When it comes to financing a home purchase, there are various mortgage options available to homebuyers, each with its own unique features, requirements and advantages.
When deciding if a USDA loan is right for you, it’s helpful to compare these loans to other loan types, such as FHA, VA and conventional loans, to help you determine which option best suits your needs and goals.
Buying a home is an exciting milestone in life but it also comes with a lot of big financial decisions. One of the first choices you’ll make is deciding between a USDA loan and a conventional loan.
I know first-hand how confusing all the mortgage lingo can be when you’re a first-time homebuyer. My wife and I just bought our first house last year and did tons of research to find the best loan for our situation.
In this article, I’ll walk you through the key differences, pros and cons, and tips for choosing between these two common mortgage options. My goal is to explain these loans in simple terms to help you make the most informed decision.
What Are USDA and Conventional Loans?
First a quick refresher on what each of these loans are
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USDA loans are government-backed mortgages aimed at helping low-to-moderate income buyers in rural areas. They are insured by the U.S. Department of Agriculture.
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Conventional loans are regular mortgages not backed by any government agency. They make up the majority of home loans today.
The main perk of USDA loans is that no down payment is required. But you do have to pay upfront and annual guarantee fees.
Conventional loans typically require a down payment of around 5-20%. But you may be able to avoid private mortgage insurance with 20% down.
Below I’ll dig into the key differences in more detail. First up…
USDA Loan Requirements
USDA loans come with much more rigid eligibility standards compared to conventional mortgages. Here are the major requirements:
Location in Rural Area
Your home needs to be in an area defined as “rural” by the USDA. Surprisingly, this includes many suburban neighborhoods too. You can check your eligibility on the USDA Property Eligibility Site.
Income Limits
Your household income must be below 115% of the median income for your area. The limit adjusts based on the number of people living in your home.
For example, the 2023 income cap for a family of 4 in Los Angeles County, CA is $141,900. Check income limits for your area.
Credit Score Requirements
- Credit score of 640+ = Streamlined approval
- 600-639 = Manual underwriting required
- Under 600 = Unlikely to be approved
The USDA can make exceptions to credit requirements in special cases.
Debt-to-Income Ratio
Your total debt-to-income ratio must be below 41% of your gross monthly income to qualify. But exceptions can be made for strong applicants.
Conventional Loan Requirements
Conventional loans are more widely available and have fewer restrictions, but you’ll still need to meet the baseline eligibility criteria:
Location
Conventional loans are available nationwide – no geographic limitations.
Income
No maximum income thresholds. You just need to verify employment and income.
Credit Score
Each lender is different, but typically:
- 620+ = Qualify for conventional mortgage
- 500-619 = May still qualify, but with stricter terms
Down Payment
You’ll need at least 5% down for a conventional loan. But many lenders allow as low as 3% down for first-time buyers.
Debt-to-Income Ratio
Aim for 36% DTI or lower. Up to 50% DTI may be allowed if you meet other criteria.
Comparing Pros and Cons
Now let’s look at the key upsides and downsides of USDA loans vs. conventional loans:
Pros of USDA Loans
- No down payment required
- Typically lower interest rates
- Ideal for low-to-moderate income buyers
Cons of USDA Loans
- Limited to rural locations
- Strict income caps
- Upfront & annual guarantee fees
- Slower approval process
Pros of Conventional Loans
- Available anywhere nationwide
- No income limits
- Used for primary home, 2nd home or investment
- Flexible terms and down payments
Cons of Conventional Loans
- Minimum 5% down payment
- Must pay PMI if under 20% down
- Minimum 620 credit score
As you can see, there are tradeoffs to each type of mortgage. Making the right decision depends on your financial situation.
7 Tips for Choosing the Best Loan
If you’re feeling overwhelmed about whether to get a USDA or conventional loan, follow this advice:
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Check if you meet location requirements – Use the USDA eligibility tool to see if your area qualifies for their loans. If not, conventional is your only option.
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Calculate your debt-to-income ratio – Make sure your total monthly debts divided by gross income falls below the limits for the loans you’re considering.
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Evaluate down payment savings – Conventional loans require at least 5% down. Can you swing this, or is a no down payment USDA loan a better fit?
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Ask about exceptions – If your credit or income situation falls slightly outside the guidelines, ask lenders if they can make exceptions. Pre-approval is key.
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Compare total costs – Consider factors like interest rates, PMI, and guarantee fees to see which mortgage will cost less over time.
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Check income limits for your area – Does your household income exceed the maximums to qualify for a USDA loan where you’re buying?
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Talk to multiple lenders – Get rate quotes and pre-approvals from several lenders to find your best deal. Credit unions often have great rates too.
Bottom line – evaluate both options and discuss your specific situation with lenders. Getting pre-approved for both USDA and conventional loans can give you more negotiating power and flexibility.
Whichever mortgage works for your budget and goals, the key is making sure you can comfortably afford the monthly payments. Homeownership is so rewarding when you set yourself up for success from the start!
Disadvantages of FHA Loans vs. USDA Loans
However, FHA loans also have their drawbacks when compared to USDA loans:
- FHA loans require a minimum down payment of 3.5%, which can be a significant upfront cost for some borrowers.
- With a 3.5% down payment, FHA loans require a minimum credit score of 580. Borrowers falling below this credit requirement will likely need to increase their down payment to qualify for an FHA loan.
- FHA loans have a maximum loan limit that varies by county, which may limit borrowing capacity in high-cost areas. This loan limit starts at $498,257 but can reach $1,149,825, depending on the location of the property.
- FHA loans require a mortgage insurance premium (MIP) both up-front and on an annual basis throughout the life of the loan.
Ultimately, the choice between USDA loans and FHA loans will depend on individual circumstances, such as the desired property location, credit score and financial capacity of the potential borrower. Whether its the convenience of FHA loans or the benefits of USDA loans, finding the right fit will set the foundation for a successful and rewarding homeownership journey.
USDA Loans: The Basics
Before diving into comparing USDA loans to other loan options, lets briefly understand the basics of USDA loans:
- Eligibility requirements: The property must be located in a designated rural area and the buyer must be a U.S. citizen or permanent resident.
- Down payment: No down payment is required, making USDA loans an attractive option for those with limited funds for upfront costs.
- Minimum credit score: The USDA does not set a minimum credit score requirement, but lenders typically look for a 640 credit score.
- Maximum income limit: Total household income cannot exceed local USDA income limits, or 115% of your area’s median household income.
- Maximum loan limit: The USDA does not have a set loan maximum limit, limit depends on the borrower’s qualifications and financial situation.
- Minimum property requirements: The property must meet specific minimum property requirements, be the borrower’s primary residence and a single-family home.
- Mortgage insurance: Private mortgage insurance (PMI) is not required, but borrowers will pay an upfront guarantee fee of 1% at closing and an annual fee of 0.35% that will be lumped into the monthly payment throughout the life of the loan.
- Closing costs and fees: Closing costs generally range from 3% to 6% of the total loan amount, and seller concessions are capped at a maximum of 6%.
What’s The Difference Between a Conventional Loan and a USDA Loan?
FAQ
Which loan is better, conventional or USDA?
Can you switch from a USDA loan to a conventional loan?
Do USDA loans have higher interest rates?
What is the difference between a conventional loan and a USDA loan?
There are some key differences between USDA and conventional loans. Let’s look at the major differences so you can decide which loan type is right for you. Conventional loans are available nationwide. USDA loans, on the other hand, are only available in eligible rural areas as determined by the USDA.
Why do USDA home loans have lower rates than conventional mortgages?
In addition to having no down payment requirements, USDA home loans often also have lower rates than conventional mortgages because the government is taking on the risks associated with lending. This is true even when the USDA issues the loans.
Is a USDA loan a good idea?
Since the USDA is taking on a lot of the risk, your lender can offer you a lower interest rate. Ultimately, government-backed loans make it affordable for lower-income households to buy a home. Unlike USDA loans, conventional mortgages aren’t insured by the U.S. government. Conventional loans fall into two categories: conforming and non-conforming.
Are USDA Loans a better option than traditional financing?
For many, USDA loans are a better option than traditional financing. The USDA Rural Mortgage program has a couple primary restrictions — income and geography. The property must be located in an eligible area. You can check if the home you want is eligible at the USDA website.