What's the Difference Between FHA and Conventional Loans?

From eligibility criteria to loan terms, understanding the difference between Federal Housing Administration, or FHA, and conventional loans may help you determine which type of mortgage is right for you.

For far too many Americans, the dream of homeownership feels out of reach. This is especially true for millennials, who carry an average of $40,614 in student loan debt.

However, for those who may struggle to qualify for a conventional mortgage loan due to a higher debt-to-income ratio or less-than-perfect credit, FHA loans may offer a promising path to homeownership thanks to their flexible eligibility criteria.

What's an FHA loan?

An FHA loan is a type of home mortgage issued by a bank or other lender and insured by the Federal Housing Administration. In simple terms, this means that the federal government is guaranteeing the loan, which reduces the level of risk for lenders and allows them to loosen their eligibility requirements.

Be aware that when lenders talk about conventional mortgages, they're referring to loans that aren't part of any specialized government program, and thus generally have stricter eligibility requirements.

Who are FHA loans for?

FHA loans are popular with low- to moderate-income homebuyers who may have difficulty qualifying for a conventional mortgage or saving for a down payment. While many people mistakenly assume only first-time buyers are eligible, experienced borrowers may also benefit from the flexibility FHA loans offer.

Eligibility for FHA loans versus conventional loans

Many factors may impact a lender's decision to approve a home loan. Still, the basic eligibility requirements for FHA loans are more flexible than conventional loans, such as fixed-rate mortgages.

For example, FHA home loans allow:

• A lower credit score threshold: While conventional loans typically require a minimum credit score of at least 620 (out of 850), borrowers with credit scores above 500 can qualify for an FHA loan.
• Smaller down-payment requirements: With an FHA loan, borrowers with a credit score of 580 or more may qualify to make a down payment as low as 3.5% of their home's purchase price. With conventional loans, most lenders require a good to excellent credit score—generally in the high 600s or above—to qualify for a down payment in this range.
• A higher maximum debt-to-income ratio: While requirements will vary by lender, FHA loans may be available to borrowers with a debt-to-income ratio as high as 43%. This means your total monthly debt payments can't exceed 43% of your monthly income. The maximum for many conventional loans is only 36%.

What should homebuyers consider when choosing FHA loans?

FHA loans can be a great option for many borrowers. However, they also have several limitations to consider.

First, it's important to note that FHA loans can only be used to finance a primary residence. They can't be used to buy an investment property or vacation home.

Additionally, be aware that in highly competitive real estate markets, an FHA loan may put you at a disadvantage when bidding against other buyers.

Why do sellers prefer conventional over FHA loans?

Often, it boils down to the FHA's more stringent appraisal process. Any home purchased with an FHA loan must meet stricter property standards. While lenders almost always require a market value appraisal when financing a home, an FHA appraisal goes further. It also considers the home's safety by assessing the soundness of construction and adherence to local building codes.

One upside to note: Those higher standards may protect you from purchasing an unsafe or unsound home that's not up to code. This might save you from many headaches and unplanned expenses down the road.

Lastly, there are some additional costs to consider. To further reduce risk, FHA loan recipients are required to purchase mortgage insurance. When closing on an FHA loan, you can expect to pay a one-time fee of 1.75% of the base loan amount for this. You'll also be required to pay an annual mortgage insurance premium, or MIP, that ranges from 0.15% to 0.75% of the loan amount, depending on the size of your down payment and loan term.

The upfront fee can be financed into the loan, but the annual MIP is generally divided by 12 and rolled into your monthly mortgage payments.

Is an FHA loan better than conventional?

Thanks to expanded eligibility requirements, borrowers with a lower credit score and a smaller down payment may qualify for an FHA loan when a conventional loan might be out of reach. Similarly, those with a higher debt-to-income ratio may qualify for an FHA loan but may need to pay down some debt before they'd be eligible to receive a conventional loan.

Ultimately, both FHA and conventional loans offer a path toward homeownership. Knowing the advantages and disadvantages of the two loan types may help you choose the right one for your needs.