Home Loan Down Payments: FHA vs. Conventional

House hunters new to home loans soon discover there are major differences between FHA and conventional loans. One of those big differences is the minimum down payment: FHA loans require a minimum down payment of 3.5% for borrowers with a credit score of 580 or higher.

While some conventional loans through Fannie Mae and Freddie Mac offer 3% down programs for first-time buyers, these programs are subject to stricter requirements.

Some first-time buyers face a choice between entering the market sooner with a lower down payment or waiting years to save a larger down payment. But during the period spent saving, the price of housing may increase, further raising the required down payment.

Loan Level Price Adjustments

Conventional loans use a system called Loan Level Price Adjustments. These are charges based on the borrower's risk profile. Factors include the loan-to-value ratio, the credit score, and the property type. When a buyer makes a small down payment, the lender considers it a higher risk. 

According to Investopedia, "A loan-level price adjustment (LLPA) is a fee applied to conventional mortgages based on the borrower’s credit risk. It affects most homebuyers using loans backed by Fannie Mae and Freddie Mac and is determined by credit score, loan-to-value (LTV) ratio, and loan type. "

For example, a borrower with a 700 credit score putting 3% down on a conventional loan will likely face a higher interest rate than a borrower with the same score using an FHA loan.

FHA interest rates are generally lower because the government insures lenders against losses. 
On a conventional loan, the lender offsets the risk of a low down payment by increasing the interest rate or charging higher closing fees. This increases the loan's monthly cost, affecting the buyer's debt-to-income ratio.

Paying Less than 20% Down

Borrowers who put less than 20% down on a conventional loan must pay private mortgage insurance. The cost of this insurance is determined by the credit score and the down payment percentage. A lower credit score results in a higher insurance premium.

FHA loans use a Mortgage Insurance Premium system. This includes an upfront payment and a monthly fee. While conventional insurance can be canceled once the loan reaches 80% of the home's value, the initial monthly cost may be an issue. 

You'll either pay more up front to cancel the insurance after 11 years, or pay less up front but pay the insurance for the lifetime of the loan. This is another factor to consider when deciding between FHA and conventional options.

Seller Concessions and Closing Costs

Home loan closing costs are typically 2% to 5% of the purchase price. Buyers can ask sellers to pay a portion of these costs, and FHA loans allow sellers to contribute up to 6% of the purchase price toward the buyer's closing costs. What the seller cannot do is contribute directly toward your down payment.

Conventional loans limit seller contributions to 3% (when the buyer puts down less than 10%.) If the closing costs on a $400,000 home are $16,000, the seller can only contribute $12,000 toward a conventional loan with a lower down payment.

Under FHA rules, the seller could cover the entire $16,000 amount thanks to the higher 6% seller-contribution limit. Both FHA and conventional loans allow the use of gift funds for a down payment. However, the documentation and usage rules can be more restrictive for conventional loans. 

For certain property types or when the credit score is lower, conventional lenders may require the buyer to contribute at least 5% of the purchase price from their own personal funds before gifts can be applied. FHA loans allow the entire 3.5% down payment to be gifted by an eligible donor.