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FHA vs. Conventional Loans

Because a home purchase will likely be one of the most expensive purchases you’ll make, how you finance your purchase is one of the most critical decisions you make in the process. There are two main financing options for mortgages: FHA loans and conventional loans.

What is an FHA loan? FHA loans are one of the tools of the Federal Housing Administration (FHA), created in 1934 to encourage and facilitate home ownership in the United States. FHA loans are government-backed loans designed to make home ownership more accessible by offering lower down-payment options and relaxed credit score requirements. FHA loans extend the ability to purchase a home to more potential buyers, particularly first-time home buyers, than conventional loans.

What is a conventional loan? Private lenders without government agency backing provide conventional loans. Because these lenders lack the government backing of FHA loans, conventional loans set higher standards for down payment and credit scores. These standards reduce risk to the lender, but they also exclude potential buyers from making a home purchase.

This article explains the major requirements and advantages for FHA and conventional loans. If you are a veteran, a VA loan is another financing option to consider, but not included in this comparison.

Requirements for FHA and conventional loans

FHA and conventional loans share similar standards for debt-to-income ratio and employment history.

Debt-to-income ratio. The debt-to-income (DTI) ratio is the percentage of your monthly gross income dedicated to debt repayment or, more simply, what you owe relative to what you earn. For example, if you pay $600 a month toward recurring debt (car loans, student loans, consumer debt, personal loans) and your gross monthly income is $3,000, your DTI is 600 ¸ 3000 or 20%. For both FHA and conventional loans, the maximum DTI for all debt—mortgage expenses and recurring debt—is 43%. Of that percentage, FHA loans impose an additional DTI limit of 31% for mortgage expenses.

Employment history.  While there is no income limit for either loan, you must be able to demonstrate two years of steady employment and income through paystubs, W2s, and tax returns. Although you may see summaries of requirements that suggest that you need two years of employment with the same employer, if that doesn’t fit your circumstances, there are acceptable exceptions that you can document. If, for example, you have changed jobs in the last six months, you can provide the previous two years of employment history. FHA loans can be more flexible about some work histories, such as seasonal work or taking time off for education and training or to raise children.

Advantages of FHA loans

These requirements set FHA loans apart from conventional loans, making them more accessible.

Lower credit score. Lenders use credit scores to assess risk, relying on the statistical analysis that produces the scores to ascertain creditworthiness. Lower scores represent more risk; higher scores represent less risk. While conventional loans requires a credit score of at least 620, FHA loans allow lenders to take greater risks and qualify borrowers with lower scores. You can obtain an FHA loan with a credit score as low as 500, though you’ll get a better rate on the loan with a credit score of 580 or more.

More flexible down payment options. The down payment is the percentage of the purchase price you pay when you buy. The down payment reduces the amount you borrow to complete the purchase. FHA loans feature down payment options unavailable to conventional loan borrowers. These include lower down payments, gifts of 100% of the down payment, and the use of down payment assistance programs. With a credit score of 580 or more, FHA loans require as little as 3.5% for a down payment.

The stricter requirements of conventional loans allow only a portion of your down payment to be a gift and prohibit the use of down payment assistance programs. Conventional loans also require 5% to 20% of the purchase price as a down payment, although recently 3% down conventional loans have been introduced to compete with FHA loans.


Advantages of conventional loans

Some circumstances make conventional loans the only or the more economical choice.

Flexible property use and standards. Only conventional loans can be used to purchase certain types of properties. Conventional loans do not require owner-occupancy. You can use a conventional loan to purchase a primary residence or to purchase a second home, vacation home, investment property, and properties that need substantial rehabilitation. FHA loans require owner-occupancy, meaning you must be purchasing a property to live in. You must take up residence at the property within 60 days of closing. In addition, the property is subject to an FHA appraisal and must meet the minimum property standards set by the U.S. Department of Housing and Urban Development (HUD).

Lower cost over the life of the loan. If you qualify and you have a 20% down payment, conventional loans are more economical over the life of the loan because they eliminate the mortgage insurance costs, the amount paid to protect the lender against loan default. If you put down less than 20%, you pay mortgage insurance but only until your conventional mortgage reaches a 78% loan-to-value (LTV) ratio. In contrast, FHA loans require an upfront mortgage insurance payment, often rolled into the loan amount, and monthly mortgage insurance for the life of the loan.

Which type of loan is best for you?

There isn’t a one size fits all answer to that question. You must consider both the eligibility and economics of your situation. Conventional loans can be more economical, but FHA loans may be more accessible. If you don’t meet the credit score requirements, have less to invest in a down payment, or your down payment is a gift, an FHA loan may be your only option. On the other hand, if you want to purchase a property to occupy, but it falls below the HUD standards, a conventional loan is your only option.

Regardless of which loan works best for you, make sure to research lenders to get the best possible terms for your loan, a key step in the home buying process for any type of loan.

Christine Shaw

Christine Shaw is a work from home mom who has been in the real estate industry for 8 years. Her passions are her kids, chocolate, and writing and sharing her personal experiences. As a single Mom she has had to navigate the in and outs of home ownership herself and enjoys helping other overcome those hurdles.

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