With home prices in many areas continuing to climb and mortgage rates still high compared to just a few years ago, many would-be buyers cannot afford the 20% down payment often required for a conventional mortgage. FHA loans may provide an affordable alternative for these individuals, but both types of mortgages come with potential advantages and disadvantages.

Here is what you need to know about how conventional and FHA mortgages differ and the implications for your bottom line.

Conventional and FHA Loan Basics

As the name indicates, FHA loans are insured by the Federal Housing Administration and issued by approved lenders. Because the FHA backs up the loans, the lenders can extend lower interest rates. FHA mortgages generally are easier to qualify for, too, making them appealing to buyers with low to moderate income (although they are not limited to such borrowers).

Conventional loans originate with private lenders, such as banks and credit unions. With no guarantee from the government, these lenders typically require higher credit scores and larger down payments from borrowers.

Dig into the Differences

Conventional and FHA loans have significant differences that home buyers should understand before choosing one over the other. These include:

Down Payments and Credit Scores
One of the major draws of FHA mortgages — especially for first-time buyers — is the ability to make a smaller down payment. You can make as low as a 3.5% down payment if your credit score is at least 580. If it is in the 500-579 range, you might qualify for an FHA loan with a 10%  down payment. Note, though, that individual FHA lenders can require a higher credit score, generally 620 to 640.

Some lenders will approve conventional mortgages with only a 3% down payment these days, if a borrower has a credit score of at least 620. However, 20% down payments are more common.

Mortgage Rates
FHA rates frequently are lower than conventional mortgage rates, making them attractive to first-time home buyers. However, you should consider the total cost over the life of the loan, including mortgage insurance. With that additional cost, a conventional mortgage with a higher rate might cost less than an FHA loan in the end. Conventional loans might have slightly higher interest rates, but often have lower fees and closing costs than FHA loans — which means the APR is lower. APR includes loan fees and interest to represent your overall borrowing costs.

Consider, too, how soon you will have 20% equity, the point at which insurance would no longer be required for a conventional mortgage. If you can get there in less than 11 years, the initial savings on the FHA rate might not be worth it in the long run.

Debt-to-Income (DTI) Ratio
Your DTI is the percentage of your monthly pre-tax income that goes to cover your debts, including the mortgage, auto and student loans, minimum credit card payments, HOA fees, and child support or alimony. The higher your DTI, the more difficult it may prove for you to pay your mortgage.

For FHA mortgages, your DTI generally needs to be no higher than 50%. On conventional loans, lenders usually will not accept higher than 45% and prefer 36% or lower.

Mortgage Insurance
Mortgage insurance protects the lender in case of default. FHA mortgages come with mandatory mortgage insurance premiums (MIPs) for all loans, regardless of the amount of the down payment. The cost is based on the loan amount and term. If your down payment is less than 10%, you must pay MIPs for the duration of the loan; if it is higher, MIPs are required for 11 years. Either way, you also pay an upfront fee, around 1.75% of the loan value, although you can roll that into the mortgage to finance it.

Conventional loans require private mortgage insurance (PMI) when the down payment is under 20%. You can cancel the insurance when your equity in the home reaches 20%, and the lender must terminate it when the loan-to-value ratio is 78%. PMI can be cheaper than the insurance for an FHA loan if your credit score exceeds 720.

Property Standards
The condition of the property is important for any mortgage, but FHA appraisals are stricter than those for conventional loans. The property must satisfy the FHA Minimum Property Standards regarding safety, security and soundness.

Appraisals for conventional mortgages are more focused on the property’s market value. The lender wants evidence that it can recover its investment if the property goes into foreclosure.

For an FHA mortgage, you must live in the property as your primary home. The loans are not available for investment properties, whether you plan to rent out the property or to flip the it, unless you live full-time in one of the units. You can, however, obtain a conventional mortgage for your primary residence, an investment property or a vacation home.

Loan Limits
Both FHA and conventional mortgages are subject to limits on the amount that can be borrowed. The maximum amount varies by county and year.

For 2024, the FHA nationwide limit for a one-unit property is $498,257 in the lowest cost areas and $1,149,825 for the highest cost areas. The limits on conventional mortgages are $766,550 for most areas and $1,149,825 for high-cost areas.

Refinancing
You will find it much easier to refinance an FHA loan. The “Streamline Refinance” process generally requires little documentation, and you may be able to skip both an appraisal and a credit check. As a result, the process is fairly speedy. However, you cannot take out more than $500 in cash or be behind on your payments.

You must provide extensive documentation to refinance a conventional loan, including pay stubs, W-2s, bank and investment account statements, tax returns, and your homeowners insurance policy. The lender also will examine your credit history and probably require an appraisal.

Loan Assumption
Unlike conventional mortgages, FHA mortgages are assumable — in other words, when you sell the home, the buyer can assume the mortgage, including the rate, if they meet the applicable requirements. This could be a marketing advantage if mortgage rates are higher when you sell the home than when you bought it.

A Balancing Act

For many people, their home is the biggest investment that they will ever make. There is no universal answer for which type of mortgage is best, but we can help you determine the most advantageous choice for your circumstances.

For more information, contact Justin Sylvan at [email protected] or 312.670.7444, or ask your ORBA advisor. Sign up here to receive our blogs, newsletters and Client Alerts.