complex, especially for first-time homebuyers. Navigating the rates, loan types, and eligibility requirements may be intimidating. 

This article will explore two major loans and their differences; FHA loans, which are government-insured, and conventional mortgages, which are privately insured, are both viable routes for homebuyers. Understanding the differences will help you pick the appropriate one for your financial goals.

Loan Types

While there are several loans for different situations, the FHA and conventional loans are the most common options for first-time homebuyers because they have fewer requirements. 

While a VA loan is only for veterans or active-duty military personnel, and a USDA loan is for rural or suburban areas, FHA and conventional home loans can be used for various property types and by many borrowers.

Define FHA Loans

FHA loans are backed by the Federal Housing Administration (FHA). They are aimed at lower—and middle-income homebuyers and are more accessible than traditional home loans because the FHA takes on most of the risk. 

Define Conventional Loans

Conventional home loans are the most common home loan. They are available to all income levels but have higher eligibility requirements because the lender backs them.

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Eligibility  Requirements

The main difference between an FHA and a conventional loan is the requirements to qualify for the mortgage. FHA loans are for low-income buyers, and because of this, they have more accessible qualifications. Conventional loans, on the other hand, often have stricter eligibility requirements. The three differences in eligibility are credit score, down payment, and DTI.

Credit Score

Although it may differ depending on the lender, an FHA loan often has a credit requirement of 580 or more. This number will also vary depending on other factors, such as down payment and income. 

A conventional loan often requires a credit report of at least 620 to qualify. Although the gap may be dismal, those 40 points can make a difference. Talk to potential lenders to understand the exact credit requirements for either loan.

Down Payment

Another factor for those considering loans is the down payment. A conventional loan requires a down payment in the range of 20% of the total. If the buyer defaults on the loan, the lender has collateral. Since the FHA is government-insured, the lender does not have the same level of concern. This means FHA loans have a down payment requirement, sometimes as low as 3.5%.

Debt-to-Income Ratio

DTI (debt-to-income ratio) is another tool for determining a potential borrower’s risk factor. Your DTI is the percentage of your income allotted for debts. 

On a conventional loan, most lenders will require a DTI of less than 50% for excellent credit or 36% for those with good credit. An FHA loan can be given with up to 56% DTI, depending on the other qualifications. A DTI of 43% or less is required if the other qualifications cannot compensate.

Interest Rates and Fees

After eligibility, the next significant difference between FHA loans and conventional mortgages is the interest rates and fees. For homebuyers who qualify for both mortgages, this is often the deciding factor. 

FHA Loan Interest Rates and Fees

Interest rates depend on the state, lender, and borrower’s qualifications. On average, FHA loans will offer better interest rates, but they may also have a higher APR—fees like MIPS (mortgage insurance premiums) and other charges. 

Conventional Loan Interest Rates and Fees

While often having lower interest rates, conventional loans also have a greater range of interest rates. The rate will vary due to various factors. While a conventional mortgage may not charge a MIP, those with lower down payments should be wary of PMI (private mortgage insurance). This is a service fee that lenders or 3rd parties may charge to protect their investment.

Loan Limits

FHA loans have a lower loan limit. This means buyers looking to purchase high-end properties may not qualify for an FHA loan. This is not often an issue because FHA loans are targeted at low-income homebuyers, but it still may be a deciding factor.

FHA Loan Limits

FHA loan limits depend on the county where the property is being bought. The average loan limit for an FHA mortgage will be around $470,000, but that number fluctuates. In affluent areas, it may reach $1,080,000.

Conventional Loan Loan Limits

While the cap for opulent areas is the same, conventional loans can be up to $726,000 (although the number will change). Being privately insured, lenders can risk more. Anything larger than the conventional loan limit is called a “jumbo” or non-conforming loan.

Approval Process

The approval process for both loans is similar, the primary difference being the qualifications. Getting approved for an FHA loan is more accessible. However, it may not offer as many benefits as a conventional mortgage.

FHA and Conventional Mortgage Approval Process

The first step is prequalification, where the lender ensures the potential lender meets the eligibility requirements. 

After this, the borrower will complete a loan application. This will include detailed information about the borrower’s finances, employment, and other related topics. This is also the phase where the borrower will submit financial documents requested by the lender. Some items that will be required are pay stubs, W-2 forms, tax returns, IDs, and more. 

The lender will then appraise the property and begin underwriting the loan. After that, the lender will decide whether to approve the loan. If both parties agree to proceed, then the time comes to close on the house.

This process may vary depending on the lender.

Mortgage Insurance

Insurance is the final factor that must be considered when deciding on a mortgage. As mentioned above, FHA and conventional mortgages have different insurance requirements, meaning dissimilar fees and different types of insurance.

Private Mortgage Insurance for Conventional Mortgages

Private mortgage insurance (PMI) protects lenders in case of a default. It is not required on home loans with down payments of 20%. On smaller down payments, the borrower will be charged a fee. In exchange, a 3rd party will protect the lender’s investment in case of default. PMI is charged until the LTV (loan-to-value) ratio reaches 80%, after which the borrower may be able to cancel the insurance.

Mortgage Insurance Premium for FHA Mortgages

MIP for FHA home loans will often last for the loan life. Sometimes, the borrower may opt-out after the LTV hits 78%. There is also an upfront insurance premium of 1.75% of the mortgage. This premium is rolled into the mortgage, but it is essential to consult your lender to understand MIPs for your FHA loan. 

Final Thoughts

FHA loans and conventional mortgages both have their benefits. While FHA loans may be better for those with less qualifications, conventional mortgages offer more flexibility. Considering factors such as eligibility, interest rates, loan limits, and insurance will help potential homebuyers decide which mortgage type is appropriate.

Click here to learn more about FHA loans, or click the link below to start the journey of buying a new home. We at Wesley Mortgage are here to help you through this life-changing process!

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