Buying a home involves making many decisions, such as which neighborhood to live in and how many bedrooms you’ll need. But not all decisions are easy or particularly fun to make, especially when it comes to how you’ll pay for your new home.
If you’re like most homebuyers, you’re planning on getting a mortgage loan. Two of the most common types of mortgage loans are Federal Housing Administration (FHA) loans and conventional loans. Depending on your credit score, income, and how much money you can put towards a down payment, one option may be more beneficial for you than the other.
So, what’s the difference between a conventional loan and an FHA loan? We’ve created this guide to help you understand the requirements, as well as the pros and cons, of each.
What is a Conventional Loan?
A conventional loan is a mortgage loan that is not backed by a government agency. You can get a conventional mortgage loan from a bank or a private lending company like Associates Home Loan.
Because conventional loans are not insured by the government like FHA loans, they have stricter requirements to protect lenders. To qualify for a conventional loan, you’ll need:
- Good credit score: Most conventional loans require a credit score of at least 640, but some lenders may require a score of 660 or higher.
- Low debt-to-income ratio: Banks and private lenders want to make sure they are lending to someone they can trust to pay back the loan. Having a low debt-to-income (DTI) ratio, which means you earn more than you pay in monthly debts (such as rent, car payments, and student loans), is generally required to qualify for a conventional loan. You can calculate your DTI using an online calculator tool.
- Private mortgage insurance: One benefit of conventional loans is that they require lower down payments than FHA loans; the minimum is only 3% of the home price. However, if you decide to put down less than 20% on a mortgage, you’ll likely have to pay private mortgage insurance (PMI). This protects the lender if the buyer defaults and can no longer afford to repay the loan in the future.
- Lower interest rates: Because interest rates are partly based on your credit score, buyers with high credit scores who qualify for conventional loans are more likely to enjoy lower long-term interest rates.
- Higher loan limits: Compared to FHA loans, a conventional mortgage loan allows you to borrow more money to purchase a home. Non-conforming loans, called jumbo loans, allow buyers to borrow up to 2 million dollars.
- Harder to get approval: Conventional loans have stricter qualification requirements than government-issued loans because they require private lenders and banks to assume a considerable amount of risk. To ensure lenders don’t default on their mortgage loans, they take additional steps to verify your credit and financial history.
What is an FHA Loan?
An FHA loan is a type of mortgage loan that is insured by the U.S. Federal Housing Administration.
There’s a misconception that FHA loans are only for first-time homebuyers. While it’s true that 83% of people who get an FHA loan are first-time homebuyers, they can also be a good option for established buyers who may not qualify for a conventional loan due to a previous foreclosure or a sudden increase in debt.
To qualify for an FHA loan, you’ll need:
- DTI ratio below 43%: Your debt-to-income ratio must be below 43% to qualify for an FHA loan. However, FHA loans are more flexible, and exceptions can be made for applicants with higher DTI ratios who also have high credit scores.
- Proof of employment: Stable income is required to repay a loan, so borrowers must be able to provide proof of employment.
- Purchase a primary residence: An FHA loan can only be used to purchase a home that you intend to live in as your primary residence. That means it can’t be used to buy vacation homes, investment properties, or a home that you intend to flip and sell within 90 days.
- Easier to qualify: With much more lenient credit requirements, FHA loans make the dream of homeownership possible for buyers who would otherwise be denied a conventional loan.
- Low down payments: While a good credit score is not a requirement for an FHA loan, it can help you qualify for a lower down payment. If your credit score is above 580, you only have to pay a minimum down payment of 3.5%.
- Limited housing options: FHA loans limit the amount of money you can spend on a home; in most parts of the country, the limit is currently around $500,000, but it depends on the cost of living in an area. You can look up the maximum FHA loan limit for your county here.
- Higher insurance costs: All FHA borrowers must pay a mortgage insurance premium (MIP), which is added to their monthly mortgage payments. An upfront MIP, equivalent to 1.75% of the loan amount, must also be paid during the closing process.
Learn More About Your Mortgage Loan Options
In general, the main difference between FHA loans and conventional loans is that FHA loans are specifically designed to help first-time homebuyers and buyers with credit issues purchase a home.
However, even if you have bad credit, it is possible to obtain a conventional loan with the right lender. At Associates Home Loan of Florida, we specialize in mortgage solutions for buyers with bad credit, including hard money loans and high-risk loans. For more information on your possible loan options, please contact our team of loan professionals.