Unless you’re sitting on a few hundred thousand dollars in cash — or win the lottery this week — chances are you’ll need to take out a mortgage to buy your next home.
While there are plenty of loan options out there to choose from, your ability to qualify — and ultimately, the best choice for you — will depend on your credit history, available cash, and personal financial goals and values.
Two of the most common options are Federal Housing Authority (FHA) loans and conventional mortgages. Each offers its own set of unique advantages and drawbacks. Here’s what you need to know in order to make the right decision.
Do I Qualify? Comparing FHA vs. Conventional Loans Requirements
Required Credit Score
You will need a credit score of 620 to qualify for a conventional loan. (The average credit score of people who take out conventional loans is closer to 740.) Borrowers can get an FHA loan with a credit score as low as 580.
Traditionally, lenders require borrowers to put 20% down to qualify for a mortgage. Even if you have as little as 3.5% to put down, you can still qualify for an FHA loan.
If borrowers receive help with their down payment as a gift from a family member or significant other, they can still qualify under FHA regulations.
The smallest amount you can put down on a conventional loan is 5%, unless you qualify for a Conventional 97 Loan. Only a portion of a conventional loan down payment can be written off as a gift.
If you put less than 20% down up front, you’ll be required to pay mortgage insurance — regardless if you opt for an FHA or conventional loan.
Reserve Funds and DTI Ratio
Conventional lenders require borrowers to have reserve funds; FHA lenders generally do not.
Lenders will also look at a borrower’s debt-to-income (DTI) ratio before they approve them for a loan. There is a strict 43% DTI ratio cap for conventional loans, but borrowers with a higher DTI ratio can still qualify for an FHA loan.
Why Choose FHA Loans?
The FHA knows what they are doing when they only require 3.5% down and lower credit score requirements. FHA loans are low-risk loans because are backed by the government rather than private entities. Low risks make room for low requirements — this makes it easier for borrowers to find an FHA-approved lender.
Flexibility for Borrowers
If you don’t have 20% to cough up for a down payment, you may feel very limited in your loan search. FHA loans give you more flexibility and options by allowing lower down payments. (Do remember that this low down payment often comes with mortgage insurance, higher interest rates, or by wrapping the costs into the loan.)
Lower Interest Rates
How much will you pay for your mortgage each month? It all depends on interest rates. FHA loans tend to have lower interest rates than conventional loans, but rates will vary depending on your down payment, credit score, and other factors.
Borrowers who may not qualify for conventional loans can still get the house of their dreams with an FHA loan, but it’s important to look over the terms of your loan and the cost of PMI before you choose this option.
Why Choose Conventional Loans?
Lower or No PMI
Lenders give out high-risk loans with conditions. One of these conditions is the cost of private mortgage insurance (PMI.) Private mortgage insurance is a percentage of your overall loan that is paid upfront and then tacked onto your monthly payments.
Conventional loans don’t require borrowers to pay private mortgage insurance if they pay a 20% down payment, decreasing the amount the borrower pays overall. Your PMI payments will automatically stop once LTV has reached 78%, but you can apply to cease PMI payments earlier.
Financing a Vacation Home, Investment Property, or More Expensive Purchase
FHA loans are typically limited to owner-occupied properties. If you are looking to purchase a vacation home or an investment property, you will have to occupy one of the units. Conventional loans cover properties that you intend to use solely as investment properties.
The loan limits for conventional loans are also higher than FHA loans. Loan limits vary depending on where you are looking to buy and how many units you would like to purchase. If you are in a low-cost area and want to buy a single-unit home, for example, you can take out $294,515 with an FHA loan and $453,100 with a conventional loan.
Financing a Home That Needs Repairs
FHA lenders pay very close attention to the state of the house before they approve your loan. Too many renovation needs may result in a rejected loan application. If you are looking to purchase a house that needs a few renovations, you might hit some delays with an FHA loan.
Overall, conventional loans have much higher requirements than FHA loans, but allow you to finance a wider variety of projects. FHA loans have lower interest rates and appear to be less expensive when you first apply, but over the life of the loan, the lower PMI payments make conventional loans more affordable.
Need Help Finding a Lender?
Still weighing your options? A good first step is to connect with an experienced real estate agent. Buyer’s agents can help you evaluate financing options and make the best possible decision, given your specific financial situation and goals.
They also provide invaluable guidance, services, and support throughout the entire home-buying process, from house hunting and making offers to negotiating, handling the paperwork, and closing.
Want to connect with a top-rated, buyer’s agent near you? Fill out our online form and a Clever representative will reach out to answer any questions you might have and make an introduction to one of our full-service Partner Agents for a no-obligation consultation.