FHA vs. Conventional Loans in Plain English

If you're in the market for a home loan, you might be confused about some of your options -- especially if your credit score is on the low side. Fortunately, FHA loans may help homebuyers with credit problems or little savings for a down payment. Conventional loans generally have stricter eligibility requirements than FHA loans but could help you save on mortgage insurance.

Here's what you should know if you're weighing whether an FHA or conventional loan is the best way to go.

[Read: Best FHA Loans.]

What Is an FHA Loan?

An FHA loan is a government-backed mortgage that comes with more flexible financial requirements than many conventional loans. Borrowers may qualify even with small down payments and poor or fair credit scores.

FHA backing "makes the loan less risky for a lender," says Tim Milauskas, loan officer with First Home Mortgage. "Lower risk to the lender equals greater leniency for the borrower."

Private banks, credit unions and other FHA-approved lending institutions originate these loans.

But FHA loans come with extra costs for the buyer in the form of mortgage insurance. Buyers make an upfront mortgage insurance premium at closing and then pay a premium every month, potentially over the entire loan term. This insurance protects the lender in case of borrower default.

What Is a Conventional Loan?

A conventional loan is a mortgage that is not backed by a government agency. Conventional loans fall into two categories: conforming or nonconforming.

Conforming loans meet lending rules set by Fannie Mae and Freddie Mac. Nonconforming loans don't fit these guidelines, so eligibility requirements may be more flexible.

Generally, conventional loans have higher down payment and credit score requirements than government-sponsored loans. Some conventional loans allow for down payments as low as 3%, but homebuyers who put down less than 20% will need to pay private mortgage insurance.

[Read: Best Mortgage Refinance Lenders.]

Comparing FHA Loans With Conventional Loans

FHA and conventional loans have several key differences, as well as advantages and disadvantages. Here's a quick comparison of conventional loans versus FHA loans:

Conventional mortgages

FHA loans

Minimum FICO credit score

Typically no lower than 620

Either 500 or 580.

Minimum down payment

As low as 3%, but 5% to 20% is typical

3.5% with a 580 credit score or 10% with a 500 score

Mortgage insurance

The borrower pays PMI if the down payment is less than 20%, but the insurance can be canceled when the loan-to-value ratio reaches 80%.

The borrower pays an upfront premium (1.75% of the loan amount) and makes monthly payments (0.45% to 1.05% of the loan), sometimes for the duration of the mortgage term.

Loan Limit

$647,200 to $970,800 in 2022 for a one-unit property, depending on location.

$420,680 and $970,680 for a one-unit property, depending on location.

Debt-to-Income Ratio

36% to 45% is typical but may stretch to 50% in some cases.


What Are the Credit Requirements of FHA vs. Conventional Loans?

Lenders generally follow credit score guidelines set by the FHA for its loans and standards put in place by Fannie Mae and Freddie Mac for conventional loans. However, lenders can choose to increase the minimum credit score on any type of home loan, and sometimes down payment can also play a role.

For an FHA loan with a down payment of 3.5%, borrowers usually need a credit score of 580 or higher. With a credit score between 500 and 579, the borrower has to put down at least 10%.

FHA loan approval with a 500 credit score is rare, Milauskas says.

"In 18 years of mortgage banking, I have never seen a below-580 credit score get an approval through the automated underwriting system," he says. Milauskas estimates that "less than 5% of all FHA loans that close are with credit scores below 580."

Some lenders accept a 3% down payment for a conventional loan, but most require a minimum down payment of 5% to 20%. Borrowers will also need a FICO credit score of at least 620 to qualify for a conforming conventional loan.

What Are FHA and Conventional Loan Limits?

Both FHA and conventional loans limit the amount you can borrow, and the maximum loan size varies by location. The Federal Housing Finance Agency sets limits for conventional conforming loans each year, and the Department of Housing and Urban Development does the same for FHA loans.

The conventional loan limit in 2022 for a single-family home in most of the U.S. will be $647,200, an 18% jump from $548,250 this year. In high-cost areas, the ceiling for a one-unit property this year is $822,375 and will increase to $970,800 in 2022. A mortgage that exceeds the conforming loan limit is called a jumbo loan.

FHA loans for one-unit properties also have new limits in 2022, including a national floor of $420,680 and a ceiling of $970,800 for high-cost locations. Rising home values account for the changes from this year's floor of $356,362 and ceiling of $822,375.

What Are Private Mortgage Requirements for FHA and Conventional Loans?

Private mortgage insurance, or PMI, pays your lender a portion of your principal if you can't pay back your home loan. Whether you have to pay PMI mostly depends on the type of mortgage you take out and your down payment.

You won't have to pay PMI on a conventional loan if your down payment is at least 20%. But with a lower down payment, you will need to make monthly PMI payments until your loan-to-value ratio reaches 80%. Once you have 20% equity in your home, contact your lender to remove PMI.

FHA loans, on the other hand, require two types of mortgage insurance: an upfront fee and a monthly fee baked into the regular mortgage payment. The upfront mortgage insurance premium equals 1.75% of the base loan amount, and the monthly mortgage insurance payment ranges from 0.45% to 1.05% of the loan amount.

You'll need to pay FHA mortgage insurance premiums for the life of the loan if your down payment is less than 10%. But if your down payment is higher, then you may be able to cancel mortgage insurance after 11 years.

What Interest Rates Can You Expect With FHA and Conventional Loans?

Conventional mortgages usually come with higher interest rates compared with FHA loans. That's partly because Fannie Mae and Freddie Mac may apply a risk-based fee called the loan-level price adjustment to conventional loans.

"These price adjustments are charges based on Fannie and Freddie's perceived risk of lending money to that individual," Milauskas says. "The charge for the LLPA is passed on to the consumer in the form of a higher interest rate."

Because FHA loans lack this fee and feature government backing, "You will almost always find a lower interest rate with an FHA loan," Milauskas says.

However, mortgage interest rates can fluctuate daily, and every lender has a different way of setting loan terms. Comparing rate quotes from several lenders within a short time frame -- to avoid damaging your credit -- may help you find a low interest rate.

Having a higher credit score may also help you qualify for the best interest rates on either type of loan. Borrowers with credit scores in the mid-700s or above typically receive the lowest interest rates, according to the Consumer Financial Protection Bureau.

[Read: Best Mortgage Lenders.]

Choosing Between an FHA or Conventional Loan

When an FHA loan makes sense:

-- You have a spotty credit history. "FHA financing has been one of the few consistent options for homebuyers with less-than-perfect credit," says Tammy Wittren, branch manager with NFM Lending. Borrowers may qualify for an FHA loan with a low credit score and a recently resolved bankruptcy or foreclosure.

-- Your debt-to-income ratio is high. Borrowers who take out FHA loans generally have higher DTI ratios than borrowers with conventional loans, so this could be a good option if you carry more debt than most.

-- You need to borrow a smaller loan amount. The FHA loan limit is typically set at 65% of the national conforming loan limit, which means FHA loans will generally be smaller than conventional mortgages.

-- You're buying a primary residence. FHA loans can only be used to buy a home you plan to occupy.

When a conventional loan makes sense:

-- Your credit score is at least 620. This is typically the minimum credit score needed to qualify for a conforming conventional loan, though some lenders increase the requirement.

-- The property won't pass an FHA appraisal. During an FHA appraisal, the lender estimates the property's value and checks the home's safety, construction quality and adherence to local code restrictions. You might decide to go with a conventional loan if the property won't pass strict standards.

-- You have a sizable down payment. Some loans require a minimum down payment of just 3%, but you may need to pay more. And you'll need put down at least 20% if you want to avoid paying PMI.

-- You're buying a second home. You can use a conventional loan to buy a primary residence, vacation home or investment property.

-- You'll be in the home for the long haul. "Long-term FHA is not the best financing for homebuyers because of the mortgage insurance," Wittren says. "The FHA mortgage insurance is far more expensive than its conventional counterpart." For this reason, you may choose a conventional loan or refinance an FHA loan into a conventional loan once your credit score is high enough.