FHA loans are a popular home financing choice throughout the United States. However, FHA loans may not always be the best option for every home buyer. While FHA loans offer a variety of great benefits, they also have a few drawbacks. Determining whether or not an FHA loan is right for you will involve comparing those benefits and drawbacks with other loan products and seeing which option works best for your specific needs and budget. To get started, let’s look at the FHA loan’s best features.
FHA Loans – Pros
One of the main reasons FHA loans are so popular is the fact that they do not require a large down payment. While conventional loans typically require 20% of the purchase price to be paid at closing, FHA loans only require a 3.5% down payment. Let’s use an example to put that into perspective:
- On a $150,000 house, a conventional mortgage would require $30,000 down in order to avoid paying PMI.
- If you were using an FHA loan, you could purchase the same house with only $5,250 down.
- That represents an out-of-pocket savings of $24,750.
Note: You may still be able to get a conventional loan without putting 20% down, but you’ll be charged costly private mortgage insurance (PMI) until you build up at least 20% equity in your home.
Another benefit of choosing an FHA loan is the less restrictive credit requirements. Conventional mortgages that are backed by Fannie Mae or Freddie Mac have a minimum credit score requirement of 620. By contrast, the Federal Housing Administration (FHA) has a minimum of 580. Keep in mind that these figures represent the minimum score at which each agency will insure a mortgage; individual lenders may set their credit standards higher.
Last, but not least, FHA loans are simply easier to qualify for than many conventional mortgages. This is due to several factors, including a more forgiving debt-to-income (DTI) ratio. The DTI ratio compares your monthly earnings with your monthly debt obligations. In general, FHA loans allow for higher DTI ratios. Conventional mortgages may also allow a higher DTI ratio, but you will likely pay a higher interest rate because of it.
FHA loans are also more forgiving of financial setbacks like foreclosures and bankruptcies. If you have had a bankruptcy or foreclosure in your past, you may find it difficult to qualify for a conventional mortgage. Although the restrictions are subject to change, there is a waiting period of 4 years for a bankruptcy and 7 years for a foreclosure or short sale before you can qualify for a conventional mortgage. With an FHA loan, the waiting periods are 2 years for a bankruptcy and 3 years for a foreclosure or short sale. Again, this may be subject to change so speak with your financial counselor or a qualified mortgage professional for the most accurate and up-to-date information.
Here are just a few more benefits of FHA loans to consider:
- Seller-paid closing costs may be allowed
- The down payment may be gifted from an approved source (i.e. borrower’s relative, borrower’s employer, a charitable organization, etc.)
- Can be refinanced through an FHA Streamline Refinance, which requires less time and paperwork
- Available with fixed or adjustable interest rates
Now that you’ve learned about the benefits of an FHA mortgage, let’s consider the features of this loan that may be less attractive.
FHA Loans – Cons
While FHA loans allow for easier qualification and a small down payment, that convenience comes at a cost. One such cost, and probably the single biggest drawback to FHA financing, is the mandatory mortgage insurance.
This is where things can get a little complicated, so read carefully…
With an FHA loan, the borrower is responsible for paying 2 different mortgage insurance premiums: an upfront premium and an annual premium. Although subject to change, the upfront premium currently costs 1.75% of the base loan amount. On a $150,000 house, with a 3.5% down payment, that leaves a base loan amount of $144,750. The upfront premium on a loan of that amount would equal $2,533.13. Add that to your down payment and other closing costs (inspection, appraisal, title fees, etc.) and you could be looking at $10,000 or more in upfront mortgage costs for your FHA loan. There is a silver lining though. The upfront mortgage insurance premium can be financed into your loan amount, along with many of your other closing costs. Talk to your mortgage professional for details.
Now let’s talk about the annual premium. The cost of the FHA loan’s annual premium varies depending on the loan term and the loan to value (LTV) ratio. The loan term refers to the length of time you’ll have the loan (i.e. 15 years, 30 years, etc.). The LTV ratio compares the amount of the home loan to the home’s value and is affected by the size of the down payment. For example, if you make a 5% down payment, your LTV ratio is 95%, since 95% of the home’s price is going to be financed. So, the lower your down payment, the higher your LTV — and the higher your LTV, the higher your annual mortgage insurance premium could be.
Since the FHA’s shining feature is its low down payment requirement, that feature may be dulled by the higher mortgage insurance associated with it. Still, if your dream is to become a homeowner and you simply don’t have the cash on hand to make a traditional-sized down payment, the FHA loan may be your most viable option.
- Other drawbacks to FHA loans may include the following:
- Interest rates may be slightly higher than conventional loans.
- With a conventional loan, the homeowner can cancel PMI payments once they build up 20% equity in their home. With FHA loans, the annual premium cannot be canceled, even after the homeowner builds 20% equity.
FHA Loans – The Bottom Line
FHA loans provide a more accessible path to homeownership for borrowers without a lot of cash, who may have less-than-perfect financial histories, or who are first time home buyers. They provide low money down financing and out-of-pocket savings, which can be immensely valuable for cash-strapped borrowers. However, the less restrictive eligibility requirements may come at a long term cost. It is up to each individual borrower to determine whether or not an FHA loan is a good choice for their home financing needs. If you’re considering an FHA loan and would like to learn more, please contact Trilogy Mortgage today.