Comparing FHA Loans vs. Conventional Mortgages

According to Mortgage Monitor from Black Knight, in 2020, the total dollar amount of mortgage originations was about $4.3 trillion, with refinance transactions accounting for $2.8 trillion – a record-breaking all-time-high. The $1.5 trillion in purchase money transactions was the largest yearly mortgage volume since 2005.

The distribution of small-dollar lending compared to larger loans (>$100K) across lending channels (i.e., FHA or Conventionally sourced) is shown below.

Small-Dollar Lending, by Lending Channel and Borrower Income

	Small-dollar Loans (Less Than $100,000)		Larger Loans ($100,000 or More)
Borrower Income	Conventional loan share	FHA loan share	Conventional loan share	FHA loan share
Less than $50,000	62.8%	24.6%	53.4%	31.8%
$50,000 to $75,000	77.1%	15.2%	55.0%	27.0%
$75,000 to $100,000	87.6%	9.7%	62.8%	22.5%
$100,000 to $150,000	94.3%	4.6%	74.6%	14.0%
$150,000 or more	98.3%	1.3%	91.1%	3.7%

Source

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FHA and Conventional Loans

WHAT IS AN FHA LOAN?

Contained within the U.S. Department of Housing and Urban Development (HUD), the Federal Housing Administration has insured mortgage loans – known in the trade as an FHA loan. FHA loan is a home loan that is insured by. The FHA’s inception can be traced back three decades as one of the original components of the New Deal.

The FHA was developed as a part of the National Housing Act of 1934 to help mitigate foreclosure incidents and make homeownership more affordable to every citizen. At this time, the 20% down payment rule came into play. Before the Act, most homeowners were limited to borrowing up to 60% of the home/property value – which essentially eliminated the possibility of much of the population owning a home.

In today’s mortgage market, the FHA is responsible for the insurance on about 8 million single-family residences. The FHA sets limits to allowable mortgage amounts, which are tied statutorily to FNMA’s limits. For 2021, the limits, which vary by location/county, range from $356,362 to an upper limit of $822,375. The loan ceiling for Alaska, Hawaii, Guam, & the Virgin Islands is $1,233,550.

For additional information on FHA loan limits by county, visit HUD’s website.

Since the mortgage crisis of 2008 –ish, the use of FHA loans for home purchases and refinances has surged dramatically. Much of the action can be attributed to historic low rates, but it is likely the source of this mortgage lending surge was a shift in subprime (Alt-A) borrowers when subprime lenders closed up shop as foreclosure rates shot through the roof.

In other words, the FHA became an alternative lending source to meet subprime borrowers’ needs when lenders (with generous, loose guidelines and higher rates) stopped doing business.

However, some ‘A’ borrowers may find the FHA may be preferable for their specific scenario.

WHAT IS A CONVENTIONAL MORTGAGE LOAN?

A conventional mortgage is a collateralized loan that’s not federally guaranteed or insured.

Conventional loans are primarily offered by two quasi-public companies – Fannie Mae (FNMA) and Freddie Mac (FHLMC). These companies seek to promote homeownership (like the FHA), but the two financial instruments (conventional vs. FHA) are quite different regarding rates, terms, and qualification criteria.

Most conventional mortgages are “conforming,” meaning the loan meets the criteria needed to be sold to the secondary mortgage market’s giants Fannie Mae or Freddie Mac. Fannie Mae and Freddie Mac essentially buy mortgages from lending institutions that are packaged and sold to investors. Selling mortgages to FNMA and FHLMC allows lenders to reuse funds, which become available to other qualified buyers.

Like FHA loans, conventional mortgages have limits. However, if the loan falls outside the upper limit, one can apply for a jumbo mortgage.

For 2021, the conforming loan limits for a single-family property were raised to $548,250. In defined high-cost lending areas, the ceiling for conforming mortgage limits was $822,375 – which is 150% of the conforming loan limit.

FHA Loans vs. Conventional Mortgages: Side By Side

Benefits of FHA Loans

In 2020, more than 84% of those buying a home using an FHA loan were first-time homebuyers. The primary selling features of an FHA loan are a low 3.5% minimum down payment requirement and the ability to purchase a home with less than stellar credit.

FHA Loans are a Good Choice for Borrowers with Poor Credit

FHA loans are rather basic, offering fixed and adjustable-rate options, but only in a limited number of mortgage options.

FHA insured loans are an excellent loan choice as it allows a FICO credit score as low as 580, for borrowers interested in the FHA’s flagship program only requiring a 3.5% down payment.

However, borrowers with scores between 500 and 580 will be required to put a minimum down payment of 10% to qualify. And note, FHA loans are not available to borrowers with a score that drops below 500.

But note, the 580 minimum score is FHA’s guideline, so mortgage lenders may require a higher credit score, which is ultimate, the lender’s decision.

Additionally, the FHA’s loan qualifications offer these benefits –

Eligible donors can off gift funds equal 100% of the borrower’s down payment & closing costs.
1 and 2-unit properties do not have a reserve requirement.

Home improvement enthusiasts and Do-it-Yourselfers should check out the FHA 203k loan program, which combines the financing for renovations/improvements/updates, as well as the home’s purchase.

Need a mortgage calculator to help refine your thinking?

FHA Loans Are Popular with First-Time Home Buyers of Owner-Occupied Residences

As noted above, if you are a first-time homebuyer, you will likely choose to finance the purchase with an FHA loan. Often, this is because first-time homebuyers have limited funds. FHA borrowers tend to –

Allow higher Loan-to-Values (LTVs) and Debt-to-Income Ratios (DTIs)
Have lower credit score requirements
Have smaller loan amounts

However, the FHA just made it a bit easier for borrowers with outstanding student loans to qualify for a mortgage. A recent move by the federal government changed the way the FHA evaluates student loan debt. Before the change, underwriters calculated 1% of the outstanding student loan balance (for loans not fully amortizing/or have not hit its repayment schedule) for the borrower’s monthly obligation to be used in the DTI analysis.

Currently, only .05% (rather than 1%) of the outstanding balance is used as a debt/obligation during the underwriting process.

Benefits of Conventional Loans

Conventional loans often compete for the same borrowers; however, conventional loans tend to provide a wider variety of loan options (in terms of programs and property types) than their FHA counterparts.

Conventional mortgages’ primary selling features are their low 3% down payment, loosened guidelines for first-time homebuyers, and its wide variety of mortgage loan products.

Conventional mortgages are an excellent option that allows borrowers with a FICO credit score as low as 620 to qualify with only a 3.0% down payment

Conventional Loans Offer More Options & Only a 3% Required Down Payment

Conventional financing offers a wide variety of mortgage options – available with fixed or adjustable-rate terms.

For 2021, the conforming loan limit for a single-family property is $548,250. In defined high-cost lending areas, the conforming mortgage limit is $822,375.

Any mortgage that is above the conventional conforming limit is considered a jumbo loan, and typically has stricter underwriting guidelines (i.e., higher down payments, etc.) as well as higher mortgage rates.

Those buyers with a 20%+ down payment are NOT required to pay mortgage insurance of any type.

Conventional Loans are Available from Most Lenders

Most lenders offering conventional mortgages do so without the need for specific approval from HUD. So, as a result, only certain lenders are authorized to originate FHFHA-insured loans, which may limit your choice of lenders.

Conventional financing is less restrictive about condominium financing (and even some single-family). This differs significantly from the FHA condo approval process. Additionally,

Conventional mortgages can be used to finance 2^nd/vacation homes or non-owner occupied/investment properties, although guidelines are modified for these properties.
Borrowers will likely find more lenders that offer conventional mortgages, which may provide a competitive edge.

Although not purely financially, it is relevant to note that sellers may favor a purchase offer with conventional financing over an FHA deal, as it is more likely that the conventional loan will make it to the closing table compared to the FHA option. The appraisal process for conventional mortgages tends to be less strict – especially if the subject property appraises below the sale price.

HOW DO FHA INTEREST RATES COMPARE TO CONVENTIONAL MORTGAGE LOAN RATES?

Comparing the Benefits of FHA Loans to Conventional Mortgages
Minimum Down Payment is 3.5%	Minimum Down Payment is 3%
Lower credit score allowed – 580 for max financing	Loan-to-Values < 80% Do Not Require Mortgage Ins.
Lower mortgage rates in most instances	Can be used on all property & occupancy types
Higher DTI’s make it easier to qualify	More loan programs are available
Shorter time for approval after foreclosure, etc.	Borrowers can have >1 loan at a time
No prepayment penalty	onforming loan floor-limits higher han the FHA
For 1-2 Units, no asset reserve requirement	More lenders from which to choose
Gift funds + 100% of closing costs & down payment	Processing & closing is often quicker
Streamlined FHA refinances offer quick, affordable options	There are no required home inspections; more flexible appraisal guidelines

Comparing the Disadvantages of FHA Loans to Conventional Mortgages
Higher minimum down payment (3.5% vs. 3%)	A higher credit score required 620+ credit score
Subject to mortgage insurance (Often for full-term)	Slightly higher mortgage rates
Upfront & monthly mortgage insurance premiums	It may be more difficult to qualify
Fewer loan type options than conventional loans	Mortgage insurance required for loans > 80% LTV
Condo financing needs building approval from FHA	Reserves may be required to qualify
Many condominiums do not have FHA approval	Possible prepayment penalty (uncommon)
Loan limits are lower in more affordable areas	Student loans could push DTI beyond allowable limits
The processing time and loan closing is slower

THE TAKE-AWAY

As the above analysis reveals, one cannot conclude that there is a definitive answer regarding which program can be called ‘the best!’ Here are a few considerations –

In the current competitive housing market, FHA loans might not be the best choice.
Sellers will likely favor purchasers with conventional financing.
Take the time to compare & contrast the available loan options – or speak to a mortgage specialist.
Generally speaking, borrowers with lower credit scores and smaller down payments may have a better chance of approval with an FHA loan.
Ask your lender for a side-by-side analysis, so you can determine which loan is more suitable.
Consider the property, as this may eliminate the FHA option.

FHA and conventional loans are simply two ways to finance real estate – the most suitable choice will depend on the unique loan scenario. Both offer competitive interest rates, flexible underwriting criteria, and similar closing costs, so ultimately, you must crunch the numbers dictated by the loan terms to determine the most advantageous option.

An analysis will help you determine if it is beneficial to go with a conventional loan with a slightly higher interest rate rather than pay mortgage insurance through the life of the loan. If you pay PMI (Private Mortgage Insurance) on your conventional mortgage, this payment can be eventually terminated by potential appreciation or a mortgage refinance.

Interested in a 0-down payment loan? Consider a VA loan or a USDA loan as a home loan option

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