Which is a Better Loan, an FHA, or a Conventional Fixed?

Usually, first-time homebuyers will begin a search for a mortgage and see that there are FHA loans and Conventional fixed loans. They share some general similarities. You are borrowing at a fixed interest rate with both loans, usually for 30 years. However, these two mortgages can have significant differences depending on your situation. One will likely be better than the other.

Many believe that FHA loans are only for first-time buyers, but this is not true. The Federal Housing Administration insures FHA loans while conventional loans are not government insured. The best choice for you will mainly depend on your down payment and credit score.

In general, FHA loans require lower credit scores than conventional loans, making them easier to qualify for. Some conventional loans have slightly lower down payments and better interest rates.

What are the requirements for an FHA Loan?

Down Payment
There is a minimum down payment of 3.5% for FHA loans for borrowers with a credit score of 580 or above.

Credit Score
FHA loans will generally be easier to qualify for. If you have a 500-579 credit score, a 10% down payment is required. It is up to the lender with any loan, and they may require higher minimums than this. Plus, as a credit score gets higher, the interest rates will be better. 

Debt to Income Ratio (DTI)
This is the amount of your pretax income that you are spending on debts, including credit cards, mortgages, auto and student loans, child support, etc. The higher this ratio, the greater the struggle with bills you will have. FHA loans require a 50% or less DTI to qualify. But lenders are more likely to approve if the DTI is 43% or below.

Mortgage Insurance Premiums
This insurance is intended to protect the lender in case of loan default.

A mortgage insurance premium (MIP) is required with FHA loans, no matter the down payment's size. This article, About FHA Mortgage Insurance Premium, goes into detail about MIPs.

You can only eliminate FHA mortgage insurance if you refinance to a conventional loan. Many borrowers purchase a home with an FHA loan and later refinance into a conventional loan once they improve their credit and gain some equity.

Loan Limits (How much can I qualify for with an FHA Loan?)
A loan's maximum amount borrowed depends on the county. And these limits can be changed annually. There are different limits for single-family homes and multi-family homes like duplexes, triplexes, and fourplexes.

Property Standards
A property's condition is an essential factor with any loan. FHA appraisals are more stringent. Not only is safety, soundness, and adherence to code required, but the borrower must live in the home (or one of the units for up to a fourplex) as their primary residence. And purchases can not be for a flipped home (sold within 90 days before this purchase).

Refinancing
If refinancing, FHA streamlines refinancing loans are straightforward. They require no credit checks, no income verification, and home appraisals are not needed in some cases. They do have five requirements:

1. Your current FHA loan can not be delinquent.
2. This can not be a cash-out refinance (the maximum you can get out is $500).
3. There must have been at least six months since the last mortgage was issued (divorce or inheritance are exceptions).
4. You have to pay the closing costs (if there are any), and the lender must approve them.
5. There must be a "net tangible benefit." You are either reducing your term or lowering your interest rate (or both).
   

A refi into a conventional loan is usually the only option to get rid of the monthly mortgage insurance premium. This is usually a smart option once the home has accumulated 20% equity (through payments or appreciation) and your credit has improved.

What are the Requirements for a Conventional Mortgage?

Down Payment
Conventional mortgages will generally require a 3% down payment or more. The smaller down payment may require additional savings to be shown.

Credit Score
Conventional loans will generally require a score of 620 and up (650 is better).

Debt to Income Ratio (DTI)
Conventional loans allow DTI up to 50%, but generally, they want to see a DTI that is 43% or lower.

Private Mortgage Insurance (PMI)
Conventional loans require PMI if a down payment is less than 20%. Once the equity reaches 20%, the owner can request that PMI be canceled, and it will automatically be canceled when the equity reaches 22% (based on the original value). PMI will cost more if you have a low credit score, but it will usually be less than FHA’s mortgage insurance premium (MIP) if your score exceeds 720. The cost of conventional loan PMI will also vary depending on the down payment size.

Loan Limits (How much can I qualify for with a Conventional loan?)
Conventional loans have a conforming loan limit set by the Federal Housing Finance Agency. These limits change annually. A larger loan than this limit is called a "Jumbo Loan."

Property Standards
An inspection of the home is required to ensure safety, soundness, and adherence to code. A conventional loan can be for a primary residence, second home, vacation home, or an investment property.

Refinancing
A similar process to obtain the loan is required. The lender will check your financial standing and the current value of the home. But a cash-out refinance is possible with a conventional loan. And closing costs can be added to the mortgage.

Pros & Cons of FHA vs. Conventional. Which is best for me?

FHA

• Allow for lower credit scores.
• Require 3.5% (slightly higher) down payments.
• Stricter property standards.
• FHA’s mortgage insurance premium (MIP) is mandatory and can't be canceled without conventional loan refinancing.

Those with credit scores below 620 will be unlikely to qualify for a conventional loan. In that case, an FHA loan is probably the best option. Borrowers with credit scores below 720 will find that a conventional loan will probably be the best deal.

Conventional

• Higher credit score required.
• Slightly smaller down payments are possible (3%).
• Liberal property and residency options.
• PMI is required for a down payment of less than 20%, but it can be canceled.
  

Borrowers with 720 or above credit scores will generally find that conventional loans cost less per month.

Summary

Those searching for a home loan with a larger down payment and a credit score above 720 will almost surely want to go conventional. A loan officer can help you compare both FHA and conventional loans. Also, suppose you are active service military, a veteran, or surviving spouse. In that case, you may be interested in a VA loan with no down payment. With a credit score above 580 and debt less than 42% of your income, you can probably find a loan that fits your needs.