When you’re trying to decide how to finance a home purchase, it’s a match-up worth considering: FHA vs. conventional loans. Both of these loans are popular, and both come with their own sets of pros and cons. Understanding what makes these different forms of financing work can help you choose the one that’s the best fit for your particular situation.
FHA vs. Conventional Loans
When it comes to FHA vs. conventional loans, what’s the biggest difference? According to The Ascent, the answer is obvious. FHA loans are guaranteed by the Federal Housing Administration (FHA). This government backing reduces the lender’s risk and allows them to extend loans to borrowers who might not otherwise qualify. In contrast, conventional loans are loans without any government guarantee. Of course, there are several other differences. Taking a closer look at each of these loans can help you understand how they really compare.
What You Should Know About FHA Loans
Every loan product has its own set of requirements. U.S. News & World Report offers a useful overview of the standards for an FHA loan:
- Credit score: Borrowers will be welcomed with a credit score of 580 or more. A score of 500 to 579 is also workable, but it may require a little more effort.
- Down payment: With a credit score of at least 580, your minimum down payment is 3.5 percent. If your credit score is between 500 and 579, you’ll need to bring at least 10 percent to the table.
- Mortgage insurance: FHA loans require mortgage insurance twice. There’s an initial, one-time premium that’s due at closing. Then, there’s a monthly mortgage insurance premium that is due with your mortgage payment. This payment is required for the entirety of your home loan.
- Debt-to-income ratio: A lower DTI is desirable and may help you secure better terms, but FHA loans have relaxed standards, so a higher DTI isn’t disqualifying. DTIs as high as 50 percent are acceptable.
- Purchase restrictions: FHA loans can only be used for a home that you intend to occupy as your primary residence. Vacation homes or investment properties aren’t acceptable uses. In addition, the property must meet specific property standards set by the FHA. If it doesn’t, repairs will need to be completed before the sale can be completed.
What You Should Know About Conventional Loans
Securing a conventional loan also requires meeting certain standards. NerdWallet provides a handy breakdown:
- Credit score: Getting approved for a conventional loan typically requires a credit score of 620 or higher.
- Down payment: Borrowers with solid credit scores may be able to access conventional loans with down payment requirements of just 3 percent.
- Mortgage insurance: Private mortgage insurance is required if you secure a conventional loan with a down payment of less than 20 percent. However, you won’t have to pay PMI forever. PMI is automatically canceled when your loan balance falls below 78 percent of your purchase price. Alternately, you can ask to have it canceled if you believe that you have equity equaling more than 20 percent of your home’s value.
- Debt-to-income ratio: Lenders prefer to see DTI ratios of 43 percent or less.
- Purchase restrictions: Conventional loans are fairly flexible. They can be used to purchase primary residences, vacation homes, second homes, investment properties, and homes to be flipped.
Which Is Better?
Which loan is better? As Credible indicates, that depends. Generally speaking, an FHA loan is better if you’re a borrower with a lower credit score and a higher DTI who doesn’t want to wait for your financial situation to improve before you buy a home. Its relaxed qualifying standards improve your odds of getting approved for the loan that you need. On the other hand, if you’re a borrower with a higher credit score and a lower DTI, a conventional loan will likely be the better option because it’s often a cheaper way to borrow.