Pros and Cons of FHA vs. Conventional Loans for First-Time Buyers

While FHA loans might not be right for every situation, they do offer a number of benefits for home buyers, especially those with credit-related issues in the past or limited down-payment funds. But they also have some potential drawbacks…

Key Differences Between FHA and Conventional

Before we can talk about the potential pros and cons of these loan choices, we have to talk about what makes them different. Here’s what you need to know.

FHA loan: A mortgage loan that gets insured by the government via the Federal Housing Administration. This insurance backing protects the lender against losses relating to borrower default and allows lenders to be more flexible when qualifying applicants.

Conventional loan: A mortgage product that does not receive any kind of government insurance. Conventional loans sometimes require insurance, known as PMI, but it’s provided by insurance companies in the private sector. There is no government backing.

Military members and veterans often have a third choice. The VA loan program allows these borrowers to buy a home with no down payment.

Benefits of FHA Loans for First-Time Buyers

FHA loans offer several benefits for first-time home buyers, when compared to conventional or “regular” mortgage financing. And we’ve touched on one of the potential advantages already. Here’s a closer look at those benefits…

1. They allow for a low down payment.

FHA loans require a down payment of just 3.5% of the home’s purchase price or appraised value. This can help first-time buyers overcome what is often the biggest hurdle to homeownership: the upfront expense.

For example, if you were buying a $400,000 home, the minimum down payment for an FHA loan could be as low as $14,000. (The math: 400,000 x .035 = 14,000)

This relatively low investment can benefit first-time home buyers who don’t have substantial savings for a larger down payment. And a lot of people fall into this category.

First-time buyers obviously don’t have profits from a previous home sale to put toward their next purchase. So they often struggle to come up with a large down payment. FHA loans (and other low-down-payment mortgage options) can benefit these borrowers.

Key point: While this program is often well suited for first-time buyers, it’s not limited to that group. Previous homeowners can also use it.

The Federal Housing Administration also allows borrowers to use down payment funds from a wide variety of sources. The money can come from a bank account, retirement account, stocks and bonds, or even a monetary gift from a family member or employer.

2. They have flexible credit score criteria.

Conventional (or non-government-backed) home loans typically require higher credit scores when compared to FHA loans. The FHA loan program, on the other hand, tends to be more forgiving of less-than-perfect credit histories.

Officially, this mortgage program requires a credit score of:

• 500 or higher just to be eligible, and
• 580 or higher if you want to use the 3.5% down payment option

Conventional mortgage loans, on the other hand, often have stricter credit standards and require higher scores when compared to FHA.

Conventional mortgages can be riskier for lenders because they lack the government-provided insurance. To mitigate this risk, lenders often impose stricter standards for borrowers—including credit scores. Some require a score of 620 or higher for conventional loans, but this can vary.

The looser credit requirements associated with FHA loans can benefit borrowers with past credit programs, such as payment delinquencies, bankruptcy or foreclosure. In fact, first-time buyers who get turned down for conventional financing can often qualify for the FHA program.

If your credit score is a bit too low to qualify for a regular mortgage loan, consider using a government-backed mortgage program to finance your home purchase.

3. Borrowers can have a higher debt-to-income ratio.

FHA loans typically allow for higher debt-to-income (DTI) ratios compared to conventional loans. The DTI ratio is the percentage of your gross monthly income that goes toward paying your recurring monthly debts. Lenders use it to measure risk.

While conventional loans often require a DTI ratio of 43% or lower, FHA loans may accept ratios up to 50% for certain borrowers.

This added flexibility could benefit borrowers who have significant existing debt obligations, like student loans, credit cards, and car payments. Just use caution when taking on this level of debt, as it doesn’t leave a lot of room for financial emergencies.

By accommodating higher DTI ratios, FHA loans open doors to homeownership for individuals who might not qualify for conventional financing.

4. FHA loans are assumable, which could attract sellers.

One unique feature of FHA loans is that they are “assumable.” This means that a home buyer could take over the existing FHA loan from the current homeowner when purchasing the house.

This could be a selling point later on, when you sell the house. If interest rates are higher when you attempt to sell the house, some buyers fill find your lower (and assumable) mortgage rate appealing.

Assumable loans can also be attractive to potential buyers who may not qualify for a new loan on their own due to credit or income limitations.

Conventional mortgages, on the other hand, are rarely assumable because they typically contain a “due-on-sale” clause that would allow the lender to charge the new homeowner for the full outstanding loan balance.

These benefits make the FHA loan program an attractive option for many first-time home buyers, especially those who might have a hard time securing a conventional mortgage.

Potential Drawbacks for Borrowers

All mortgage options have certain pros and cons, and that applies to the FHA loan program as well. We’ve covered the main advantages above. Now, let’s look at the potential downsides.

1. Mortgage Insurance Premiums

All home buyers who use an FHA loan to buy a house have to pay for mortgage insurance.

In fact, if you zoom out far enough, you’ll see that the FHA loan program is basically one big insurance fund. It’s designed to reduce risk for lenders, enabling them to offer loans to borrowers they might not otherwise accept.

But it’s the home buyer who pays into the insurance fund to keep it running.

FHA loans actually require two different insurance premiums:

• There’s an upfront premium that equals 1.75% of the base loan amount. It can be paid up front or rolled into the loan.
• There’s also an ongoing annual insurance premium. The annual premium can vary due to several factors, but for most borrowers it comes out to 0.55% of the loan amount (divided by 12 and paid monthly).

FHA mortgage insurance increases the size of your monthly payments, and you might have to pay the annual premium for as long as you keep the loan. This is a major downside for some borrowers.

In contrast, conventional mortgage loans only require private mortgage insurance (PMI) when a borrower makes a low down payment. Borrowers who put down 20% or more on a conventional loan can avoid PMI entirely.

If you can only afford a small down payment, you’ll probably end up paying mortgage insurance (regardless of the loan type). But if you can put down 20% or more, you might be better off using a conventional mortgage.

2. FHA Loan Limits

First-time home buyers who use FHA loans are subject to maximum size limits imposed by the Federal Housing Administration. These “loan limits” can vary by county because they are based on median home prices in a particular area.

In 2024, FHA loan limits range from $498,257 to $1,149,825 for a one-unit residential home, depending on the county. These limits can also change from one year to the next, due to rising home prices. You can find the limits for your area on the HUD.gov site.

These limits can be a disadvantage for some buyers, especially in pricier real estate markets where a lot of homes are priced above those limits. Such properties typically do not qualify for FHA financing (unless the buyer covers the difference out of pocket).

First-time buyers who want to purchase a more expensive home may need to consider alternative financing options, if the loan amount exceeds FHA limits.

3. Limited Eligibility for Condominiums

This program has specific requirements for condominium projects. In short, condos must be on the FHA-approved condominium list or meet certain criteria for single-unit “spot approval.” This restriction could limit the pool of properties available to you, particularly in markets with a high concentration of condos.

4. Property Condition Requirements

All FHA loans require a home appraisal, and the purpose is twofold. The appraiser will estimate the market value of the house and also check to see if it meets the minimum property requirements (MPRs) for FHA financing.

While these requirements are designed to protect the buyer and lender alike, they could also limit your housing options. Homes that need significant repairs just to be habitable typically do not qualify for FHA financing.

Depending on local market conditions, this appraisal requirement could be an advantage or a disadvantage for a first-time buyer. So let’s talk about that next.

5. Possible Disadvantages in the Market

In a competitive housing market, some sellers might be hesitant to accept offers from buyers using FHA loans. This is largely due to the required home appraisal mentioned above. Some sellers believe that they’ll have to make a lot of repairs if the buyer has an FHA loan.

The truth is FHA appraisals really aren’t that strict. They mostly focus on basic health-and-safety items like foundation damage and faulty wiring. But as a home buyer, you should know that some sellers might view your mortgage choice in a negative light.

This may or may not be an issue, depending on your local market conditions:

• In a seller’s market where multiple offers are common, home buyers using FHA loans might find themselves at a disadvantage against buyers with conventional mortgages.
• But in a slower market, the seller might only receive one offer at a time, and be less “picky” as a result.

Ultimately, you have to choose the mortgage option that works best for you, based on your financial situation and goals. Just know that your mortgage choice could affect you when making an offer, particularly in a competitive real estate market.