If your lifelong dream is to buy a house of your own but you’re worried that your income level won’t get you approved for a home loan, you might have heard that getting an FHA loan is your only chance.
FHA mortgages are loans that you can use to buy a house in the United States. The Federal Housing Administration (FHA) will not directly lend you the money but they will guarantee your loan that you can borrow from an FHA-approved lender.
FHA loans are known to have more relaxed requirements compared to conventional loans because the program was created for low to moderate-income individuals to allow them to become homeowners. This is the reason why it attracts first-time homebuyers, people with lower credit scores, or those who do not have money for a huge down payment. But is the FHA loan as good as it is drummed up to be? In this article, we will discuss the benefits and downsides of FHA loans.
What are the Benefits of an FHA Mortgage?
Compared to conventional loans, FHA loans are more accessible, especially to lower-income families and individuals. Here are the advantages of an FHA mortgage loan vs a conventional mortgage.
Lower Credit Score Requirement
If you want to apply for a conventional loan to buy a house, most lenders would require a credit score of at least 620. If your credit score is nowhere near that or if you are just starting out, this is definitely a deal-breaker. With an FHA home loan, you can apply even if your credit score is from 500 to 580. But don’t get too excited. The Covid-19 pandemic in 2020 has made it reportedly more difficult for people with lower credit scores to qualify even for an FHA loan.
According to a Forbes article, while the minimum FHA credit score requirement remains unchanged, most lenders now require a score of at least 680 for a home buyer to qualify. With many people losing their jobs during the crisis, the risk of foreclosures is also higher making lenders wary of people with less than excellent credit scores. This makes this primary advantage not exactly beneficial in the current situation.
Lower Down Payment
A conventional loan typically requires a down payment of 20%. On the other hand, if you get an FHA home loan, the down payment required can be as low as 3.5% as long as your credit score is 580 or above. If your credit score is from 500 to 579, the down payment has to be 10% but that is still way lower than the down payment required when getting conventional mortgages.
More Forgiving Debt-To-Income Ratio
The debt-to-income ratio refers to all your monthly payments of debt divided by your gross monthly income before taxes and deductions. Many conventional lenders require borrowers to have a debt-to-income ratio of 36% or lower before they lend you money. If you’re applying for an FHA loan, this debt-to-income ratio can be up to 43%.
The Down Payment May Be Gifted 100%
Saving up for the down payment of a house is usually the roadblock for many first-time home buyers and low-income families. The good news is that with an FHA loan, it is allowed for this down payment to be gifted 100% as long as the person awarding the gift is not expecting you to pay the money back. Typically, 100% gifting of the down payment is often not allowed in conventional loans.
FHA Loans Are Assumable
If you are planning to sell your house, the buyer has the option to assume the loan at the same interest rates. This could help you sell the house faster especially if your FHA interest rates are much lower than current housing market prices.
What Are the Downsides of FHA Mortgage?
What is the downside of an FHA loan? There are quite a few. These cons of FHA loans could influence why this loan might not be right for you. Knowing and understanding these factors are very important to guide you in your home-buying decision.
You Have To Pay Two Types Of Mortgage Insurance
Many mortgage lenders consider FHA loans a higher risk. Because of this, the Department of Housing and Urban Development (HUD), which manages the FHA program, requires that the buyer pays for mortgage insurance. The purpose of FHA mortgage insurance is to protect the lender in case of default.
With an FHA mortgage, buyers have to pay for not one but two mortgage insurance premiums (MIP) :
1. Upfront mortgage insurance premium
This mortgage insurance premium has to be paid within 10 calendar days of mortgage closing or disbursement date. The cost is typically 1.75% of the base loan amount.
2. Annual mortgage insurance premium
Aside from the upfront MIP, there’s an annual premium that has to be paid, which is usually .45% to 1.05% of the average outstanding balance of the loan. Contrary to the term, this amount can usually be added to the monthly mortgage payments. This amount has to be paid for the entire duration of the loan. So, if you are paying for the house for 30 years, you also have to pay this fee for that long.
In a conventional loan, you can avoid mortgage insurance altogether if you pay at least a 20% down payment. If your down payment is lower, you will typically be required to pay for private mortgage insurance or PMI but not the upfront insurance. When you reach 20% home equity, you can also ask for the PMI to be canceled. You cannot do this with FHA loans.
There’s A Limit On How Much You Can Borrow
If you’re planning to buy a million-dollar home, then this is not the right loan for you. As mentioned earlier, FHA loans are mainly created for lower-income families so there is a limit on how much you can borrow. The amount will vary depending on where you live and the type of house you’re looking to buy.
For 2020, FHA loan limits for low-cost areas for a single-family home loan are $331,760. These low-cost areas are usually rural areas where real estate is generally cheaper. For high-cost areas, the limit for a single-family home loan is $765,600. Examples of high-cost areas include San Francisco, Washington D.C., and New York City.
You May Have To Pay Higher Interest Rates
There is a misconception that all FHA loans have lower interest rates compared to conventional loans, however, this is not always the case. The loan type that you get, whether FHA or conventional, does not dictate the interest rate of your mortgage. Rather, it will still be your credit score that will influence the best rate that you can get.
Those who have low credit scores might find that FHA loans could offer better mortgage rates. On the other hand, if your credit score is very good (640 to 679) or excellent (680 and above), it is possible to find a better rate with a conventional loan.
The Property Has To Go Through Strict Appraisal Process
While FHA implements a more relaxed set of guidelines when it comes to FHA loan applicants or borrowers, this is not the case when it comes to approving the properties involved. So, even if you as an individual qualifies to apply for FHA loans, the house that you want to buy has to also meet all the set requirements and standards by the HUD.
The property will have to go through a stringent appraisal process. In this process, a HUD-approved appraiser has to visit the property to ensure that it meets all the requirements, especially health and safety standards.
Your Choices Are Limited If You’re Planning To Buy A Condo
There are specific HUD guidelines when it comes to buying condominiums under an FHA loan, which is why many condo buildings do not qualify or meet the FHA standards. The only way to buy a condo is to have that condo on the HUD-approved condo list. So, if you are looking to buy a condo in a specific area, if that is not on the approved list, you won’t be able to get an FHA loan for that.
Sellers Tend To Avoid Buyers Using FHA Loans
Many real estate listing agents advise sellers to veer away from offers backed by an FHA loan. They do this because they don’t want to go through the stringent appraisal and inspections required by the HUD. It is easier for sellers to accept offers from buyers with conventional loans that will not require them to go through the strict HUD process. Some listing agents also believe that there is a higher risk for the deal to fall through during the underwriting process. These are perceived by agents as a disadvantage to sellers so many would advise sellers to receive offers from buyers using a conventional loan.
The Home Has To Be Your Primary Residence
If you are looking to buy a second home or a property that you can rent out as an investment, you cannot apply for an FHA loan. Under FHA rules, the property has to be your primary residence. This means you have to occupy and live in that house.
How to Qualify for an FHA loan?
After learning about the upsides and downsides of an FHA home loan, you might still be confused about whether you should apply for one or not. When do the advantages outweigh the disadvantages of an FHA loan? Is it still a good decision to pursue this type of loan?
For some people, an FHA loan could be their only option at the moment. If you fall under one or more of the following categories, getting an FHA home loan could benefit you.
- Your conventional loan application was already disapproved.
- Your credit score is below 600.
- You filed for bankruptcy previously. As long as the discharge date of the bankruptcy is 2 years or more, you can apply for an FHA mortgage.
- You can only pay a small down payment amount.
- Your parents or family members want to gift you your home down payment.
- There are a lot of available real estate options in the area where you are looking to buy, meaning the market is not very competitive.
- The house you are buying costs less than $300,000.
- You don’t mind going through the property appraisal process of the HUD.
On the other hand, if you have a decent credit score of above 620, it might be better to look for a conventional loan with more favorable interest rates. If the minimum down payment is your concern, it might be better to wait for a few months and save up. This will allow you to avoid paying mortgage insurance premiums and also give you more muscle when bidding for a home you want.
Final Thoughts on the Pros and Cons of FHA Loan
An FHA loan is an excellent choice if you’re a new home buyer or someone who has a less-than-perfect credit score. If you don’t have a lot of cash to pay upfront, an FHA loan can be an affordable choice thanks to its low down payment and lenient credit requirements. Given that conventional loans are excellent alternatives, too, when it comes to buying a house, you need to compare both the pros and cons of FHA loans first before making a decision.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
