The Federal Housing Administration (FHA) provides mortgage loans that can be used as a tool for first-time homebuyers to qualify for a loan. A limited number of buyers may also qualify for FHA loans. They are only offered through approved private lenders.
What makes the FHA mortgage a unique lending product is that it is an insured loan. The government absorbs the cost of a default instead of the lender, which allows households that may not normally qualify for a traditional mortgage to still have the opportunity to purchase a home.
About 8 million mortgages are currently insured through the FHA. Since its founding in 1934, over 38 million mortgages have been insured by the program. Here are the FHA loan pros and cons to think about.
List of the Pros of FHA Loans
1. Lower credit scores qualify for FHA loans.
Borrowers are able to obtain an FHA loan with a lower overall credit score than they would with a traditional mortgage product. In 2018, households who qualify for an FHA loan must have a minimum FICO score of 580 to receive a down payment advantage. If their credit score is below 580, they still aren’t excluded from the program. They just need a bigger down payment.
2. Down payment options are lower than traditional mortgages.
With a traditional mortgage product, lenders may require a down payment of up to 20% before they will approve the loan. With FHA loans, a household with a FICO score of 580 qualifies with a 3.5% down payment. If the credit score is below 580, then a 10% down payment is required. For those with a credit history that is somewhat questionable, an FHA loan makes it possible to qualify with lower requirements.
3. Interest rates are still competitive with FHA loans.
After the Great Recession, the idea of offering sub-prime loans became the foundation of numerous horror stories. With FHA loans, however, the interest rates are competitive with traditional lending products. For some borrowers, the interest rates offered by these government-backed mortgages are actually lower than what higher credit households might receive to encourage home ownership.
4. Fees are lower on FHA loans.
The closing costs of FHA loans tend to be lower than they would be with a comparable traditional mortgage product. Mortgage insurance and other fees are typically lower for borrowers with this loan as well.
5. Foreclosures or bankruptcies in the past are not exclusionary.
As long as borrowers meet the requirements of an FHA loan, including two lines of credit for those who qualify, then they are not excluding from this type of loan. Households are typically required to meet certain requirements, such as offering a good payment history, having good credit after the bankruptcy or foreclosure, or specific stipulations which are related to their unique financial picture.
6. Co-buyers are permitted with these loans.
FHA loans do require owner-occupancy for approval. They do allow for co-buyers to live away from the home, assuming that the co-buyer is a U.S. citizen or permanent resident. Non-family co-buyers limit the loan-to-value ratio available for the loan, however, which can reduce the amount of the overall mortgage which is available.
List of the Cons of FHA Loans
1. Mortgage insurance can be a long-term cost.
Because FHA loans qualify in the sub-prime lending arena, the mortgage insurance payments tend to be a long-term requirement. Some homeowners may be required to make these payments with their mortgage for several years before their credit profile improves enough to eliminate them. That cost can add thousands of dollars to the monthly home expense on an annual basis. If you can put together a 20% down payment on a traditional mortgage, this cost typically goes away.
2. Defaults disqualify applicants from the FHA program.
The U.S. government will not offer an FHA loan to anyone who has a defaulted product with any government agency. The most common reason for a default is an unpaid student loan. A default remains for several years, even after the financial responsibility of it has been completed. For that reason, anyone with a defaulted student loan is encouraged to go through a loan rehabilitation process if it is available to them.
3. Owner-occupancy is required.
FHA loans are typically not something that can be used for investment properties. If a household qualifies for an FHA loan, then they are required to live on that property. Co-buyers that are outside of the household do not have this requirement. Should buyers separate after purchase, the possibility of a required home sale as part of the settlement process may be required.
4. There is an upfront mortgage insurance premium to pay.
This cost is typically about 1.75% of the base loan amount. An annual premium of about 1% in the base loan amount is also required. Many lenders can roll these costs into the loan, which reduces out-of-pocket expenses for borrowers. That can be advantageous, though it also means the monthly required mortgage payment is somewhat inflated compared to what it would be otherwise.
5. Property restrictions apply.
Even some owner-occupied properties are excluded from FHA loans. Condominiums tend to be the one specific type of property that receive the most exclusions. Condo projects must be government-approved before a loan will be granted. For urban home buyers, that may limit the number of property options which are available to them.
6. Some home owners may avoid FHA offers.
Because there are certain inspection requirements for homes that receive an FHA offer, property owners can sometimes disregard offers made with this lending product. Although sellers may sometimes be required to cover some of the closing costs of an FHA loan still, the purchasing negotiations can often limit this responsibility. Even then, however, a transaction tends to “feel” easier with cash-in-hand or a traditional mortgage when compared to an FHA mortgage.
7. You must have the down payment to qualify.
If you cannot make the required down payment, then you typically do not qualify for the FHA loan. In the past, some borrowers were able to make a $0 down payment with this lending product because the down payment was rolled into the mortgage itself. Although some exceptions may still apply, buyers should expect to pay at least 3.5% down when trying to purchase a home.
These FHA loan pros and cons make it possible for some households to qualify for a mortgage when they may not qualify for a traditional lending product. The primary question to ask is this: would it be better to spend the money on a down payment for a home? Or would it be wiser to use financial resources to improve your credit score? Evaluating these key points can help you determine what choice to make for your own finances.