As a prospective homebuyer trying to determine the best decisions for your financial future, it’s likely that you’ve found yourself overwhelmed by the options available to you, especially if your credit score is below average. Luckily, homebuyers have options such as FHA loans to help individuals with poor credit and other financial challenges. While both FHA and conventional loans allow homebuyers to finance the purchase of a home, knowing the differences between FHA and conventional loans can help you make the best decision for your unique financial situation.
FHA loans are backed and insured by the Federal Housing Administration (FHA). They offer more flexible financial requirements that enable homebuyers with low to moderate income, limited savings, and poor credit history to qualify for a mortgage, even with small down payments and poor or fair credit scores.
FHA backing minimizes the risk for the lender, which allows them to extend greater leniency to the borrower. However, FHA loans introduce extra costs to the homebuyer in the form of an upfront mortgage insurance premium, paid at closing, and then a paid premium every month. This mortgage insurance protects the lender from unforeseen circumstances, such as missed payments, or the homebuyer’s default on the loan.
Additionally, a homebuyer must consider their debt-to-income ratio, which compares how much you owe for bills and debts each month against your monthly income. Specifically, it’s the percentage of your total monthly income that goes towards payments such as rent, credit cards, mortgage, student loans, or other debt. Ideally, your debt-to-income ratio must be 50% or less to qualify for an FHA loan.
FHA Loans are best for the following homebuyers:
- Homebuyers with poor credit history, or modest credit rating may qualify for an FHA loan even if their credit score is below average or if they have a recently resolved bankruptcy or foreclosure on their credit history. Homebuyers usually need a credit score of 580 or higher to qualify for an FHA loan, with a minimum down payment of 3.5%.
- Homebuyers that need to borrow a smaller loan amount will find that the FHA loan limit is generally set at 65% of the national conforming loan limit. This means that FHA loans will typically be smaller than conventional mortgages.
- Homebuyers who are purchasing a primary residence are particularly a good fit since FHA loans can only be used to buy a home that will serve as your primary residence.
- Homebuyers with a high debt-to-income ratio may find FHA to be a good option if they carry far more debt than the average household.
Unlike FHA loans, conventional mortgages aren’t backed or secured by the government. There are two categories of conventional loans; conforming or nonconforming. Loans that meet lending rules set by Fannie Mae and Freddie Mac are considered conforming loans; nonconforming loans scarcely fit these guidelines, allowing more flexible eligibility requirements. Generally, conventional loans command a higher down payment and credit score requirement than government-backed FHA loans.
FHA Loans are best for the following homebuyers:
- Homebuyers with established credit and low debt levels usually qualify for conventional mortgages. Typically, the minimum credit score needed to qualify for a conforming conventional loan is 620, though some lenders may increase the requirement.
- Homebuyers purchasing a property that failed an FHA appraisal. FHA appraisals are incredibly stringent compared to conventional appraisals. During an FHA appraisal, a property’s total value is assessed, but then further vetted for safety, soundness of construction, and adherence to local code restrictions. A homebuyer may choose a conventional loan if your property does not pass these strict standards.
- Homebuyers with the financial flexibility to put a substantial down payment may benefit from a lower monthly payment with a conventional loan.
- Homebuyers intending to be in the home for a long time may be at a disadvantage with a long-term FHA. As a result of the mortgage insurance imposed on FHA loans, long-term FHA does not offer the best financing for homebuyers. It may be best to choose a conventional loan or refinance an FHA loan into a conventional loan once your credit score has improved enough.
The most important aspects of the comparison between FHA Loans vs. Conventional Loans come down to a homebuyer’s credit score, their financial flexibility regarding their debt to income ratio, and the size of the down payment they can manage. The difference between the two loans is most evident in the minimum requirements set in these areas.
Generally, a homebuyer with a higher credit score will receive a better interest rate with both FHA Loans and Conventional Loans. However, borrowers with credit scores below 620 are unlikely to qualify for conventional mortgages, so FHA loans are likely the best option for them. Meanwhile, borrowers with credit scores of 720 or higher are likely to find that their monthly payments cost less on conventional loans.