What is the Difference Between an FHA Loan and a Conventional Loan?
When you’re a first-time home buyer, reason suggests that you want to play it safe when it comes to the loan you choose. In other words, you probably seek to apply for a mortgage in which you’re likely to be approved.
Thus, conventional wisdom suggests you should go for a conventional loan, right? Well, much like looks, words can be deceiving.
An FHA home loan could potentially be a better fit for you. Generally speaking, the qualification standards for an FHA home loan are easier and don’t require as high of a credit score. That isn’t to throw shade at conventional loans, though.
But before we get too heavy into the details, let’s back up a bit, as you may be wondering what a conventional mortgage is and how it compares with other mortgage loan products. Depending on your needs and financial abilities, you may find that there’s nothing at all conventional about a conventional loan. Here at Bungalo, FHA loans are among the more common loan program selections for buyers, but our specialists are more than happy to work with you if a conventional loan is the one you ultimately choose. Understanding the distinctions of each will help you make the right decision. So, let’s get into learning more about these loans and what makes each unique.
What is a conventional loan?
A conventional loan simply means that the loan is not insured by a federal agency. Unlike a VA loan – which is backed by the Department of Veterans Affairs – or an FHA loan – which is funded by the Federal Housing Administration, an arm of the Department of Housing and Urban Development – a conventional loan is essentially any mortgage product that is separate from the government.
What does “backed” mean? A government backed loan is an indication that the government guarantees a mortgage lender that they’ll be fully compensated in the event the borrower defaults.
The fact that a conventional loan is not a government backed loan makes it harder to obtain if you don’t have a high enough credit score. Since lenders make their approval decisions based upon risk – meaning the likelihood that a borrower will be able to make their mortgage payments – a conventional loan applicant must reach a higher threshold. Risk can also affect what interest rate is charged. A lower interest rate may be possible when other factors are taken into account.
Take your credit score. Your credit score is used for a lot of things by creditors in addition to interest rate determination. It serves as a barometer of how you manage your expenses. The higher the credit score, the more reliable a potential borrower is considered to be.
How high does your credit score need to be for a conventional loan? Truthfully, there is no magic number, as lenders assess creditworthiness through many different variables, such as salary, your tax documents, available savings, assets and a few other factors. Generally speaking, though, conventional loan approval requires a score of at least 620, according to Experian.
Now let’s talk about the FHA loan.
What is an FHA loan and why are they a top pick for first-time buyers?
As previously noted, an FHA loan is backed by the Federal Housing Administration. Ever since it was created – back in the mid-1930s – it’s been one of the more popular mortgage programs, particularly among first-time buyers, who represent about a third of the housing market at any given time, according to the National Association of Realtors. The reason why goes back to approval – it’s notably easier in comparison to a conventional loan. Whereas a conventional loan entails a credit score of 620 or more, it’s possible to be approved for an FHA loan with a FICO credit score that is between 500 and 580, or thereabouts.
Another major selling point for the FHA mortgage is down payments. One of the most common misconceptions about down payments is you have to come up with 20% of the house’s list price to be approved for a loan. Not true. With an FHA loan, borrowers can put as little as 3.5% of a home’s cost toward the down payment. One of the biggest obstacles to homeownership is the down payment since certain mortgages require borrowers to spend more up front, conventional loans being one of them (depending on their credit score, which we’ll get into more later). The FHA mortgage program has made the American dream eminently more attainable.
More flexible DTI
An additional advantage of FHA loans is a more lenient debt-to-income ratio. Often referred to as DTI, debt-to-income ratio refers to what percentage of a borrower’s regular income goes toward major payments, such as a car loan or credit card debt. The higher the percentage, the less discretionary spending that person has. Approval for an FHA loan is possible with a DTI of 50%. So if half of what you earn goes toward payment obligations, you may still qualify. With a conventional mortgage, borrowers’ DTI usually have to be less than 50% (although not always).
So, let’s review: Conventional loans require higher credit scores, lower DTIs (again, usually) and occasionally larger down payments when compared to the FHA mortgage. So it would seem like an FHA loan is a no-brainer pick if you’re a first-time home buyer seeking simplicity and cost convenience.
The truth is conventional loans have several things going for them as well – we wouldn’t be writing about them if they didn’t. Let’s start with mortgage insurance.
Mortgage insurance may not be necessary
Private mortgage insurance is something that lenders frequently require borrowers to purchase as a precondition to mortgage approval. Whether it’s necessary or not depends on the size of the down payment. Usually, down payments that are less than 20% trigger the need for private mortgage insurance, which provides financial cover for lenders should a borrower default. Those that can come up with 20% or more don’t have to buy private mortgage insurance, which includes those who choose a conventional loan. This fact alone can save borrowers thousands over the life of a loan.
Can you guess which one mandates private mortgage insurance? You got it: FHA loans do. This means even if you can afford to pay one-fifth of a house’s price upfront, mortgage insurance is still necessary. It also can’t be canceled, whereas mortgage insurance can be with a conventional loan. In fact, it’s automatically canceled once a house’s equity has reached a certain threshold, usually of around 78%.
The only way to cancel mortgage insurance for an FHA mortgage is by refinancing to a conventional mortgage.
Another check in the conventional mortgage column has to do with down payments. Earlier, we mentioned that conventional mortgage borrowers frequently spend more on their down payment. But it’s actually possible to be approved for a conventional loan with as little as a 3% down payment. There’s a caveat to this, though. If your credit score is deemed to be too low, then a 3% down payment likely won’t fly. Since conventional loans aren’t backed by the government, exceptionally low down payments are typically reserved for those with stronger credit, such as a credit score that’s in the high 600s or 700s.
Bottom line: An affordable down payment is possible with a conventional loan, but you’ll have to reach a higher standard of creditworthiness.
Higher loan limit for conventional mortgage products
If you’ve seen home prices nowadays, you know that they can get pretty expensive. In fact, while interest rate levels have been in record low territory for a while now, the median price for a home has risen every month for 113 months in a row, according to the National Association of Realtors.
This means that you may need to borrow more from a mortgage lender to afford your monthly payment. Conventional mortgages are more lenient in that regard. While both a conventional loan and an FHA loan have loan limitations, a conforming loan tends to be more flexible and has a higher loan limit ceiling. Much of this depends on the market that a house is selling in and the rules established by the Federal Housing Finance Agency (FHFA), the entity that establishes the terms and guidelines of conforming loan products.
If the cost of a house goes beyond the limit established by the Federal Housing Finance Agency, you may still be able to get a conventional loan, but it would depend on your credit score. And once again, the more that you seek to borrow, the higher your credit score will need to be, especially if it’s a jumbo loan, which is a type of conventional loan that is outside the purview of the FHFA. This means it’s a non-conforming loan.
Sellers frequently prefer conventional loan borrowers to FHA loan borrowers
Competition is a reality when you’re buying real estate; other people are almost assuredly to be interested in the property that you’re considering. You may have an edge on others with a conventional loan than with an FHA loan. There are several reasons why, but a big one has to do with appraisals. In order to be approved for an FHA loan, the property must go through an appraisal, the standards of which are governed by the FHA. In addition to assessing the property’s overall value, an appraisal examines the integrity of the building to ensure that it’s move-in ready. It also focuses on what repairs are needed so if anything needs to be fixed gets addressed.
These requirements place more onus on the seller as far as preparations are concerned. Since there isn’t as much red tape with conventional loans, sellers often choose the path of least resistance.
The same goes for inspections. In the event an FHA loan borrower decides before closing that they no longer want the house, the inspection stays on the home. That isn’t the case if the same scenario happened with a conventional loan borrower.
Bottom line: There’s more predictability and less regulatory scrutiny with a conventional loan borrower than an FHA loan borrower.
So, should you choose an FHA loan or a conventional mortgage? There’s truly no right or wrong answer – only the right one for you. And you can’t go wrong when you buy direct through Bungalo. Assuming pre-approval, we accept all mortgage loans and simplify the purchasing process, so you don’t have to worry about bidding wars or inspections; every Bungalo home undergoes multiple rounds of rigorous inspections conducted by licensed experts. So if you see it on our website, you know it’s move-in ready. This guarantee is backed by our 90-day post-close protection pledge. Contact us today to get started.
This article is meant for informational purposes only and is not intended to be construed as financial, tax, legal, real estate, insurance, or investment advice. Bungalo always encourages you to reach out to an advisor regarding your own situation.