FHA vs. Conventional Loans: An Overview

Consumers qualify for various types of mortgages based on their financial profiles. A lot of mortgages tend to be conventional loans. But there are others that are backed and insured by the Federal Housing Administration (FHA). While both allow consumers to finance the purchase of a home, there are several key differences between the two.

FHA loans make homeownership possible and easier for low-to-moderate-income borrowers who may not otherwise be able to get financing because of a lack of or a bad credit history, or because they don't have enough saved up. Those who qualify for an FHA loan require a lower down payment. And the credit requirements aren't nearly as strict as other mortgage loans—even those with credit scores below 580 may get financing. These loans are not granted by the FHA itself. Instead, they are advanced by FHA-approved lenders.

People with established credit and low levels of debt, on the other hand, usually qualify for conventional mortgages. These loans are generally offered by private mortgage lenders like banks, credit unions, and other private companies. Unlike FHA loans, these mortgages aren't backed or secured by the government.

Key Takeaways

  • People with established credit and low levels of debt usually qualify for conventional mortgages.
  • People with more debt and a modest credit rating typically qualify for Federal Housing Administration insured mortgages.
  • FHA loans require a lower minimum down payment and lower credit scores than conventional loans.
  • Conventional loans are not backed by a government agency and are granted by private mortgage lenders—banks, credit unions, and other financial institutions.

Federal Housing Administration (FHA) Loans

Federal Housing Administration (FHA) loans are federally insured and issued by FHA-approved lenders, including banks, credit unions, and other lending companies. FHA loans are intended for borrowers with limited savings or lower credit scores.

FHA loans can be used to buy or refinance single-family houses, multi-family homes with up to four units, condominiums, and certain manufactured and mobile homes. There are also specific categories of FHA loans that can be used for new constructions or to finance the renovation of an existing home.

Because FHA loans are federally-insured—which means that lenders are protected in the event that a borrower defaults on their mortgage—these lenders can offer more favorable terms to borrowers who might not otherwise qualify for a home loan including lower interest rates. This means it's also easier to qualify for an FHA loan than for a conventional loan.

The qualifying standards of FHA loans make home-buying more accessible for a greater number of people. As of 2020, you can borrow up to 96.5% of the value of a home with an FHA loan. FHA mortgage applicants with credit scores as low as 580 may be approved for a home loan—provided they have enough to cover the 3.5% down payment requirement. Those whose credit scores fall below 580 may still qualify, but generally need to put down a minimum of 10% of the purchase price. The majority of lenders require FHA mortgage applicants to have credit scores between 620 and 640 for approval. These government-backed loans may also have additional closing costs that aren't required by conventional loans.

FHA loan down payments may be as little as 3.5% depending on your credit score, while conventional mortgages require anywhere between 3% to 20%.

Conventional Loans

A conventional loan is a mortgage loan that is not backed by a government agency. Conventional loans are originated and serviced by private mortgage lenders, such as banks, credit unions, and other financial institutions. Conventional loans present the most risk for lenders since the federal government does not insure them. For this reason, lenders extend conventional mortgages to applicants who have the strongest financial profiles. Conventional down payment requirements range from 3% to 20%, depending on the mortgage product.

In order to qualify for a conventional loan, consumers typically have stellar credit reports with no significant blemishes and credit scores of at least 680. Conventional loan interest rates vary depending on the amount of the down payment, the consumer’s choice of mortgage product, and current market conditions. Most conventional loans come with fixed interest rates, which means the rate never changes throughout the life of the loan. Borrowers are able to refinance if rates change.

Conventional loans can be divided into two categories—conforming and non-conforming loans. Conforming conventional loans follow the lending standards set forth by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Special Considerations

Mortgage Insurance

Borrowers may be required to pay mortgage insurance, depending on the mortgage terms and the amount of the down payment. Unlike other types of insurance, mortgage insurance protects the lender—not the policyholder—if the borrower stops making payments and defaults on their financial obligations.

Mortgage insurance is built into every FHA loan. Premiums are paid in two different ways. The first is through an upfront payment, which may be rolled into the loan and paid throughout its life. The second way is by making monthly payments. Borrowers who can put down 10% or more pay these premiums for 11 years. Anyone who makes a down payment of less than 10% must make these premium payments for the duration of their mortgage.

Most lenders prefer to issue conventional loans for no more than 80% of the market value of a home—the equivalent to making a 20% down payment. The percentage of the home's value that is represented by the amount of the loan is indicated by the loan-to-value (LTV) ratio. For example, a borrower who puts down 15% ($45,000) on a $300,000 home requires a loan of $255,000. This would yield an LTV ratio of 85%. Lenders require an LTV ratio of 80% or less as a way of protecting themselves against the risk that the borrower will fail to repay the mortgage. This is why people with conventional mortgages who make less than a 20% down payment, pay mortgage insurance—also called private mortgage insurance (PMI)—until their LTV ratio reaches 80%.

PMI can cost between 0.3% and 1.5% of your loan amount annually. Like other types of mortgage insurance, PMI is paid for by the borrower and is intended to protect the lender from experiencing financial loss if they are forced to foreclose on the property. The proceeds from PMI may be used by lenders to cover the costs associated with re-selling a home that is in foreclosure.

Other Government-Backed Loans

FHA loans are not the only type of government-backed loans. There are two other types of government agency-insured loan programs—VA loans and USDA loans.

Veterans Affairs (VA) loans are backed by the U.S. Department of Veterans Affairs. These loans are available to qualified members of the armed services, their spouses, and other beneficiaries. VA loans don't require a down payment and they typically don't charge mortgage insurance.

Loans are available for borrowers in rural areas through the U.S. Department of Agriculture (USDA). They are intended for low- to moderate-income homebuyers, and they don't require a down payment. There may also be more flexibility with credit score requirements.