Conventional Loan vs. FHA Loan: What’s the Difference?
07/25/2022 Erik Ringerud
PMI MORTGAGE INSURANCE FANNIE MAE FREDDIE MAC
There are many different loan options available. Today, we want to take a closer look at two of the most commonly purchased mortgage types: conventional loans and FHA loans.
What’s the difference between FHA and conventional loan options? And more importantly, which one is right for you?
Conventional loans by definition are loans that are not backed or insured by any government entity. They are funded by a private lending institution and then typically sold to a government-sponsored entity such as Fannie Mae or Freddie Mac. Available through private financial lenders (such as banks, mortgage companies like Pennymac and credit unions), conventional loans are the most widely used mortgage type.
When you take out a conventional mortgage, the bank or other lender buys the property on your behalf. They turn the title over to you, with the agreement that you will pay them back for the full purchase of the home, along with interest. Because the loan is not guaranteed by the government, a conventional loan represents greater risk to the lender — if you default on the mortgage, no one is going to step in and repay the lender the remaining amount on the loan. This is why lenders prefer to only extend conventional loans to applicants with solid financial profiles.
Click here to see current rates and learn more about conventional loans.
What Are Requirements for a Conventional Loan?
In order to be eligible for a conventional loan, the borrower will need to demonstrate clear financial stability and responsibility to prove to the lender they are worth the investment risk. Key requirements include the following:
- Proof of steady income
Your lender will want to know that you have a source of income to cover regular mortgage payments. You may be asked to share tax documents, paystubs and other proof of income.
- Low DTI
Your debt-to-income ratio (DTI) is the comparison between how much recurring monthly debt you carry vs. your monthly gross income. To qualify for a conventional mortgage, your DTI should be no more than 45%, though some limited exceptions may apply.
- Good credit
Specific credit score requirements for homebuyers vary from lender to lender, but traditionally conventional loans are reserved for borrowers with credit scores of 620 or higher.
- Adequate cash reserves
How much cash you have on hand after paying closing costs is also relevant. You will need to show your lender that you have enough cash reserves to last at least two months.
- Ability to cover minimum down payment
If you are not able to pay the down payment, then a monthly mortgage will be difficult to accomplish financially. In a conventional loan, you’ll be expected to pay at least 3% of the total loan as the down payment. However, if you don’t want to deal with mortgage insurance, you’ll need to bump that up to about 20%.
What are the Pros and Cons of a Conventional Loan?
For those who qualify, conventional loans bring with them a number of advantages. However, they may be problematic in other areas.
Conventional Loans: Pros
- Minimal down payments
Conventional loan down payments can be as low as 3% of the cost of the purchasing cost.
- Flexibility on loan terms
Conventional loans are available at both fixed rates and adjustable rates.
- Possibility of no mortgage insurance
Those who choose to pay 20% or more of the total purchase cost in their down payment will not need to include mortgage insurance as part of their mortgage payments.
- Higher loan limits
Conventional loans tend to offer increased loan limits, allowing buyers to borrow more than would otherwise be possible.
- Usable on any kind of residence
Conventional loans can be used to finance primary residences, second homes, investment properties, etc.
Conventional Loans: Cons
- Higher minimum credit requirements
Most lenders won’t consider extending a conventional loan to anyone with a credit score below 620.
- Stricter DTI requirements
Generally speaking, you will need a DTI of 45% or lower to be considered for a conventional loan.
- Mortgage insurance required for lower down payments
The lender will require you to pay additional private mortgage insurance for loans with down payments lower than 20%.
FHA loans are guaranteed by the Federal Housing Administration (FHA). Because these loans are backed by the government, they represent lower risk to the lender. Should you default on the loan, the FHA steps in to protect the lender from losing out on their investment. This allows for less-strict requirements for eligibility than many other mortgage options. However, one major trade off is you will be required to purchase mortgage insurance.
Click here to see current rates and learn more about FHA home loans.
What Are Requirements for an FHA Loan?
- Proof of steady income
Although FHA loans do not have any maximum or minimum income limits for eligibility, you will still need to demonstrate to the lender that your income is consistent enough to allow you to make payments on time.
- Medium-to-low DTI
To qualify for an FHA mortgage, your DTI should be no more than 50%.
- Fair credit
Credit score requirements are less stringent for FHA loans. Borrowers should have a minimum credit score of 580, though those with lower credit scores may be eligible provided that they are willing to make a larger down payment.
- Home appraisal
An FHA-approved inspector must first appraise the home you are considering buying.
- Primary residence
FHA loans are for primary residences only. The property you are buying with the loan cannot be intended as a second home or investment property, and you must occupy the property within 60 days of closing.
- Ability to cover minimum down payment
For an FHA loan, you will need to pay at least 3.5% as a down payment, provided that you have a credit score of at least 580. Those with lower credit scores may be required to pay a higher percentage.
What are the Pros and Cons of an FHA Loan?
Probably the main difference between conventional and FHA loan options is accessibility. FHA loans reduce eligibility requirements, opening up homeownership to those who may not qualify for a conventional loan. In doing so, FHA loans may demand more from the borrower over the lifetime of the loan.
FHA Loans: Pros
- Broader eligibility requirements
FHA loans are designed to be available to prospective homebuyers even when they might not have ideal credit scores or DTI ratios.
- Down payment options
Borrowers with a credit score of at least 580 can secure a minimum down payment as low as 3.5%.
- Foreclosure protection
Because FHA loans are backed by the government, the FHA can provide some assistance in the event that you default on your loan. This includes a pre-foreclosure period during which the borrower has the opportunity to either settle their missed payments or sell the home to pay off the remainder of the debt.
FHA Loans: Cons
- Additional insurance costs
Probably the biggest drawback of an FHA loan is the additional cost of mortgage insurance. This generally includes a one-time upfront mortgage insurance premium (UFMIP) which you will need to pay at closing, as well as an ongoing monthly mortgage insurance payment.
- Eligibility limited to primary residences
FHA loans can only be used to finance a primary residence; second homes, vacation homes and investment properties are not eligible.
- More restrictive loan limits
FHA loans tend to be more limited in terms of the maximum amount a homebuyer can borrow.
- Higher property standards
Before you can secure an FHA loan, your property must be appraised first and pass a strict safety inspection.
Conventional Loan vs. FHA Loan: Final Thoughts
Which is better, conventional mortgages or FHA loans? It all depends on your needs. Those who meet the more stringent requirements of a conventional mortgage often find that they can save more over the life of the loan. On the other hand, those without impeccable credit or whose DIT is too high to qualify for a conventional loan may discover that an FHA loan is the perfect solution to allow them to purchase a quality home.
If you’re having trouble choosing between your options, or if you’d like a little more guidance with your home mortgage decision, contact PennyMac today! Our experienced professional Loan Officers can help you find the right solution to put you in the home of your dreams.
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