FHA Loans vs. Conventional Loans: Key Differences

Applying for a home loan can be tricky because with so many options out there, it can be difficult to know which is right for you. Most homeowners perform an expensive search to understand which home loan product is best for them. Such individuals, unless they qualify for the advantageous VA loan, typically narrow their choices down to two options: an FHA loan or a conventional loan.

These loans vary in many ways, so it’s vital to understand each loan’s pros and cons before choosing. In this guide, we will discuss the main differences between FHA loans and conventional loans to help you decide which is right for you.

What Are Conventional Loans?

As their name implies, conventional loans are ordinary loans offered by banks to people who want to borrow money for different purposes. Ordinary home mortgages are a common example of a conventional loan.

What Are FHA Loans?

FHA loans are backed by the Federal Housing Administration, a government agency that seeks to make homeownership available to more Americans through easier requirements. Many people favor FHA loans due to the conveniences they offer, such as lower minimum down payments and lower minimum credit scores.

FHA Loans vs. Conventional Loans

Now that we know the basic difference between FHA and conventional loans, it’s time to compare them. While these loans have very different requirements and benefit different types of homeowners, we simplify and explain the key differences for you.

Down payments.

The down payment requirement for FHA loans and conventional loans is quite different. For an FHA loan, the minimum down payment is based on your credit score. For example, if your credit score is 580 or higher, you can expect to pay a 3.5% down payment on an FHA loan. If your credit score is under 580 but above 500, you will need a 10% down payment.

The down payment on a conventional home loan is based on much more than your credit score. There’s no official minimum credit score, and lenders will give you wiggle room on the down payment and a better interest rate the more you put down. Often it can be lower than what you would have to put down with an FHA loan, even as low as 3% (the average down payment is 13% according to the National Association of Realtors). This makes conventional loans better for people with limited funds to put down for their down payment.

Credit scores.

Your credit score is vital when applying for any kind of loan. As mentioned above, your credit score directly affects your down payment amount when you take out an FHA loan. What’s more, too low a credit score can make you ineligible for both FHA and conventional loans.

The lowest credit score you can have and still qualify for an FHA loan is 500. While it’s good to be qualified, you should be prepared to pay a higher down payment the lower your credit score is. Also, while 500 is the bare minimum, most FHA lenders want to see a score of 580 or higher.

Conventional loans require even better credit scores, and they reward borrowers who have excellent credit by offering a lower interest rate. You need a credit score of 620 to qualify for an ordinary home mortgage. However, it is possible to get around this requirement if you have a mortgage cosigner with a high credit score. In this situation, the lender will calculate the average credit score between you and your cosigner when deciding whether you qualify for the loan.

Interest rates.

Interest rates are important to consider before taking out any loan. After all, someone who intends to spend many months or years paying back a loan should look for the lowest interest rate they qualify for, because interest adds up to a lot of money.

It’s difficult to compare interest rates for FHA loans and conventional loans side-by-side due to how much they vary. However, we can list the different factors that influence the interest rates for each loan type.

FHA loan interest rates vary based on your income, credit score, down payment amount, the loan amount, and market conditions. Conventional loan interest rates vary based on the loan-to-value ratio (that’s how much money you want to borrow compared to the home’s price) and your credit score.

Mortgage insurance.

If your down payment is below a certain percentage, lenders will require you to carry mortgage insurance, but what they call it and how long it lasts varies widely between FHA loans and conventional loans. (A major benefit of VA loans is no insurance is required.)

If you opt for an FHA loan and put down less than 10%, you will be required to pay a mortgage insurance premium ever after. MIP will add 0.15% to 0.75% of the loan amount (effective March 2023) to your mortgage payment. If you put down 10% or more, MIP will stop after 11 years. A big difference with FHA loans compared to conventional loans is that no amount of down payment will let you avoid MIP entirely.

On the other hand, if you opt for a conventional loan, whether you pay insurance or not depends on your down payment. Lenders will require you to carry private mortgage insurance (PMI) to offset their risk when you put down less than 20%. But good news: Unlike FHA loans, this insurance requirement ends when you attain 20% equity. And you can avoid the insurance entirely by putting down 20%.

Home appraisals.

FHA loans and conventional loans differ a lot in terms of the appraisal process. FHA loan home inspections have a reputation for being quite demanding. It’s not uncommon for real estate agents to tell sellers to avoid buyers whose offer depends on an FHA loan because if the home fails inspection, the sellers are back to square one.

Conventional loans, however, have a relatively straightforward approval process no matter the lender. Inspections are thorough but not stringent, and the home's likelihood of passing can usually be estimated accurately.

Part of the approval process for both FHA loans and conventional loans is a home appraisal. This detailed inspection helps ensure that the home is worth what the seller is asking for it.

Loan limits.

Both FHA and conventional loans have upper limits, and they will vary depending on your location. The FHA loan limit in low-cost counties is currently $472,030. One example of a county in this category is Niagara Country, New York. Expensive counties like Orange County, California, have a much higher FHA loan limit, around $1,089,300.

The loan limit for conventional loans varies from $726,200 to $1,089,300 depending on the county. This means in most cases, you can expect to enjoy higher loan limits if you opt for a conventional loan over an FHA loan.

Who Should Choose an FHA Loan?

Now that we know the key differences between FHA loans and conventional loans, you might be wondering what kind of loan is right for you. An FHA loan is a better choice if you have a low credit score, a high debt-to-income ratio, and not a lot of cash saved up for a down payment.

Who Should Choose a Conventional Loan?

Conventional loans are the better choice if you have a credit score above 620, have enough money for a sizeable down payment, and have a low debt-to-income ratio. Conventional loans are also better if you’re looking for flexible repayment terms.

Other Types of Government-Backed Loans

FHA loans are usually the first type of loan that people come across when researching government-backed loans. However, a few other government-backed loans are out there, like USDA loans and the aforementioned VA loans.

VA loans are loaned by private lenders but backed by the United States Department of Veteran Affairs. To qualify for one of these loans, you must meet certain requirements. Obviously, you must be a current or past member of the armed services or a qualified spouse. You can find all the requirements here, but chances are if you qualify, you already know it. These loans are highly advantageous because you don’t need to make a down payment or carry mortgage insurance.

USDA loans are available to people who reside in rural areas. The United States Department of Agriculture provides such loans to homebuyers who fall into low or moderate income groups. USDA loans don’t require a down payment. They also tend to be more lenient when it comes to the borrower's credit score.

FHA Loans vs. Conventional Loans: Making the Right Choice

As you can see, there are many key differences between FHA loans and conventional home loan. These home loan types cater to different kinds of homebuyers, and sometimes you can rule one out pretty quickly based on how much money you’ve saved for a down payment, how much you want to borrow, and your credit score.