While the number of all-cash home buyers soared to 30% in 2021, most home buyers will still need to take out a mortgage to cover the full sale price of their new property. If you’re planning to purchase a home soon, you might be researching all of the different loan options that are available. Two of the most common ones are FHA and conventional loans. The general comparison is that FHA loans are typically reserved for first-time homebuyers while conventional loans are for established buyers. However, that isn’t always the case. Today, we’re sharing how each loan type works so you can understand the differences of FHA vs. Conventional Loans for New Homes.
FHA Loans for new homes?
An FHA loan is one that the Federal Housing Administration (FHA) has secured. Although the FHA secures it, your bank or another FHA-approved lender will issue the loan.
FHA loans typically require a lower minimum down payment than conventional loans. In addition, credit score requirements are a little more lenient, enabling applicants with lower scores to apply for and secure funding. While these loans are popular with new homebuyers, their primary aim is to make homeownership accessible and affordable for low-to-moderate-income families.
The trade-off with an FHA loan is that most will come with slightly higher interest rates. Plus, buyers will be required to pay private mortgage insurance (PMI) in addition to their monthly mortgage.
You can read more about FHA loans and the benefits they can provide to homeowners in our recent post.
What Is a Conventional Loan for New Homes?
A conventional loan refers to any loan that is not insured by a U.S. government agency, such as the:
There are many different types of conventional loans available, and they remain the most common and popular choice for homebuyers today. Rather than the government, these loans are originated, backed, and provided by private mortgage lenders, such as:
- Credit unions
- Other financial institutions
There are two main types of conventional loans. These include conforming loans and non-conforming loans.
Conforming loans meet the guidelines set forth by the two government-backed mortgage companies: the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
These loans usually have strict requirements around the minimum requirements that potential buyers must meet to receive approval. For instance, most lenders look for a credit score of at least 620, as well as a minimum down payment of 5% depending on the scenario.
Non-conforming loans do not adhere to these standards. Instead, they offer a little more flexibility but usually come with different terms and conditions. Examples include:
- Jumbo loans
- Subprime loans
- Portfolio loans
- Adjustable-rate loans
- Amortized conventional loans
FHA vs Conventional Loans for New Homes: What are the Differences?
As a future homebuyer, you have lots of mortgage options to consider. Let’s take a look at the main ways that these two types of loans differ.
Minimum Down Payment
A down payment is money put toward the final sale price of a home, used to offset the total price of the loan. As long as they have a credit score of 580 or higher, FHA loans only require homeowners to apply a down payment of 3.5%.
While some conventional mortgages will allow payments this low, most require homeowners to put down at least 5%. The only exception would be a homeowner with an exceptional credit score (700s) and plenty of savings.
Credit Score Requirements
As mentioned, homebuyers can apply for an FHA loan with a 3.5% down payment as long as their credit score is at least 580. However, that doesn’t mean applicants with lower scores can’t apply. If your credit score is between 500 and 579, you are still eligible for an FHA loan.
However, due to the higher risk that your lender must incur, your down payment percentage will rise as well. Alternatively, conventional loans are usually reserved for homeowners with credit scores of at least 620.
As you shop around for the best terms, keep in mind that each lender will set its own loan options. This means that while the FHA might specify a minimum credit score, the lender you speak with might require a higher score for eligibility. With either type of loan, a higher credit score will usually mean access to more favorable rates and lower down payments.
Private Mortgage Insurance
In the event that a buyer defaults on a loan, private mortgage insurance (PMI) protects the lender from shouldering the entirety of their financial burden. If you cannot pay a 20% down payment on a conventional loan, your lender will add PMI to your monthly statement.
While only a select number of homebuyers pay PMI on a conventional loan, every buyer who secures an FHA loan has to pay PMI. For both types of loans, the amount of PMI you pay will vary according to the size of your down payment.
One major difference is the longevity of the payment. If you’re paying on an FHA loan with a down payment of less than 10%, your PMI payment will last as long as your loan lasts. If your down payment is higher, then you’ll only pay PMI for 11 years.
Conversely, you’ll stop paying PMI on a conventional loan as soon as your equity reaches 22% of the total purchase price. The only way to eliminate PMI on an FHA loan is to convert the loan to a conventional one.
Lenders will look at your debt-to-income (DTI) ratio to help determine how much of a risk you might be as an applicant. Your DTI ratio details the amount of your monthly, pre-tax income that you have to use to pay all of your regular, required debts, including:
- Your mortgage
- Your auto loans
- Your student loans
- Your minimum credit card payments
- Child support (if applicable)
If your DTI is high, it indicates that you don’t have a lot of money left over each month for savings. In other words, you’re living paycheck to paycheck, which can be a red flag for a lender.
To qualify for an FHA loan, your DTI will need to be less than 50%. Although most conventional lenders require a DTI of 43% on used homes and 45% on new homes, some will go as high as 50%, too.
Comparing FHA vs Conventional loans for new homes, there’s a limit to the amount of money that you can borrow. However, it isn’t cut and dry across the board. Rather, the county you live in will dictate your local loan limits.
Regulators are the ones responsible for setting those limits and can change them annually. In 2022, the FHA loan limit is $420,680 for low-cost areas. In higher-cost markets, it can go as high as $970,800.
The Federal Housing Finance Agency (FHFA) sets the limits for conventional loans. In 2022, the limit for most U.S. mortgages is $647,200. If a loan exceeds that amount, it usually falls under the jumbo loan category.
In a similar vein, both loans limit the type of property that a buyer can purchase. In general, FHA loans tend to have stricter appraisals than conventional loans. During these appraisals, the appraiser will assess the property’s value, as well as vet it for various features, including:
- General safety
- Construction quality and soundness
- Adherence to local codes and restrictions
In addition, FHA loans mandate that the buyer must use the loan to purchase their full-time residence. This means you cannot use an FHA loan to buy a vacation home or a secondary property. You also can’t use it to fund an investment property or a home that you intend to flip in fewer than 90 days.
Conventional loans tend to have more lenient property guidelines. While you will still have to schedule a home appraisal, you aren’t limited in how you can use the home. Buyers can use a conventional loan to purchase a vacation home, investment home, or any other type of residential property.
If you need to refinance your home down the road, it’s important to know what your type of loan will allow.
If you made a down payment of less than 10%, you can refinance an FHA loan down the road to get rid of the monthly PMI payments. Once you’ve accumulated 20% equity in your home, you can refinance into a conventional mortgage and eliminate the extra monthly expense.
Navigating Your Loan Options
Now that you know a little more about FHA vs conventional loans for new homes, you can make a more informed decision going forward.
While FHA loans tend to have more flexible lending requirements, they also come with certain restrictions. Similarly, a conventional loan may have stricter application terms, but you can achieve more favorable rates if you meet the eligibility criteria.
Searching for a new home in the Triangle area? We can help you find the perfect spot. Feel free to search all of our available properties online and contact us to learn more or schedule a visit!