Understanding FHA and Conventional Loan Differences

Key Takeaways

• An FHA loan is a federal government-backed home loan that is insured by the Federal Housing Administration. 

• A conventional loan is a home loan offered by private lenders sans any direct government backing, meaning that unlike FHA loans, they are not guaranteed or insured by the government. 

• Compared with conventional loans, FHA loans are generally less restrictive regarding credit score and down payment requirements.

Those who seek to enter the real estate market will likely need a loan at some point to do so, and understanding one’s loan options can help ensure suitable terms. The main choice is between a Federal Housing Administration (FHA) loan and a conventional one. But what is the difference? Keep reading for FHA vs. conventional loans to make the right decision.

What is an FHA Loan?

An FHA loan is a federal government-backed home loan that is insured by the Federal Housing Administration. 

Government-backed loan requirements are generally less rigid than for conventional loans, although some governmental agencies establish their own eligibility standards. 

FHA loans can be either fixed-rate or adjustable-rate mortgages. Loan repayment terms are commonly 15 or 30 years.

Each year, new loan limits are established on FHA loans. However, such limits vary depending on where in the nation a home purchase is sought. For example, the upper limit in low-cost counties such as rural Missouri is $472,030, while the upper limit in high-cost counties, say, Orange County, California, is $1,089,300.

To determine the upper limit in one’s county, the easiest way is by visiting the U.S. Housing and Urban Development’s website for FHA mortgage limits. Note that pursuing an FHA loan in lieu of a conventional one means that such loan limits could restrict the amount of house one can ultimately buy.

What is a Conventional Loan?

A conventional loan is a home loan that is offered by private lenders sans any direct government backing. This means that unlike FHA loans, conventional loans are not guaranteed or insured by the government. 

Conventional loans are classified as either conforming or nonconforming. With the former, loan standards are established by federally backed mortgage institutions Fannie Mae and Freddie Mac. Such loans may not exceed the conforming loan limit, which is $726,200 for 2023, with higher-cost areas at $1,089,300.

In addition to Washington, D.C., high-cost areas exist in California, Connecticut, Colorado, Georgia, Florida, Idaho, Maryland, Massachusetts, and New Hampshire. They are also present in New York, New Jersey, North Carolina, Tennessee, Pennsylvania, Wyoming, and West Virginia. 

Nonconforming loans, typically jumbo loans, are offered to individuals who seek to purchase a house that exceeds conforming loan caps. Note that because of their size, jumbo loans typically have stricter underwriting guidelines.

As with FHA loans, conventional loans can be either fixed-rate or adjustable-rate mortgages. Conventional loan terms can range from eight to 30 years.

FHA vs. Conventional Loans: Credit Score

Whether one applies for an FHA or conventional loan, their credit score will be evaluated. Lenders use the scoring to assess risk. 

Compared with conventional loans, FHA loans are generally less restrictive regarding credit score requirements. Conventional loans also generally call for a lower debt-to-income ratio.

Conventional Loans

A conventional loan generally requires a minimum credit score of 620. If a borrower is applying alone, the lender will consider the median score of three major credit bureaus: Experian, Equifax, and Transunion.

If the application is with another borrower, the score that lenders generally consider is the average median score. For example, if one borrower has a median score of 720, and the co-borrower’s median score is 580, Fannie Mac will average the two figures, landing at a score of 650. 

FHA Loans

It is possible for someone with a credit score as low as 500 to qualify for an FHA home loan. However, the applicant must come up with a 10% down payment. A rule of thumb is that the higher one’s credit score, the lower the required down payment.

In general, most FHA loan lenders want an applicant with a co-borrower to have a lowest-median credit score of at least 580. For individual applicants, lenders consider the middle score.

FHA and Conventional Loan Requirements: Down Payment

Compared with conventional loans, FHA loans generally require a slightly smaller down payment.

Conventional Loans

Most conventional home loans require a minimum 5% down payment, although 3% is acceptable for some loans.

Because a relatively smaller down payment means more risk, the lender will likely require purchase of private mortgage insurance (PMI), the payments for which are built into the monthly mortgage payments.

Note that many people believe that conventional home loans require a 20% down payment. That is a time-worn misperception. What the 20% down does is permit home buyers to skirt insurance premiums. More on mortgage insurance later.

FHA Loans

A 3.5% down payment is enough for an FHA loan, but only if one’s credit score is at least 580. Scores of between 500 and 579 require 10% down.

For example, a 3.5% down payment on a $400,000 house calls for $14,000.  By contrast, a conventional loan down payment of 3% on a $400,000 house is $12,000. 

FHA vs. Conventional Loans: Interest Rates

Mortgage interest rates are affected by the overall economy, investor demand, and the Federal Reserve. Still, lenders will factor in one’s credit score, the amount the applicant is seeking, the applicant’s down payment, and whether an adjustable- or fixed-rate mortgage is sought.

Depending on the prevailing interest rate following expiration of the initial fixed-rate period, monthly payments on adjustable-rate mortgages change periodically.

Note that applicants can often prepay discount points to the lender to garner a lower interest rate, and thus a lower monthly payment.

Conventional Loans

These rates depend on external factors noted above in addition to the applicant’s credit history and loan-to-value ratio, which is the loan amount relative to the value of loan collateral. 

FHA Loans

Because these loans are federally backed, which decreases lender risk, FHA interest rates can be more competitive relative to conventional mortgages. The interest rate offered will hinge on factors including market interest rates and the applicant’s credit score, income, the loan amount sought, the down payment, and more.  

FHA vs. Conventional Loans: Mortgage Insurance

Mortgage insurance protects the lender from borrower default.

Conventional Loans

As mentioned, if 20% is not put down, the borrower must pay for a PMI. There are multiple ways to do so:

• Monthly premium. This is an annual rate that is divided by 12 and is the most commonly used option.
• Single premium policy. This option requires an upfront payment.
• Split premium. This is an upfront payment and a monthly premium, where the seller makes the upfront premium.
• Lender-paid PMI. Here, the lender folds the mortgage insurance into the monthly principal and interest payment by giving the borrower a somewhat higher interest rate. Note that lender-paid PMI cannot be canceled unless the home is refinanced or sold.

FHA Loans

This kind of loan requires what is called a mortgage insurance premium (MIP). Unless the borrower makes a down payment of at least 10%, FHA loan insurance is usually paid for the life of the loan. If the down payment is 10% or more, MIP drops off after 11 years. One must pay an upfront mortgage premium, which usually equals 1.75% of the base loan amount.

The borrower also must make payments of about 0.15% – 0.75% of the base loan total, all based on the length of the mortgage, the total mortgage amount, the applicant’s LTV ratio, and the down payment.

What Should You Choose?

Whether a person should pursue an FHA or conventional loan for their housing needs largely depends on the factors above and one’s personal situation.

An FHA loan may be a better fit if the applicant has credit score issues, a lower down payment, and a relatively high debt-to-income ratio, which compares one’s monthly gross income to their monthly debt payments.

On the other hand, a conventional loan may make more sense if the applicant’s credit score is at least 620 and they have a down payment of at least 3% — 20% if the aim is to avoid PMI. Such a loan might also work better if the applicant has a low DTI and flexible repayment terms are desired. 

FHA vs. Conventional Loans: Real Estate Investing

Beyond taking out a loan for a home, there are other ways to invest in real estate, an alternative asset class that essentially includes any securities other than stocks and bonds. For example, the alternative investment platform Yieldstreet offers private investment opportunities including a Growth & Income REIT (real estate investment trust). The fund seeks to make debt and equity investments in various commercial real estate properties across markets and property types, with a minimum buy-in of $10,000.

In general, real estate also remains a popular way to diversify investment portfolios – spread one’s capital across varied investments and asset classes. Diversification can markedly reduce overall volatility and protect against inflation.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

When it comes down to it, determining which loan type would work best is a matter of evaluating one’s financial state and needs. An honest assessment of that, and the loans’ requirements, will likely lead to the best decision. 

In the bigger picture, adding real estate to one’s investment portfolio can help lower overall risk, which is key to successful investing.