FHA vs. Conventional Loan: Which Is Better?

Buying a home is one of the biggest financial decisions you’ll ever make, so choosing the right type of mortgage is important. For many prospective homeowners, this comes down to selecting between FHA vs. conventional loans — two of the most popular types of mortgages.

If you’ve decided it’s the right time to buy a home, the next step is exploring your mortgage options. This guide will explain how those two mortgages work. We’ll also go over the pros and cons of FHA loans vs. conventional loans, and help you make the best choice.

What’s the Difference Between FHA and Conventional Loans?

The difference between FHA and conventional loans is that FHA loans are government-backed. They’re easier to get than conventional loans, with more flexible credit requirements. However, they have additional costs for mortgage insurance premiums, and the home must be your primary residence.

What Is an FHA Loan?

An FHA loan is a mortgage issued by a private lender and insured by the Federal Housing Administration (FHA). Only FHA-approved lenders can issue this type of mortgage. These loans have less stringent qualifications, because lenders are protected by insurance in case the homeowner defaults.

Qualification Requirements for FHA Loans

The qualification requirements for an FHA loan are:

• FICO® Score of at least 580 with a 3.5% down payment

• FICO® Score of 500 to 579 with a 10% down payment

• Debt-to-income (DTI) ratio ideally under 43%, but some lenders will accept 50% or higher

• Mortgage insurance

• Stable income and proof of employment

• The home must be your primary residence

Lower Credit Scores: FHA Loans

One of the big advantages of an FHA vs. a conventional mortgage is the lower credit score requirement. Conventional loans normally require a FICO® score of 620 or higher. Compare that to scores as low as 500 for FHA loans. Your FICO® score refers to a specific type of credit score that is the most widely used by lenders.

43% Debt to Income Ratio: FHA Loans

Your DTI ratio is a key factor in figuring how much mortgage you can afford. To calculate it, add up all your monthly debt obligations, including your planned mortgage payments. Divide it by your gross monthly income. For an FHA loan, the recommended range is under 43%. So, if your gross monthly income is $10,000, your monthly debt payments should be below $4,300.

Extra Fees: FHA Loans

While FHA loans have more lenient qualification requirements, they also come with some extra fees. You need to pay an FHA Mortgage Insurance Premium (MIP) up front at 1.75% of the loan amount. In addition, you’ll pay a monthly insurance premium. This will vary based on the specific loan details and can fluctuate between 0.15% and 0.75% per year, paid monthly.

There are two ways to remove MIP premiums from your mortgage:

• Refinancing an FHA to a conventional loan

• Making 11 years of on-time payments, if your down payment was 10% or more

What Is a Conventional Loan?

A conventional loan is a mortgage that’s not backed or insured by the government. Conventional loans are issued by private lenders, such as banks or mortgage companies. They normally have stricter qualifications and higher interest rates than FHA loans and may require private mortgage insurance.

Qualification Requirements for Conventional Loans

The qualifications for conventional loans vary depending on the lender, but common requirements are:

• FICO® Score of at least 620

• Down payment of at least 3% to 5%

• Two years of income history

• No recent bankruptcy or foreclosure on your credit history

Higher Credit Scores: Conventional Loans

While it’s possible to be approved for a conventional loan with a FICO® Score of 620, keep in mind that your score heavily affects your mortgage’s interest rate. For the lowest mortgage rates, you need a score of at least 760. Let’s say you’re getting a 30-year mortgage for $450,000. Here’s a detailed look at how rates differ depending on your FICO® Score:

Minimum down payment amounts depend on the lender, with many accepting anywhere from 3% to 5%. A lower down payment makes it much easier to save for a house. However, if you don’t put down at least 20%, you’ll need to pay private mortgage insurance.

Longer Clean Credit: Conventional Loan

One of the other differences between a conventional loan vs. an FHA loan is that a conventional loan requires a longer clean credit history. There’s a 2-4 year waiting period to get a conventional loan after filing bankruptcy, vs. a 1-2 year waiting period to get an FHA loan. The typical waiting period after a foreclosure is seven years for a conventional loan compared to three years for an FHA loan.

FHA vs. Conventional Loan

FHA loans generally cost less when you have a low to average credit score or a small down payment. Conventional loans usually work out better if you have a high credit score and a large down payment. To demonstrate this, we’ll compare two scenarios and see how much FHA vs. conventional loans would cost in each one.

Let’s say you’re buying a $500,000 home with a 5% down payment of $25,000. You have a 640 FICO® Score. Your 30-year mortgage options are an FHA loan with a 6.8% interest rate or a conventional loan with a 7% interest rate. Here’s how their costs would compare:

The FHA loan is the clear winner here. It has lower monthly payments, lower upfront costs, and saves you nearly $12,000 overall.

But let’s say you’re buying that same $500,000 home, except this time, you have a 20% down payment of $100,000. And your FICO® Score is 760. So — you could get a 30-year FHA loan with a 5.8% interest rate or a 30-year conventional loan with a 6% interest rate. Look at how loan costs compare now:

In this case, you’re much better off with a conventional loan. Costs are lower across the board, and you save over $20,000 overall.

FHA loans tend to have lower monthly payments, but higher upfront costs than conventional loans. If interest rates are equal, conventional loans are typically less expensive over a 30-year term. Whether you should get an FHA or conventional loan depends on your needs and what you can qualify for.

Private Mortgage Insurance: Conventional Loans

Private mortgage insurance (PMI) is an insurance policy on a conventional mortgage loan arranged by the lender and paid for by the borrower. It protects the mortgage lender if the homeowner defaults.

Lenders usually require PMI if you make a down payment less than 20% with a traditional mortgage. If you put down a smaller down payment, the lender needs to finance more of the home purchase, making it harder to recoup its costs if you default.

PMI Example: Conventional Loan

Let’s say you apply for a mortgage for a $500,000 home. If you make a 20% down payment of $100,000, the lender finances the remaining $400,000. In a worst-case scenario where you default, the lender can repossess and sell the home. Since it financed 80% of the sale price, it stands a good chance at recouping what it’s owed.

Now imagine you put down 3%. That’s only $15,000, so the lender needs to finance $485,000. The lender has far more risk, because if you default and home prices drop, it may not recoup the full value of the mortgage. A PMI policy that will protect the lender.

PMI Costs With a Conventional Loan

The cost of PMI is based on the loan amount and normally ranges from 0.25% to 2% per year, depending on your credit score. If you have a higher credit score, you’ll qualify for lower PMI rates.

Your down payment also affects the cost of PMI, which is based on your loan amount. With a larger down payment, you won’t need to borrow as much, and you’ll save on PMI.

For example, let's say you're buying a $500,000 home. If you put down a 5% down payment of $25,000 and have a loan amount of $475,000, PMI will likely cost $1,187.50 to $9,500 per year, depending on your credit. If you make a 10% down payment of $50,000 and finance $450,000, PMI will likely cost $1,125 to $9,000 per year.

For more info, see our home mortgage calculator.

How to Remove PMI from a Conventional Loan

There are a few ways you can remove PMI from a conventional loan.

1. The Homeowners Protection Act requires your mortgage lender to terminate PMI once you have:

   1. Paid 22% of your mortgage and have a loan-to-value (LTV) ratio of 78%.

   2. Reached the midpoint of your mortgage’s amortization schedule. If you have a 30-year mortgage, the midpoint is 15 years. If you have a 15-year mortgage, the midpoint is 7.5 years.

2. You can request that the mortgage lender remove PMI once you reach 20% home equity. The simplest way to do this is to make your mortgage payments until the LTV ratio is 80%. Then you can contact the lender and ask that it remove your PMI.

However, you may be able to get rid of PMI more quickly by refinancing your mortgage or reappraising your home. These options both work well if your home has risen in value since you’ve bought it.

Other Mortgage Loan Options

In addition to FHA and conventional loans, there are special types of mortgages available for some buyers. Two of the most common are VA loans for veterans and USDA loans for homebuyers in eligible rural areas.

VA Loans

VA home loans are guaranteed by the U.S. Department of Veteran Affairs (VA). They’re available for service members, veterans, and eligible surviving spouses. The main benefits of VA loans are:

• No down payment (unless required by the lender, which is rare)

• No mortgage insurance

• Competitively low interest rates

• Closing costs are capped at 1% of the loan amount

• No minimum credit score

There is, however, a VA funding fee. This is a one-time fee paid when you close your VA loan. It ranges from 0.5% to 3.6% depending on what you’re using the VA loan for and your down payment amount.

USDA Loans

USDA loans are guaranteed by the USDA (U.S. Department of Agriculture) through its Rural Development Guaranteed Housing Loan Program. They’re available to low-and-moderate income consumers buying homes in rural areas. The main benefits of USDA loans are:

• No down payment required

• Competitively low interest rates

• Flexible credit requirements

USDA loans don’t technically have mortgage insurance, but they do have a couple of fees that serve the same purpose. There’s a 1% upfront guarantee fee and a 0.35% annual fee.

Choosing the Right Type of Mortgage

Now that you know the difference between conventional and FHA loan options, you can choose the one that best fits your finances. Whichever you choose, make sure to use a mortgage calculator to estimate homeownership costs. Once you know how much buying a home will cost, an intuitive app like Monarch Money can help you and your spouse budget better and work towards that goal.