FHA Loans vs. Conventional Loans

Your dream home is something you can spend years thinking up – details like the kind of picture window you want to sit by while you drink your morning coffee, the exact shade of blue you’d paint the living room, a big backyard where the kids can play with the dog. But once you find a house where you can envision those dreams coming true, you usually want to act pretty fast.

That’s why it’s so important to understand what the different types of home loans are – and how they would fit into your financial situation. There are a lot of different options when it comes to mortgages, and understanding the difference between an FHA loan and a conventional loan could help you make a better decision.

You should explore all your home loan options before getting a mortgage, and that’s where we come in. Contact one of the home loan experts at Arkansas Federal Credit Union to learn more about your options and which type of loan might work best for you – and keep reading to get some insight into what differentiates an FHA loan from a conventional loan.

What is an FHA Loan?

A Federal Housing Administration loan, or an FHA loan, is exactly what it sounds like – a home loan that’s backed by the Federal Housing Administration. This means that the loan is insured by the federal government, and FHA loans are largely intended for people who might have trouble securing loans from private lenders due to factors like a low credit score. FHA loans tend to be popular with first-time home buyers because they require a lower down payment.

What is a Conventional Mortgage?

A conventional mortgage, or conventional loan, is any mortgage that is not guaranteed or insured by the government. With a conventional loan, the lender takes on all the risk by originating the loan, so your credit history and financial situation will be more closely scrutinized when you apply for a conventional loan.

How to Compare FHA Loans and Conventional Loans

While FHA loans and conventional loans set out to accomplish the same goal – helping you pay for your house – there are several differences between FHA loans and conventional loans. It’s important to consider all aspects of each type of loan and how they might differ so you can figure out which loan is the best option for you. It’s also worth noting that the differences between conventional loans and FHA loans can vary by lender because while minimum standards are set federally, some lenders may have stricter requirements for their loans.

Minimum Down Payment and Credit Score

The biggest differences between FHA loans and conventional loans tend to be the minimum requirements for down payment and credit score. With an FHA loan, you’ll typically need a 500-579 credit score¹ to qualify, and you’ll make a minimum 3.5% down payment. With a conventional loan, you can offer as low as a 3% down payment, but you’ll need a credit score of at least 620 to qualify. These are minimums, but you’re more likely to qualify and get a better interest rate for either if you have a better credit score.

Debt-to-Income Ratio

Your debit-to-income (DTI) ratio is the amount of your monthly income that you already allocate towards paying debts (things like your mortgage, student loans, auto loans, child support, minimum credit card payments, etc.). The higher your DTI, the riskier you look to lenders, as you might be more likely to struggle to meet your monthly loan payments. 

If you have a DTI between 43-50%, you’re more likely to qualify for an FHA loan, although you can still qualify for an FHA loan with a DTI above 50%. With a conventional loan, a DTI below 36% is preferred, but you could still qualify up to 50%.

Mortgage Insurance

Private mortgage insurance (PMI) is a type of insurance that protects a mortgage lender if the borrower is unable to pay their mortgage. PMI is usually around 0.5%-1.5% of the loan amount per year, and it will be added to your monthly mortgage payment.

On a conventional loan, PMI is required with any down payment that’s less than 20%. Once you have 20% equity in your home, you may be able to cancel the PMI², but it’s important to note that if you choose a conventional loan, PMI will play into your monthly budget for a time.

If you take out an FHA loan, a PMI will be required, no matter what your down payment is. If your down payment is 10% or higher, you can cancel the PMI after 11 years, but any down payment less than 10% will mean you pay mortgage insurance premiums, or MPIs, for the entire life of the FHA loan.

Part of the reason FHA loans are attractive is because they typically come with lower interest rates. But this doesn’t always mean that an FHA loan will be cheaper, especially when you take into consideration what you’ll be paying in mortgage insurance premiums. 

Appraisals

No matter what type of home loan you choose, you’ll need to have an appraisal before you close on your house. After your offer is accepted, the lender will order an appraisal to determine the value of the property. The appraisal will also determine factors such as your interest rate, minimum down payment, and, ultimately, whether or not you’ll be approved for the loan. For the different types of home loans, lenders will have different approaches to the appraisal step of the process.

If the borrower is seeking an FHA loan, the appraisal will be a bit stricter. Lenders will take into consideration the property value, safety, soundness, and adherence to local codes. Because an FHA loan is backed by the government, there are more restrictions to what it can fund, so lenders will want to ensure that the value matches the money they are providing.

With a conventional loan, an appraisal is still important but will not be as scrutinous as the appraisal for an FHA loan. The purpose of an appraisal for a conventional loan is to verify the property’s market value supports the loan amount being requested.

Regardless of what type of mortgage you use, it’s also recommended that you have an inspection, which is another type of thorough home investigation that’s more focused on ensuring that the home is in good condition.

Property Type

Between FHA loans and conventional loans, there are different requirements for what the property must be used for. The property must be your primary residence if you’re seeking an FHA loan, while the property can be used for any purpose under a conventional loan.

Get Started on a Loan Application Today!

The home-buying process is one that’s made of lots of important decisions, and settling on which type of home loan you’re going to use is one of the bigger ones. There are a lot of factors that come into play at this step, and it’s important that you carefully consider each of them before making a decision. You want the best mortgage for your situation – and it may not always be the one that seems like the obvious choice.
Have questions about the process or specifics about the different types of home loans? That’s normal – and something we can help with. Get more information by visiting afcu.org/mortgage, or stop by one of our local branches to talk to a mortgage expert.