Conventional Mortgages vs. FHA Loans

There are a lot of terminologies used in real estate that are foreign to most first-time home buyers. It’s important to know the lingo when you are buying a house. If you do, your real estate agent will take you more seriously.

So, it’s time to learn some basics when it comes to mortgages and loans.

What is a Conventional Mortgage?

A conventional mortgage is a home loan that doesn’t take advantage of any government mortgage programs. This means that the lender takes on the full risk of the loan, and the borrower must meet certain qualifications for approval.

The most common government-backed mortgage programs are FHA Loans, VA Loans, and USDA Loans. A conventional mortgage does not use any of those.

However, it's important to be aware that this type of loan typically carries a higher interest rate and requires a good credit score for approval.

So, if you're looking for a regular mortgage, you'll need to have a solid financial history, plus a great credit report. A conventional mortgage might not be the way to go for everyone, but if you meet all the requirements, you could get one.

Usually, that means:

High credit score

Your credit score shows how likely you are to pay back a loan on time. It's based on things like your payment and credit history. To be eligible for a loan, you typically need a credit score of at least 620. If your score is higher, you may qualify for a lower interest rate. And if you have a really good score, you may get the best loan terms available.

Decent debt-to-income (DTI) ratio

Your DTI ratio compares your debts to your income. Basically, it’s all your monthly debt payments divided by your gross monthly income. It's best if your debt makes up less than 43% of your income.

Down payment

When buying a home, it's typically recommended to have at least a 20% down payment saved up. While some lenders may accept a smaller down payment, they often require the borrower to purchase private mortgage insurance and pay a monthly premium until they have earned 20% equity in the home. This insurance protects the lender in case the borrower is unable to repay the loan.

Who may not be eligible for a conventional loan?

Anyone with more debt than average, not enough savings, or a lukewarm credit score won't be able to qualify for a conventional loan.

These are the conditions that lead to ineligibility:

Below 20% or even 10% of the down payment
Experienced foreclosure or bankruptcy in the last 7 years
DTI ratio exceeding 43%
Credit rating below 650

If you get disqualified for a conventional mortgage, ask why in writing form. Don't lose hope because there's a chance to qualify for different programs to get a mortgage.

What is a Conforming Mortgage?

The term “conventional mortgage” is sometimes confused with “conforming mortgage.”

A conforming mortgage is a conventional mortgage that meets the guidelines established by Fannie Mae and Freddie Mac. These include minimum credit scores, minimum down payments, and maximum loan limits.

View nationwide conforming loan limits.

Most conventional mortgages are “conforming” but not all.

What is a Jumbo Loan?

Typically it's much easier to get a mortgage that conforms to the requirements set by Fannie Mae and Freddie Mac. However, it's not impossible.

Loans that exceed the conforming loan limits are called “jumbo loans.” To get one, you will need a higher credit score, a larger down payment, and a higher income.

What Documents Do You Need to Apply for a Conventional Mortgage?

Now, let’s talk about the required documents needed to apply for a conventional mortgage:

Proof of income

2 years of W-2 statements
30 days of pay stubs that display income and year-to-date income
Statement of your investment and savings accounts from the past 60 days or three months when applying for a loan
2 years of federal tax returns

Moreover, borrowers need to offer evidence of any extra income, like bonuses or alimony.

Assets

To ensure that applicants have enough funds to cover the down payment, closing expenses, and cash reserves, they are required to provide investment account statements and bank statements.

If the applicant is receiving money from family or friends to help with the down payment, a gift letter should be provided. This letter confirms that the money given is a gift and not a loan, and typically needs to be notarized.

Employment of verification

Lenders currently require borrowers to have a consistent employment history before approving a loan. As part of this process, the lender may ask for pay stubs and even contact the borrower's employer to confirm employment and income. If the borrower recently changed jobs, the lender may also contact the previous employer.

For self-employed borrowers, additional paperwork is typically required to prove their income and business.

What is an FHA Loan?

An FHA Loan is a mortgage program designed to help Americans become homeowners. It's provided by a bank or other private lender but is insured by the government.

As mentioned earlier, a conventional mortgage requires a 20% down payment and a credit score of 610+. On the other side, FHA mortgages only require 3.5% down and a minimum credit score of 580+.

FHA stands for Federal Housing Administration. With an FHA Loan, the government agrees to insure your mortgage in case of default. This means that if you are unable to pay your mortgage, the FHA will pay back the bank so they don’t lose money.

If you default on an FHA Loan you will still lose the house. But from the bank's perspective, an FHA Loan is safer. Because the bank is protected, they are willing to give riskier loans to people with lower credit scores or smaller down payments.

FHA Mortgage Qualification Requirements

As with any other loan, the FHA mortgage comes with its qualification requirements. The most basic ones are checking for legal age, lawful residence in the US, and a valid Social Security Number.

Down payments and credit score

FHA loans are available to people with a lower credit score, even as low as 500. If your credit score is between 500 and 579, you can still get an FHA loan, but you'll have to pay a higher down payment of 10%.

However, if your credit score is 580 or higher, you can get an FHA loan with a lower down payment of 3.5%. But remember, if you have a lower credit score and put down a smaller down payment, you'll have to pay a higher interest rate on the loan.

History of respecting debts

Lenders will check your job history and how you've been paying your bills and rent for the past 2 years. If you've missed paying your income taxes or federal student loans, lenders will probably say no to your application.

However, if you work out a payment plan with them, they may consider you. If you've gone through foreclosure or bankruptcy, you'll usually need to wait 2-3 years before you can apply for the loan again.

But if you've been working hard to improve your credit, you might be able to get approved sooner.

Evidence of consistent employment

Mortgages have to be paid back and FHA-approved lenders need to know you can handle it. That means you have to show proof of current, consistent employment - like a year-to-date balance sheet, profit-and-loss statement, and tax returns.

If you’ve been self-employed for more than two years, you can still qualify as long as your income and employment history look good. Basically, you need to have worked in the same or related profession for two years before you went self-employed.

Abundant income

HOA fees, mortgage payments, mortgage insurance, real estate taxes, and homeowner’s insurance need to be below 31% of your gross income.

This is referred to as the front-end ratio in banking terminology. The back-end ratio includes all monthly consumer debts, mortgage payments, and mortgage insurance. This ratio needs to be below 43% of the gross income.

Pros and Cons of FHA Loans

Let’s now go through the pros and cons of FHA loans.

Pros:

Federally supported
Lower down payment
Available to applicants with lower credit ratings

Cons:

Not all real estate properties are eligible
Takes longer to secure and requires much more paperwork
Demands the purchase of mortgage insurance and recurrent premiums (MIPs)
High-interest rate
Can’t be used on investment real estate or second homes

What's the Difference Between FHA and Conventional Loans

	Conventional loan	FHA loan
Down payment	3% to 20%	3.5% with a credit score of 580+
Minimum credit score	620	500
Mortgage insurance	None with a minimum down payment of 20%	Yearly MIP for the loan lifetime or 11 years, and upfront MIP
Loan terms	10, 15, 20, or 30 years	15 or 30 years
Down payment gifts	If the down payment is less than 20%, only a portion of it can be gifted.	Full down payment
Mortgage insurance premiums	0.5%-1% of the mortgage annually	Upfront 1.75% of the mortgage and yearly 0.45%
Down payment assistance programs	No	Yes

Which Loan is Better: FHA or Conventional?

If you're trying to decide between a conventional or FHA mortgage, it's all about your particular situation.

Conventional mortgages require fewer documents but can come with expensive mortgage insurance premiums. On the flip side, FHA mortgages accept lower credit ratings and don't require as much time to overcome credit challenges. It really comes down to what works best for you.

Wrap-Up

There are a lot of options when it comes to financing a home. Conventional mortgages are the most common. Most conventional mortgages are considered “conforming” which means they meet the requirements set by Fannie Mae and Freddie Mac.

If a loan exceeds the conforming loan limits then it's called a jumbo loan.

If a loan is below the FHA loan limits but the homebuyer does not have a big enough down payment or a high enough credit score then an FHA Loan is a good option.

If you qualify, there are other loan programs that can help, such as VA Loans or USDA Loans.

It's a big choice, so take your time and make sure you look at all the options before you decide.

Alan Reed

Alan is a real estate investor based in Northeast Pennsylvania with experience renovating and operating everything from single-family rentals to strip malls and storage facilities.

February 20, 2020 (Updated April 22, 2024)

Conventional Mortgages vs FHA Loans