The Pros and Cons of Conventional Mortgages and FHA Loans
The country’s two most common types of mortgages today are conventional loans and FHA loans.
Conventional mortgages conform to Fannie Mae/Freddie Mac guidelines and are a financial agreement between the lender and borrower.
FHA loans are between the lender and borrower, but the Federal Housing Authority backs FHA loans for borrowers who typically don’t qualify for a conventional loan.
Because of that fact, you might think conventional loans are the gold standard of mortgages, while FHA loans are what you would be forced to take if you can’t qualify for a conventional loan. This isn’t necessarily the case, however.
There may be a situation where an FHA loan would be preferable to a conventional loan and vice versa.
There are a lot of differences between the two types of loans, and understanding all of the requirements and features of each is essential to getting yourself the best deal when it comes to financing the cost of your home purchase.
Let’s look at the pros and cons of FHA loans and conventional loans to help you see which loan might be right for you.
Pros and Cons of Conventional Loans
Conventional loans are what many buyers strive to qualify for because they often will result in a cheaper total cost of financing. This is mainly true because conventional loans may not need private mortgage insurance (PMI).
Pros of Conventional Loans
- First, conventional loans have no upfront PMI, and as long as you make a down payment of at least 20% at closing, you will also avoid monthly PMI payments. If you make a down payment of less than 20% for a conventional loan, you can request your PMI payments be canceled once you’ve reached a loan-to-value ratio of 78%.
- Conventional mortgages also allow you to finance the purchase of more expensive homes. For 2019, the Department of Housing and Urban Development set a national conforming property limit of $484,350 for a one-unit property. Properties above that amount would need to be financed through a jumbo loan.
Cons of Conventional Loans
- In exchange for the higher loan limits and no or shorter-term PMI, lenders require stricter standards regarding the borrower’s financial situation. Generally speaking, lenders require a minimum credit score of 620 to qualify for a conventional loan. In addition, you must have a debt-to-income ratio of 45% or less and assets in reserve.
- Conventional loans also require you to make a larger down payment. The minimum down payment on a conventional loan is 5% unless you qualify for a Conventional LTV loan as a first-time homebuyer, which would allow you to make a 3% down payment.
- Finally, interest rates tend to be higher on conventional loans. You need good credit to get the best rates, regardless of FHA vs. conventional. You may be able to secure a low rate with a conventional loan if your credit is good or you have a low DTI.
FHA Loan Pros and Cons
- You can typically qualify for an FHA loan with a minimum score of 580. If you have a credit score of at least 580, you can make a down payment as low as 3.5%, and the entire down payment and your closing costs can be covered with gift funds.
- Similarly, your debt-to-income ratio does not have to be as low as it would be for a conventional loan. Reserve funds are generally not required either, as they are with conventional loans.
- Another positive is you may have the option of financing the cost of upgrades, modernization, and renovation of a home through the FHA 203(k) loan program. This program would allow you to finance the cost of these upgrades through the mortgage, instead of forcing you to either pay for the upgrades in cash or through more expensive financing options such as credit cards or personal loans. This could be a great option if you’re purchasing an older home or one that would be considered a fixer-upper.
- The biggest negative to FHA loans is the mortgage insurance premium (MIP) fees you must pay in exchange for a lower credit score, lower debt-to-income ratio, and/or lower down payment. Rates are market-based, and consumers pay extra fees, so a lender will take on a “riskier” loan. The fees are paid to accommodate more flexible credit qualifications.
- The first fee is the upfront MIP, which equates to 1.75% of the total loan cost, due at closing. Then there will be an annual MIP, charged monthly — no matter how much down payment you make. Even if you make a 20% down payment, you will still be required to pay a monthly MIP.
- Another negative to FHA loans are the type of properties that qualify. First, the FHA has stricter standards when it comes to the condition of the property. The FHA requires homes financed through this program to be in better shape than conventional loans would unless you’re financing through the FHA 203(k) program.
- Not all condos and townhomes qualify to be financed through an FHA loan, either.
- Finally, the limit for how much you can finance through an FHA loan is also lower. The FHA loan limits are 65% of the national conforming limit, which for 2023 is $472,030 for a one-unit property. However, the FHA does allow for high balance loan limits in particular areas and may go as high as $1,089,300 through December 31, 2023.
Conventional vs. FHA – Which Is Better?
Generally speaking, a conventional loan would be preferable to an FHA loan, but for reasons you may not think. The reason for this is that if you qualify for a conventional loan, you are typically in a better financial position:
- with a higher credit score
- a better debt-to-income ratio
- a larger down payment
- and more money in the bank
This doesn’t mean an FHA loan isn’t good or a consolation prize to the conventional loan. FHA loans are the most popular mortgage program for first-time homebuyers, for example, because this group of people typically hasn’t had the ability to build up credit or assets to make a large down payment — through no fault of their own.
As the cost of goods in all areas continues to rise, more people buying their second home are also opting for FHA loans, willing to pay the MIP in exchange for the ability to make a smaller down payment.
Have a Qualified Mortgage Expert Help You Decide
In sum, whether a conventional or FHA loan is “better” is a very personal calculation. That’s why it’s so important you work with a mortgage professional who can educate you about what program would be right for you.
At Embrace Home Loans, we have more than 35 years of experience serving homebuyers of all kinds from all walks of life. Our experts can guide you through decision-making and help you get the best loan. Call us today at (888) 907-6261.