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If you're a first-time homebuyer with good credit, you'll probably qualify for an FHA loan—a mortgage backed by the Federal Housing Administration—but a conventional mortgage will likely save you money over time. Here's how to decide which type of mortgage may work best for you.
Advantages of FHA Loans
FHA loans are not limited to first-time homebuyers, but they are meant to help borrowers with limited or spotty credit histories. By design, their eligibility requirements are less stringent than what you'd find with many conventional mortgages that are not backed by government agencies.
- Down payment: The 3.5% minimum down payment requirement on FHA loans is lower than what many (but not all) conventional loans require. If you have a credit score of about 650 or higher, the low down payment requirement is likely the main reason you'd be considering an FHA loan. As you'll see below, however, there are other low-down-payment options worthy of consideration if this is the case for you.
- Credit score: The credit score requirement of 580 on FHA loans is lower than what most lenders require for conventional loans. (The vast majority of conventional loans conform to standards set by Fannie Mae and Freddie Mac, which require minimum FICO® Scores☉ of 620.) It's even possible to qualify for an FHA loan with a FICO® Score as low as 500, but you must put down 10% of the purchase price to do so.
- Debt-to-income ratio: All mortgage lenders look at your debt to income ratio (DTI), the percentage of your monthly pretax income that goes toward debt payments. Lenders view borrowers with high DTIs as posing more financial risk, and they tend to prefer DTIs of 36% or less for conventional mortgages. You can qualify for an FHA loan with a DTI ratio as high as 43%.
Financial Trade-Offs of FHA Loans
The lower barriers to entry on FHA loans come with financial trade-offs, and those additional costs are the main reason to consider a conventional loan if you qualify for one:
- Mortgage insurance: You'll be charged an upfront mortgage insurance premium (MIP) of 1.75% of the loan amount on every loan. (This amount can be financed and added to the monthly loan payment, with applicable interest charges.) Depending on your credit scores, an additional MIP of 0.45% to 1.05% of the loan amount is also charged annually and added to your monthly payment. If you make a down payment less than 10% on an FHA loan, these MIP charges remain for the life of the loan; if you put 10% or more down, MIP charges are removed after 11 years.
- Interest rates: Depending on your credit score, lenders that issue FHA loans typically charge interest rates that are anywhere from 0.5% to 1.5% higher than those available on conventional loans.
These costs, particularly on loans where MIPs are required for the entire life of the loan (or until you refinance), can add up to tens of thousands of dollars over the life of a 30-year mortgage. If your good credit qualifies you for a conventional loan with better borrowing terms, it's wise to consider one.
What's the Difference Between an FHA Loan and a Conventional Loan?
When deciding whether an FHA loan or a conventional loan will work best with your credit score and financial situation, consider the following factors.
| FHA Loans vs. Conventional Mortgages | ||
|---|---|---|
| FHA Loan | Conventional Loan | |
| Down payment/loan-to-value (LTV) requirement | Down payment is as little as 3.5% of purchase price (maximum LTV ratio of 96.5%). | Down payment of 20% of the purchase price (80% LTV ratio) is standard, but loans are available with as little as 3% down (97% LTV). |
| Mortgage insurance | If your down payment is less than 10% (LTV 90% or greater), mortgage insurance is required for the life of the loan. If your down payment is 10% or greater, mortgage insurance can be removed after 11 years. An upfront mortgage insurance premium of 1.75% of the loan amount is required on all loans but can be rolled into the monthly payments. An additional fee may be paid monthly. | PMI, currently priced at about 0.2% to 2.0% of the loan amount, is required if your down payment is less than 20% of the purchase price, but can be removed when equity in the house reaches 20%. |
| Credit score requirement | FICO® Score of 580 or higher for a 3.5% down payment. FICO® Score of 500-579 requires a 10% down payment. | A minimum FICO® Score of 620 is required on loans that meet Fannie Mae and Freddie Mac standards, but lenders have great discretion when issuing loans that don't. |
| Debt-to-income ratio | Generally 43% or lower, but borrowers with large cash reserves may qualify with DTIs as high as 50%. | The standard maximum is 36%, but DTI ratios as high as to 50% may be acceptable for borrowers with high credit scores and sizable assets or alternative income sources. |
| Interest rates | Typically 0.5 to 1.5 percentage points higher than on conventional loans. National average on a 30-year fixed-rate loan at the time of publication was 3.151%. | National average on a 30-year fixed-rate loan was 2.88% at the time of publication. |
| Home price limits | Purchase price cannot exceed the federal conforming-loan limit for the county where the home exists; in 2021, that limit is $548,250 for a single-family home in most of the U.S., but in more expensive housing markets the limit can be as high as 150% of that, or $822,375. | No limit on jumbo loans and other non-conforming loans. On conforming loans—those eligible for purchase by Fannie Mae or Freddie Mac—purchase price cannot exceed local loan limits set annually by the Federal Housing Finance Authority. As of 2021, the limit for most of the U.S. in 2021 is $548,250 but in counties where housing is more costly than the national average, the limit can be as high as $822,375. |
Other Loan Options to Consider
If you have high credit scores but are having a hard time raising a down payment of 20% (or even 10%) of the purchase price, FHA loans are not your only option. Consider some of these alternatives:
- Freddie Mac Home Possible loan: Freddie Mac, as the Federal Home Loan Mortgage Corporation is popularly known, devised the Home Possible loan to lower the barriers to homeownership. Down payments start at 3% and can come from family, employer assistance, a secondary loan or "sweat equity." The minimum credit score requirement is 660 (680 if you're refinancing an existing loan), but if you or a co-applicant lack a credit score, you still could qualify through an alternative underwriting process.
- Fannie Mae 97 LTV loan: The Federal National Mortgage Association, better known as Fannie Mae, authorizes two categories of mortgage loans that require minimum down payments of 3% (or LTV ratios of 97%):
- The Fannie Mae Home Ready 97 LTV loan is designed for low-income borrowers—specifically those with incomes below 80% of their local area median income as designated by the U.S. Census Bureau.
- The Fannie Mae Standard 97 LTV loan is open to any borrower, provided at least one applicant is a first-time homebuyer and all applicants have credit scores. (An automated underwriting process that uses credit scores is required for loan approval.)If all applicants for Fannie Mae LTV loans are first-time homebuyers, at least one must complete a homeowner education program.
- VA loan: Backed by the U.S. Department of Veterans Affairs, VA loans are designed for qualifying veterans, servicemembers, their spouses and other beneficiaries. They are available with no down payment and do not require mortgage insurance. A funding fee of 2.3% of the loan amount is required if you put less than 5% down—down payments can be as low as 0%. If you make a down payment of 10% or greater, the fee drops to 1.4% of the loan amount.
- USDA loan: Guaranteed by the U.S. Department of Agriculture, USDA loans can help low- to moderate-income homebuyers who want to purchase a home in eligible rural areas. They don't require down payments, and offer flexible credit score requirements. (A minimum FICO® Score of 640 is required for rapid approval using the USDA's automated application process, but you can be approved with a lower credit score via the process of manual underwriting.)
Get Your Credit Ready for a Mortgage Application
To optimize your credit profile for mortgage approval, check your free credit report and get your credit score for free through Experian to know where you stand. Make sure to pay your bills on time, avoid taking on major new debt, and pay down your credit card debt as much as possible before applying for a mortgage.