A distinction that borrowers come across in their search to finance a home is that between FHA loans and conventional loans. They also often hear about one being harder to obtain than the other.
In this article, I’m going to cover the differences between FHA loans and conventional loans, go over the general requirements of each, and point out some of the advantages to stand to gain by choosing one over the other.
As a borrower, it’s important to have as much information as possible on each type of loan program, so they can make an informed decision and choose the best possible option for them.
Let’s start by discussing the key differences between the two types of loans.
FHA vs Conventional Loans – Key Differences
Getting a loan to buy a house will have a strong impact on your future finances, therefore, it’s best to “shop around” for mortgage loans to see which are your best options.
Here’s an overview of the most important differences between conventional and FHA loans:
1. FHA is a Government-Insured Loan Program
Although both types of loans originate in the private sector, the Federal Housing Administration loans are insured by the federal government.
The government provided insurance is designed to protect the mortgage lender against borrower defaults. The insurance is paid by the borrower in the benefit of the lender.
Conventional loans, however, do not receive federal backing, they’re not insured by the federal government. Instead conventional loans are insured by private insurance mortgage.
The borrower will be required to pay mortgage insurance with both types of loan, however, with conventional loans private mortgage insurance is not required in every case.
2. Conventional Loans are More Difficult to Qualify For
With both types of loans, you will be dealing with a mortgage lender that operates in the private sector. The mortgage lender sets the requirements for approval that you must meet in order to qualify for the loan.
Besides the qualification criteria of the mortgage lender, the FHA loan system has another tier of requirements that borrowers must meet, namely that of the federal government.
The FHA is managed by the Department of Housing and Urban Development (HUD), and the HUD creates specific requirements and guidelines for borrowers.
Despite this “two-tier” qualification requirement, FHA loans are still generally easier to qualify for compared to conventional loans.
The reason is that since FHA loans are backed by the federal government and the lender is guaranteed repayment whether the borrower defaults or not, lenders tend to be more relaxed with their requirements compared to when they need to approve conventional loans.
Because of the higher degree of protection offered to mortgage lenders, they’re more willing to accept a higher degree of risk. For example, they may approve a borrower with a credit score that’s too low to qualify for a conventional mortgage loan.
Therefore, contrary to popular belief, it’s easier for borrowers to get approved for an FHA-backed mortgage loan compared to a conventional loan.
Another misconception about FHA loans is that the government lends money directly to consumers, which isn’t the case at all.
The money still comes from the mortgage lender that operates in the private sector, but the government insures the loans originated by the private sector and guarantees that even if the borrower does not make repayments, the lender still receives repayment.
3. FHA Loans Require Less Down Payment
I mentioned that mortgage lenders have more relaxed approval criteria when it comes to FHA loans and that they’re willing to approve even a borrower with a lower credit score than that would be required for a conventional loan.
Mortgage lenders will also accept less down payment from borrowers, allowing them to put down as little as 3.5% of the purchase price or appraised value.
These are the reasons why the FHA loan program is popular with borrowers with little money saved up and a bruised credit score.
Some mortgage lenders do offer conventional loans with 3% down payment, but if you’re viewed as a high-risk borrower, most mortgage lenders will not go below the minimum 5% down payment requirement, and most might ask for a 20% initial investment.
Therefore, borrowers that need to minimize their upfront, out-of-pocket investment and borrowers with a less than perfect credit score gravitate towards FHA mortgage loans.
Now that you know how conventional loans compare to FHA loans, let’s take a closer look at the “two-tier” approval criteria of FHA loan.
FHA Loan Requirements
I mentioned that even though FHA loans have a “two-tier” approval system, it’s still generally easier for a borrower to qualify for an FHA-backed mortgage insurance than a conventional loan.
Here is an overview of the approval requirements for FHA loans:
1. Credit Score & Down Payment
For maximum financing, borrowers must have a credit score of at least 580 and a down payment of at least 3.5% of the purchase price or the appraised value.
A minimum credit score of 500-579 is also acceptable from the FHA’s standpoint but a minimum down payment of 10 percent is required for maximum LTV of 90 percent.
With FHA loans, the down payment can be partially or entirely gifted by a family member, relatives, a close friend, employer or other HUD approved donors.
While FHA loans don’t require PMI (private mortgage insurance), they do require government provided insurance that must be paid by the borrower.
There are two types of MIPs, the annual MIP, which is paid monthly and the upfront MIP, which is paid as a lump sum at closing of the loan.
The annual MIP is payable for the entire loan term if the borrower makes a down payment lower than 10%.
This is one of the major disadvantages of the FHA loan program, because the MIP ends up inflating the borrower’s monthly mortgage payment.
With conventional loans, PMIs can be cancelled if the borrower puts down at least 20% of the purchase value.
3. Debt-to-Income Ratio < 43%
The Debt-to-Income Ratio (DIR) of the borrower must be below 43% of their gross income. The DIR means mortgage plus all monthly debt, i.e., credit card payment, car payment, student loans, etc.
Borrowers may be able to get approved even with a high a percentage as 50%. In this case the mortgage lender will be required to justify why the borrower constitutes an acceptable risk.
4. Primary Residence Requirement
FHA loans are only approved for primary residence occupancy, meaning that the borrower must use the home their financing with an FHA as primary residence.
This also means that an FHA loan will not be approved for vacation homes or for homes purchased for investment purposes.
Another important aspect that borrowers must know about the FHA loan approval is that the property that’s being financed must meet the minimum health and safety standards as defined by the HUD guidelines.
To this end, the mortgage lender will arrange for a property appraisal. The FHA appraiser will appraise the value of the property while also making sure that the property is fit for occupancy as defined by the HUD.
Therefore, the appraiser will check the condition of the foundation, roofs, heating and/or cooling systems, they will make sure that bedrooms have a suitable egress, and that stairwells have handrails, etc.
The appraisal concludes in an appraisal report that will become part of the loan approval documentation.
The FHA appraisal is paid for by the borrower, usually up-front. The property appraisal costs between $300-$400 depending on the size, location, type of property, and other aspects.
5. Steady Income & Proof of Employment
Borrowers must have a steady employment history or must have been with the same employers for the past two years.
6. Bankruptcy and Foreclosure Requirement
While FHA loans can be approved even if the borrower has gone through bankruptcy or foreclosure, there are certain requirements they must meet.
Generally, a borrower must be three years out of foreclosure or two years out of bankruptcy to qualify for an FHA loan. They must also have re-established good credit and meet all the other requirements of the mortgage lender and the FHA.
If there are extenuating circumstances in favor of the borrower, the waiting period can be reduced.
There are significant distinctions between FHA loans and conventional loans, but one of the most striking differences is the way these mortgage loans are insured.
FHA mortgage loans are backed and guaranteed by the federal government, while conventional loans are insured by private mortgage insurance.
Because there is government provided repayment guarantee for mortgage lenders that offer FHA loans, they are more likely to take on a higher risk and approve borrowers with a lower credit score and less down payment than is standard for conventional loans.
This aspect is also what makes FHA loans more appealing to borrowers with less saved up cash or a credit score that isn’t perfect.
It’s important to note that no loan program is completely perfect, they all have their advantages and disadvantages.
Being informed about them is key in choosing the right mortgage loan for you.