Here is an article that I refer my clients to when they have the same question.
While many people deciding on a loan product rely exclusively on their lenders recommendation, you should understand the basic difference between an FHA loan and a Conventional Loan. The term Conventional Loan includes all loans under the current FNMA and FHLMC lending limits. Some of these may be called Conforming, A paper, subprime, Alt A, A Minus, BC (bad credit) and other industry names.
Most people that have heard of FHA loans tend to associate them with purchase money transactions. While purchases are the most common use, FHA loans are also available for rate and term refinance loans as well as Cash Out refinances.
The main advantage of a fha vs conventional loan is that the credit qualifying criteria for a borrower are not as strict as conventional loan financing and the down payment or Equity requirements are less. In comparing a purchase money FHA loan against a Conforming or A paper loan, the FHA loan will generally have the least amount of money required to close and the lower payment, see fha vs Conventional loan comparison (pdf file). FHA loans will allow the borrower who has had a few "credit problems" or those without a credit history to buy a home. An FHA Underwriter will require a reasonable explanation of these derogatories, but will approach a person's credit history with common sense credit underwriting. Most notably, borrowers with extenuating circumstances surrounding a bankruptcy that was discharged 2 years ago can be approved for maximum financing. Conventional A Paper financing, on the other hand, would require 4 years to have passed to be eligible for consideration and relies heavily upon credit scoring. If your score is below the minimum standard, you will not qualify or you will be place in a higher rate Subprime, Alt A or A minus loan product.
If a borrower does have past credit issues an FHA loan may be significantly cheaper than an alternative loan such as subprime, ALT A, or A minus. These other programs generally have higher interested rate of require a larger down payment or Equity position. Many of these alternative loan products have Pre Payment penalties where as FHA loan do not have such penalties. In fact FHA loans can be easily refinanced under the Streamline program.
Another advantage of a fha vs conventional loan is that FHA is one of the few home mortgage programs that allow a borrower to have their down payment gifted from a family member, a governmental agency, or non-profit organization. This allows home buyers without the necessary money to buy a home today.
Even though FHA charges an annual renewal mortgage insurance premium of 0.5% of the loan amount, this fee is generally half that charged by low down payment Conforming A Paper conventional mortgages (which range from 0.55% up to .96% per year). Subprime, Alt A and A minus rates range from 0.55% to 4.18%. For a $100,000 mortgage, FHA would charge approximately $41.67 per month and a typical low down (3%) conventional mortgage with a renewal premium of 0.78% would charge $65.00 per month. That's a $280 savings per year.
However, conventional financing does not require an upfront mortgage insurance premium when a borrower closes on the loan. With FHA financing, that fee for a 30 year loan is 1.50% of the loan amount that the borrower can wrap into the mortgage. On a $100,000 for 30 years at 8%, that's an additional $11.01 that the borrower must pay each month. That's almost an additional $132 the borrower must pay each year (fortunately the interest a borrower pays on his or her mortgage on a primary residence is tax deductible).
One drawback to FHA loans is that the loan limits set for FHA loans are typically less than the loan limits for conventional financing in most parts of the country. If a borrower is looking for a mortgage that exceeds the FHA loan limits for the area, the borrower would have to put additional money down on the property or finance under a conventional mortgage, Subprime, Alt A or A Minus product. Under the 2008 stimulus package FHA loan limits have been raised in many areas and FHA offer FHA Jumbo Loans
Hope this helps!