"Who Qualifies for 3% Down on a Conventional Loan, and How Does It Compare With FHA?"

Two years of automatic transfers finally put a number in your savings account that you are proud of, and it is still a long way from twenty percent of any home you like. The first lender you called heard "small down payment" and went straight to FHA. The second one mentioned three percent down on a conventional loan, and the call ended before you could ask who gets that.

A 3% down conventional loan is for a home you will live in, and there are two ways to qualify. Either someone on the loan has not owned a home for three years, or the income your lender counts is under the HomeReady or Home Possible limit for that address. FHA takes 3.5% down, accepts lower credit scores, and its mortgage insurance usually lasts the life of the loan.

I'm Jeff Moran, a mortgage broker in Bluffton, South Carolina, originating since 1996, NMLS #483943, through C2 Financial Corporation, licensed in fifteen states. I price the 3% conventional options and FHA on the same file, and the comparison below is the one that decides it.

Two ways to put 3% down on a conventional loan

A conventional loan with 3% down is a loan for 97% of the home's value. Fannie Mae's Eligibility Matrix allows that on a one-unit primary residence with a fixed rate, and Freddie Mac's HomeOne section allows the same 97% on its side. Each agency gives you two ways to qualify.

The first way is the standard 97% loan, which Fannie Mae runs under its ordinary purchase rules and Freddie Mac calls HomeOne. It asks for a first-time homebuyer on the loan and does not look at how much you earn.

The second way is the income-limited loan, HomeReady at Fannie Mae and Home Possible at Freddie Mac. It does not ask whether you have owned before, and it does compare your income with the area where the home is. Either one is enough.

Who counts as a first-time homebuyer on a 3% down conventional loan?

A first-time homebuyer, for this purpose, is someone who has not had an ownership interest in a property in the last three years. Fannie Mae's purchase transaction section ties it to the application itself: at least one person on the loan answers "No" to the question about owning a property in the last three years. Freddie Mac's HomeOne section asks for at least one First-Time Homebuyer the same way.

A client who sold a home four years ago and has rented since is a first-time homebuyer under this rule. A couple where one spouse owned a condo last year and the other never has still qualifies, because only one of you has to meet it. The three-year clock is the whole test, and you will want to answer that question on the application carefully, because your lender reads it straight from there.

The standard 97% loan has a fixed rate. Its term runs up to 30 years. The home is a one-unit primary residence. The loan amount stays within the standard maximum that Fannie Mae and Freddie Mac buy, so the larger high-balance amounts allowed in some high-cost counties are out. Neither agency sets an income limit for this way in.

The income limits for HomeReady and Home Possible

The income-limited loan is the other way to qualify. Fannie Mae's HomeReady FAQ and the HomeReady eligibility section of its Selling Guide set the limit at 80% of the area median income for the home's location. Freddie Mac's Home Possible section 4501.4 uses the same number: qualifying income, converted to an annual figure, cannot be more than 80% of the area median income where the home is.

The income that gets measured is your qualifying income, which is the income of the people on the loan that the lender counts when deciding whether you can afford the payment. Freddie Mac's section says the lender relies on that income, and Fannie Mae counts the same thing. A partner who is not on the loan does not count against the limit.

The limit belongs to the home's address, not to where you live today. Each agency publishes its own lookup by address, and Freddie Mac's section says the lender has to use the Home Possible Income and Property Eligibility tool. A client who owned a home two years ago can still use either program if the income fits.

The dollar figure is different in every county, so the lookup is worth running before you settle on FHA.

The occupancy rule and the homebuyer education class

Every 3% down conventional loan is for a home you will live in. Fannie Mae's purchase section says everyone on a 97% standard loan must occupy the property, unless the down payment help is a Community Seconds loan, a second mortgage from a housing agency or employer that Fannie Mae recognizes. Freddie Mac's HomeOne section says the same. Home Possible has more room: at least one person on the loan has to live there. A parent who signs the loan with you without moving in is allowed on a one-unit home, with a lower cap on the loan-to-value, which is the loan amount measured against the home's value. If you would like a parent on the loan who will not live with you, it helps if you let me know on the first call, so we price the program that fits.

A homebuyer education class is required on some of these loans. Fannie Mae's homeownership education section requires it on a purchase above 95% loan-to-value when everyone on the loan is a first-time homebuyer, and on HomeReady when all the occupying clients are. Freddie Mac's homeownership education section applies the same rule to Home Possible and HomeOne.

The agencies each offer a free course: Fannie Mae's HomeView and Freddie Mac's CreditSmart Homebuyer U. The provider cannot be the lender, and the certificate goes in your loan file before closing. You can take it before you find a home.

How does 3% down conventional compare with FHA?

FHA is the other common loan for a small down payment. My FHA explainer covers the program on its own.

The down payment

FHA's maximum loan on a purchase is 96.5% of the home's value under Handbook 4000.1's loan-to-value limits, which means 3.5% down. That half percent rarely decides anything on its own.

On a Home Possible one-unit home, Freddie Mac's Home Possible section on sources of funds requires no minimum contribution from your own funds. The entire down payment can come from an eligible gift, and that often matters more than the half percent. My article on sourcing gift funds for a down payment covers how that gets documented, and the one on down payment assistance programs covers the grants and second mortgages that often pair with these loans.

The credit score

The same FHA handbook section allows maximum financing when your minimum decision credit score is 580 or higher, allows a loan up to 90% of value between 500 and 579, and does not insure a loan below 500. The minimum decision credit score is the middle of your three scores, and the lowest middle score when more than one of you is on the loan.

Fannie Mae's credit score section sets 620 as the floor for a manually underwritten fixed-rate loan, meaning one an underwriter reviews by hand. A file run through Desktop Underwriter, Fannie Mae's automated underwriting system, has no fixed minimum score. Conventional also adjusts the rate to your score and your down payment, and FHA mostly does not. My article on why FHA quotes better than conventional on the same credit covers that mechanism.

The mortgage insurance

Both loans carry mortgage insurance at this down payment. On a conventional loan, Freddie Mac's mortgage insurance section requires it on any loan above 80% of value, and a private insurer prices the premium to your credit and your loan-to-value. That section also sets how much of the loan the insurer has to cover if the loan goes bad: 35% on a standard 30-year loan between 95% and 97% loan-to-value, and 25% on Home Possible at the same loan-to-value. That coverage figure is the insurer's share of the risk rather than your premium, and less of it is one reason the income-limited programs usually price their mortgage insurance lower than the standard 97% loan does.

FHA charges an upfront premium that is usually financed into the loan and an annual premium collected inside your payment. Appendix 1.0 of the FHA handbook sets the amounts, and they are the same for every client regardless of credit score. Your Loan Estimate shows the dollar figure for your own loan.

The life of the loan

The same FHA appendix sets how long the annual premium lasts. On a loan with a term over 15 years and a loan-to-value above 90%, the premium runs for the mortgage term. With 3.5% down, that means you pay it for the life of the loan, until you refinance or sell.

Conventional mortgage insurance comes off. Once you have paid the loan down to the level set in the Homeowners Protection Act, the federal law on this, you can ask the servicer, the company that collects your payment, to remove it. Further down the schedule the same law requires the servicer to cancel it on its own. When mortgage insurance goes away covers both routes and the appraisal path that gets you there sooner.

FHA is the better loan for lower credit scores, and 3% down conventional for solid credit

FHA tends to be the better loan when your credit score is in the range where conventional pricing gets expensive. Below the mid-600s the conventional rate and mortgage insurance both climb while FHA's stay where they were, and somewhere in that range FHA becomes cheaper month to month. FHA also wins when nobody on the loan fits the three-year rule and the qualifying income is over the HomeReady and Home Possible limit. Then the choice is FHA at 3.5% or a conventional loan at 5% down.

The 3% conventional loan tends to win when your credit is solid, because the rate rewards it, the private mortgage insurance is priced to it, and the insurance ends. If you fit HomeReady or Home Possible with a good score, it is unusual for FHA to beat it over the years you own the home.

The way to settle it is to price both loans on your file. It helps if you look past the rate to the total monthly payment with the insurance in it. Then it is worth comparing what that payment looks like once the conventional insurance comes off, since that is where the lower rate often turns into the higher cost.

Common mistakes with a small down payment

The first mistake is assuming "first-time" means never. Someone who owned a home more than three years ago can still use the standard 97% option.

The second is checking income against the wrong number. The limit applies to the qualifying income on the loan, at the address of the home you are buying. Household income is the wrong figure, and the county you live in now is the wrong place.

The third is taking the lower rate as the cheaper loan. The payment with insurance in it, and how long that insurance lasts, is the comparison that matters.

An example of how the two loans read side by side

Numbers below are made up to show the mechanism, and nothing here is a quote. Say the home is $320,000 and your qualifying income is under the limit for that address.

Purchase price                         $320,000
Conventional down payment at 3%          $9,600
FHA down payment at 3.5%                $11,200
Difference in cash at closing            $1,600

The $1,600 matters, and the mortgage insurance on each estimate makes a bigger difference over time than that $1,600 does. On the conventional loan, the premium is priced to your credit score and is scheduled to come off. On the FHA loan at this down payment, the annual premium runs for the term of the loan, so the exit is a refinance or a sale. With a good credit score, the conventional loan usually carries the lower insurance cost from the first month, and the conventional insurance is the one that comes off.

Your next step

The useful first step is seeing both loans priced for your own scenario. You are welcome to run your numbers and see rates for your scenario, your debt ratio and closing costs, with no credit pull and no account. You can choose a rate option there, and that selection can change as we compare the two programs. When you are ready for a letter a seller will take seriously, getting pre-approved is where the income lookup and the three-year question get reviewed properly. If you would rather talk it through first, you are welcome to call me. My loan programs overview covers VA, jumbo and the rest.

Nothing here is a loan approval, a denial, a commitment to lend, or tax or legal advice. The program your loan is placed with is decided on your own file.

Common questions

Do I have to be a first-time homebuyer to put 3% down on a conventional loan?

No. The standard 97% loan at Fannie Mae and Freddie Mac's HomeOne loan require at least one first-time homebuyer, meaning someone with no ownership interest in a property in the last three years. HomeReady and Home Possible do not require a first-time homebuyer at all. They look at occupancy and income instead.

What is the income limit for HomeReady and Home Possible?

Both programs cap qualifying income at 80% of the area median income for the location of the home you are buying. Fannie Mae's Selling Guide, in its HomeReady eligibility section, and Freddie Mac's Seller/Servicer Guide, in its Home Possible eligibility section, each state that limit, and each agency publishes an address lookup that gives the dollar figure for a specific property.

Do I have to take a homebuyer education class for a 3% down loan?

Only when everyone on the loan is a first-time homebuyer. Fannie Mae's homeownership education section of the Selling Guide requires it on a purchase above 95% loan-to-value in that case, and on HomeReady when all occupying clients are first-time. Freddie Mac's homeownership education section applies the same rule to Home Possible and HomeOne. The agencies each offer a free course, and the completion certificate has to be in your loan file before closing.

Can the 3% down payment be a gift?

On a Home Possible one-unit home, yes. Freddie Mac's Home Possible section on sources of funds requires no minimum contribution from your own funds on a one-unit property, so the whole down payment can come from an eligible gift. On the other programs each agency's gift rules apply.