Conventional Loan vs FHA Loan - Difference and Comparison

What is a Conventional Loan?

Conventional loans are not guaranteed by any government agency but generally comply with the guidelines set by Fannie Mae and Freddie Mac. After a lender loans money to a borrower who wants to buy a home, the lender usually sells the loan to either Fannie Mae or Freddie Mac. Because of this, lenders must ensure that borrowers meet Fannie and Freddie's guidelines for loans.

Conventional loans are of two types: conforming and non-conforming. Conforming loans adhere to Fannie and Freddie's guidelines and are for amounts less than $417,000 (or higher in some areas that have a high cost of living). Non-conforming loans either are above the lending threshold Fannie and Freddie set (see jumbo mortgage) or are made to borrowers who do not otherwise qualify for a conforming loan (e.g., someone with a lot of debt). Non-conforming loans usually have a much higher interest rate than conforming loans.

What is an FHA Loan?

FHA loans are guaranteed by the U.S. Federal Housing Administration (i.e., the FHA). This guarantee reduces the risk lenders face when issuing loans, thus allowing lenders to lower their qualification criteria. This sometimes makes FHA loans the only way that borrowers with a poor credit score (<600) or low down payment (as little as 3.5%) can buy a home.

In exchange for this guarantee from the FHA (which is practically a guarantee from the U.S. government), the borrower must purchase mortgage insurance through the FHA. This increases the long-term cost of the loan for the borrower but enables the purchase of a home that might have otherwise been impossible without more upfront help.

The application process is similar for both FHA-insured and conventional mortgages. A pre-approval from a lender is usually the first step in the loan application process.

Eligibility

Eligibility for Conventional Loans

Most conventional loans require borrowers have a credit score of at least 620, and scores below 700 may lead to either extra fees or a higher interest rate. Conventional lenders, such as a banks or credit unions, usually require a down payment of 20 percent (or less, with the purchase of private mortgage insurance) and typically have a ceiling of 45% for the debt-to-income ratio. Other criteria for conventional mortgages may include a steady job history, full documentation of income and assets, and price stability in the neighborhood where the home is located.

Eligibility for FHA Loans

FHA loans require a minimum down payment of 3.5% and generally require borrowers pay for FHA mortgage insurance. The minimum credit score required is 500; however, only borrowers with a credit score of 580 or higher qualify for the lowest (3.5%) down payment option. Others are required to put 10% down.

Mortgage Insurance

FHA loans require mortgage insurance, which must be paid both upfront and monthly. Most 15- or 30-year FHA loans require the borrower to pay 1.75% of the loan amount at closing, along with a 0.5% annual renewal premium for the length of the loan. Half of the upfront mortgage insurance premium is refundable when the home is sold. Monthly premiums are not required if the down payment is more than 22% of the value of the home. However, for most FHA borrowers, such a high down payment is not feasible.

Conventional loans do not require any upfront mortgage insurance payment. However, ongoing mortgage insurance is required for conventional loans where the borrower has made a down payment of less than 20%.

Mortgage Insurance Pricing

For borrowers trying to choose between a conventional loan and FHA loan, mortgage insurance premiums are a significant factor. Pricing for private mortgage insurance through a private institution is risk-based for conventional loans. This means the premium is lower for those making a higher down payment and those with higher credit scores. This is not the case with FHA loans; all borrowers are required to pay 1.75% of the loan amount upfront. This cost is typically bundled into the loan.

Closing Costs

FHA loans allow borrowers to use money that is a gift from a relative, nonprofit organization, or government agency to pay 100% of the down payment at closing. Conventional loans, on the other hand, place some limits on this. For instance, some conventional lenders may avoid a borrower whose down payment is mainly made up of a gift from a relative; conventional lenders usually want to see that the majority of down payment is made up of funds the borrower earned and saved.

Assumable Loans

FHA loans are generally assumable, i.e., the loan can be transferred to a new owner when a house is sold. The new owner can take over the FHA loan without the additional cost of obtaining a new loan. This is a big advantage for both sellers and buyers and can make it easier to sell a home. Of course, the new owner must meet the eligibility criteria for an FHA loan for it to be transferred.

Technically, any mortgage can be assumable, but such transferring of conventional loans is virtually unheard of. FHA and VA loans are typically the only loans that are assumable. However, even FHA loans are less likely to be assumable in recent years.[1]

Prepayment Penalties

A prepayment penalty is a penalty fee imposed on borrowers who repay a loan, in part or in full, too quickly, thus lessening a lender's return for the initial loaning of the money. Prepayment penalties are not allowed in FHA loans, whereas there can be fees for paying the money back early with a conventional loan. Some states disallow prepayment penalties, and loan terms vary by lender, so it is a good idea to check contract agreements before making a decision. Try to avoid any loans that have a prepayment penalty. Subprime mortgages are likely to have prepayment penalties.

Acceptance

Some condominium complexes and non-owner investment properties do not allow FHA financing, so a conventional mortgage may be the only option when buying such real estate; there are no such restrictions with conventional mortgages.

Pros and Cons

Conventional mortgages are easier to process and allow home equity to build faster, as they require higher down payments. However, borrowers need a good credit score to qualify for a lower interest rate, and some lenders require up to 20% as a down payment.

Lenders for FHA loans are more willing to look at the overall credit picture, rather than just the credit score alone. They require a much lower down payment, and have no minimum credit score requirement. They are a good choice for those with less-than-perfect credit scores, borrowers with moderate debt-to-income ratios, and those who do not have much money for down payments.

Popularity

After the 2008 financial crises, FHA loans have risen to a larger percentage of overall mortgage issuance.

Gross mortgage issuance (including refinancing) in America, by type. Source: Bloomberg

References

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