The process of buying a home—from setting a budget and applying for a loan to putting an offer on the right property—is an intimidating process for anyone. For first-time homebuyers, it can feel especially daunting. Many, especially those who struggle to come up with a large down payment, may consider FHA loans as a cost-effective alternative to conventional home loans.
However, the right loan can mean different things to different people, whether it’s saving thousands on interest rates or fees, leaving you with enough money left over each month to lead a comfortable life, or getting a big enough loan for the house that your family needs. And in many cases, it can mean the difference between qualifying for a loan at all. Knowing how to compare loan products to find the one that best meets your needs is a crucial part of a successful homebuying experience.
In this post we’ll compare FHA and conventional home loans, looking at how they differ in terms of down payment and credit requirements, interest rates, fees, and more. Keep reading to learn more about each type of loan so you can make an informed decision when it’s time for you to apply!
What is a Conventional Mortgage?
A conventional mortgage is a mortgage that is not guaranteed by the government through a department loan program (like the Federal Housing Administration, Department of Veterans Affairs, or Department of Agriculture loan programs).
Instead, these loans are guaranteed entirely by your lender. Because they aren’t backed by the government, the lender assumes more risk on the loan—if you stop paying or allow the property to lose value through neglect, they could take a loss. To minimize their risk, there may be stricter lending requirements, including firmer credit-score cutoffs, larger down payments, and lower debt-to-income allowances.
With conventional loans, you apply for a loan with the bank, the loan is subject to the bank’s approval, and the loan stays with the bank, unless they determine to sell it to another financial institution under the same terms (a somewhat common practice).
Conventional loans come in many varieties: fixed interest rate or variable interest rate, term lengths of 10 to 30 years, conforming or jumbo (loan for a larger amount of money). We’ll go into each of these in more detail in the next section.
Types of Conventional Mortgages
Individual buyers have individual needs, and conventional mortgages come in many forms to meet those needs, from having a longer term length to lower monthly payments to having a higher borrowing limit than conventional conforming loans allow for. Let’s take a look at the different options available for conventional home loans.
Fixed-Rate vs. Variable Rate
A fixed-rate home loan has a set interest rate for the life of the loan, which is locked in at closing, or if your loan has a rate lock during your initial application. Fixed interest rates provide predictability—though your taxes may go up, your monthly payment will always remain the same when your interest rate is fixed. And if you have a low rate or you expect interest rates to go up, fixed interest rates offer peace of mind and a long-term benefit in the form of lower, set monthly payments.
Variable interest rate loans are a bit more complex. Also known as ‘adjustable-rate mortgages’ or ARMs, with these loans your interest rates can go up (and sometimes down), based on current market rates. These loans usually come with an initial period where the interest rate is set, after which the rate will readjust annually. The most common form is the 5/1 ARM, where the initial set rate period lasts five years, followed by adjustments every one year thereafter. However, other common ARM formations include 3/1, 7/1, and 10/1. Generally, the shorter the introductory period, the lower the interest rate will be.
Variable interest rates have the downside that rates often go up after their initial period, meaning that your monthly payment will go up as well. However, during periods of high interest rates, they can be a sensible choice. Initial interest rates tend to be lower than fixed-rate loans, and if you expect market rates to go down in the future, you could benefit from a lower ongoing rate as well, over locking in a higher, fixed-interest rate.
If you plan to sell your home before the initial interest period, you’ll never have to worry about the rising rates. Additionally, if your interest rate and payments rise substantially, there is always the possibility of refinancing your loan—but keep in mind you’ll need to pay closing fees on a new loan. To get a better understanding of the benefits and drawbacks of these kinds of loans, check out our post When to Consider a Variable Rate Mortgage.
Term lengths have two main functions: they dictate your monthly payment amount, and they determine how much interest you’ll pay over the life of your loan. Banks tend to offer lower interest rates for shorter-term loans, which can be appealing to borrowers looking to save money on interest costs. The tradeoff is that while your interest rate is lower, your monthly payment will be higher, because you are paying off your total loan amount over fewer monthly installments.
The most common term lengths are 30 years and 15 years, but it’s possible to get 10-year, 20-year, and 25-year mortgages as well—and some banks even offer other term length options, including mortgages for less than 10 years.
Because 30-year mortgages have the lowest monthly payment, they tend to be the most popular choice, especially for first-time homebuyers. If you sell your home before your term is up, you simply pay off the balance with the proceeds from the home sale. It’s also possible to make extra payments to pay off your mortgage quicker, and 30-year mortgages offer great flexibility in this: pay more when you can, or simply pay your normal monthly payment when a higher payment isn’t in the budget.
For more tips on selecting the right mortgage length for your needs, check out our post, Should I Choose a Short Term or Long Term Fixed Mortgage Loan?
Conforming vs. Nonconforming
A conforming loan is a conventional loan that is below $762,200 and conforms to (meets) certain requirements for approval. The Federal Housing Finance Agency sets this limit, while other qualifying criteria for conforming loans are set by the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”)—government sponsored organizations that invest in mortgage loans.
On the other hand, non-conforming loans are simply loans that don’t conform to these regulations. Conventional non-conforming loans are loans for larger amounts than $762,200 (at the time of writing), sometimes called “jumbo loans”. Government-backed loans with different qualification requirements, including FHA mortgages, are another example of non-conforming loans. Let’s look at these next.
What is an FHA Loan?
Offered through your bank and backed by the Federal Housing Administration, FHA Mortgage Loans make banks able to offer borrowers more flexible qualification requirements, putting homeownership in reach for individuals who may not otherwise qualify for a home loan, while assuring banks that their investment in your home purchase will not carry any additional risk for them.
FHA loans can come in both fixed-rate and adjustable-rate varieties, as well as common term lengths of 15 and 30 years, offering similar options as conventional loans for tailoring the loan to unique borrower needs. Let’s explore what makes them different from conventional loans.
Conventional vs. FHA Qualifications
As we mentioned above, government-backed loans allow banks to approve loans for “riskier” borrowers—those who may have less money for a down payment, slightly lower credit scores, or higher debt-to-income ratios. This can mean certain borrowers may be able to get a loan for more money than they would qualify for with a conventional loan, or even qualify for a loan at all.
Down Payment Requirements
While some home loans require no down payment at all, both conventional and FHA loans require you to put some money down.
Conventional loans usually require larger down payments than FHA loans, and 20% is the amount preferred by lenders. However, it may be possible to put down less, sometimes as low as even 5%, depending on other factors.
Any loan with less than 20% down is considered a higher risk to banks, as market prices can fluctuate, and homes can go ‘underwater’ (be worth less than the loan balance). That’s why conventional loans with down payments of less than 20% will require private mortgage insurance, or PMI. The national average for PMI is 1.25% of the mortgage, but can vary loan to loan. The good news is that once you reach at least 20% equity in the home, you can apply to have your PMI removed.
One of the main reasons why first-time homebuyers apply for FHA loans is that they do not require a 20% down payment. In fact, the minimum down payment is only 3.5%, as long as your credit score is above 580. And for scores of 500-579, down payments can be as low as 10%.
FHA loans do not have private mortgage insurance. They do, however, have their own fee called an “Annual Mortgage Insurance Premium” or MIP. This fee was recently lowered, and is currently equivalent to .55%, divided by twelve (12 months) and added onto your monthly payment. Unlike PMI, this fee can’t be simply removed from your loan once you’ve paid off 20% of your mortgage, though if you put at least 10% down initially, your mortgage insurance premium will end after 11 years of payments.
There is no rule that says you can’t put more money down on FHA loans. In fact, it’s best to put down as much as you can, as the more you are able to put down, the less interest you will pay over time, and you can possibly avoid paying your MIP for the entire duration of the loan. Talk to a mortgage lender about the fees associated with all of your loan options to see what works best for your financial needs.
Credit requirements alone may be the deciding factor for whether or not you even qualify for a conventional loan. Fortunately, FHA loans are designed to provide the opportunity for borrowers with lower credit scores who, by all other requirements, are good candidates for home purchase. Let’s explore the differences.
Conventional Loan Credit Requirements
Though credit score requirements vary by lender, you will usually need a credit score of at least 620. Keep in mind that this is only the minimum, and with a score of 620, you may not be able to access the best mortgage rates. Higher scores can unlock lots of benefits, including earning you a better interest rate or an approval with a lower down payment.
In addition to a minimum credit score, you must have a debt-to-income ratio (DTI) of no more than 45%. This means that no more than 45% of your income can go to covering debts, including your new home loan, as well as credit card balances, student loans, car payments, and other debt items.
FHA Credit Requirements
Because of their government backing, FHA credit score requirements are lower: 580 for a 3.5% down payment, or 500 for a 10% down payment. If you don’t have great credit, but have a score of at least 500, FHA loans can be your bridge to homeownership. As we discuss in our post, How Soon Can I Buy a Home After Credit Problems?, individuals with lower scores can take steps to improve their credit to meet these less-stringent requirements.
Beyond lower credit scores, FHA loans also grant more wiggle room on your debts. FHA loans generally allow a debt-to-income ratio of up to 50%. An important thing to note is that lower credit scores or higher debt-to-income ratios can reduce the loan amount you qualify for.
One of the most common questions asked about these loans is how their interest rates compare. There is no straight-forward answer, as rates on both loan products can vary based on your credit score, region, down payment, as well as from bank-to-bank.
With that said, FHA mortgage rates tend to be lower than those of conventional loans, though usually not by a significant amount. A mortgage calculator can help you see how the difference in interest rates will play out over the life of your loan. Other fees for FHA loans, including the mortgage insurance premium, may offset this savings, however. That’s why you want to look at your total payment and out of pocket costs when comparing loans, not just the interest rate.
Other FHA Considerations
While FHA loans may seem like an ideal lending product, there is a reason why many individuals still choose conventional mortgages. These can include:
- Lower insurance premium fees. While borrowers with smaller down payments will have to pay private mortgage insurance for conventional loans, this can be removed once you’ve paid off 20% of your home. However, with FHA loans, mortgage insurance is often for the life of the loan if your initial down payment is less than 10%.
- Fewer upfront fees. In addition to standard closing costs, unlike conventional loans, FHA loans also require an upfront mortgage insurance premium of 1.75%. While this can be rolled into your financing, it will add to your overall loan closing costs, increase your monthly payment, and/or reduce the size down payment you can afford.
- Less-strict property requirements. Conventional loans usually require an appraisal, but many don't even require a home inspection. On the other hand, the federal government requires that homes meet stricter requirements for property conditions to be sure that the property will make a good home for the homeowner, and their investment is protected. The FHA requires its own appraisal to ensure this, which can be intimidating for both homebuyers and home sellers.
- Fewer additional requirements. With FHA loans, there is less flexibility for how a home is used. It must be occupied within 60 days of closing, and must be a primary, owner-occupied residence (not a rental).
We Can Help You Make the Right Choice
There are many considerations to keep in mind when determining what loan will be the best fit for your homebuying journey. As you weigh your options, take advantage of the expert knowledge of lending professionals to navigate the pros and cons of each type of loan, matching the right loan to your budget and needs.
CS Home Mortgage is a full-service mortgage lender, offering assistance and expertise from pre-application questions to closing. Whether you’re considering a conventional loan, FHA loan, or other home loan option, our local lenders based in Northwest Arkansas and Southwest Missouri are here to help.
Visit one of our convenient locations, contact us, or apply online when you’re ready to move forward with your preferred loan option.