The Pros And Cons Of An FHA Loan: Explained
In the pursuit of homeownership, affordability and accessibility are essential considerations. This is particularly true for borrowers navigating the real estate landscape for the first time or with limited financial means. Among the options available, FHA loans can help ease the financial barriers of buying a home. However, additional monthly costs and FHA housing standards can still make your quest to become a homeowner difficult. Becoming well-versed in the pros and cons of FHA loans will allow you to navigate the obstacles and accomplish your dream of homeownership.
What Is An FHA Loan?
An FHA loan is a mortgage loan the Federal Housing Administration (FHA) insures. The FHA is part of the U.S. Department of Housing and Urban Development (HUD). While the FHA doesn't give mortgage loans from the government, it backs loans that FHA-approved lenders give to borrowers who can't get financing through a conventional mortgage. This insurance protects the lender if the borrower defaults on the loan, making it less risky for lenders to extend mortgages to individuals who might not qualify for conventional loans.
FHA loans have lower financial requirements, helping borrowers get the mortgage they need to finance a home purchase. As a result, first-time home buyers and low-to-moderate-income households often use this loan type if they lack the financial standing to qualify for a conventional loan.
However, FHA loans also have higher appraisal standards. This aspect is a double-edged sword: on one hand, the standards could prevent a borrower from buying the home they want because of an issue such as water damage. On the other hand, the standards help borrowers find safe homes. As a result, the government ensures it’s investing in a livable, inhabitable property when it backs an FHA loan.
FHA Pros And Cons: At A Glance
FHA loans are more accessible to borrowers, but the benefits come with specific costs. Here’s a rundown of the pros and cons of FHA loans.
Low minimum credit scores
Stricter appraisal rules
Low down payments
Mortgage insurance premiums (MIPs)
Less strict debt-to-income ratio requirements
Adjustable-rate interest fluctuations
Favorable interest rates
Compensating factors for applications
Benefits Of An FHA Loan
FHA loans offer borrowers advantages to increase accessibility and affordability. Here are the benefits of an FHA loan to expect:
1. Lower Minimum Credit Scores
FHA loan credit score minimum requirements range between 500 and 580, depending on the lender. This can help credit-challenged borrowers qualify for a mortgage. It’s advisable to have a score of at least 580 because scores beneath this threshold the minimum down payment requirement increases from 3.5% to 10% and necessitates a lower housing expense ratio and debt-to-income ratio.
2. Low Down Payments
The down payment requirements for FHA loans are 3.5% of the loan amount for borrowers with credit scores of 580 or higher. For comparison’s sake, conventional loans usually require 5% down unless you’re a first-time home buyer or make not more than 80% of the median income in your area. As stated above, scores lower than 580, may increase the FHA down payment requirement to 10%. As a result, qualifying for an FHA loan means you’ll need several thousand dollars to put down in most cases. For example, a $200,000 home would require a $7,000 down payment for a borrower with a credit score of 580 or higher.
Remember, the down payment is separate from closing costs, which cost 3% to 6% of the purchase price. So, you’ll need a lump sum to cover both the down payment and the closing costs, including origination fees, MIP fees and appraisal fees. Fortunately, the reduced down payment could help you afford the closing costs.
3. Less Strict Debt-To-Income Ratio Requirements
Your debt-to-income ratio (DTI) is how your monthly debt obligations compare to your income. The FHA may accept borrowers with up to a 57% DTI ratio. When you apply for an FHA loan, lenders consider your debt (like student loans, auto loans, credit cards and a housing payment) and divide the total by your monthly income. The resulting percentage is your DTI. For example, $1,000 of monthly debt payments and $3,000 of monthly income equals a 33% DTI, which would qualify you for an FHA loan.
4. Favorable Interest Rates
FHA loans have backing from the federal government, meaning your lender will still receive payment if you default on your loan. For this reason, FHA loans have competitive interest rates, increasing the affordability of your monthly mortgage payment.
In addition, the FHA offers both fixed-rate and adjustable-rate loans, each with their perks and caveats. Fixed-rate loans have a consistent interest rate throughout the life of the loan. This way, the loan payment never changes, giving your budget stability. However, if interest rates dip in the future, your fixed rate won’t match it. You’ll keep the rate you received when you first received the loan.
Conversely, adjustable-rate mortgages (ARMs) offer a low introductory interest rate, helping you save money for the introductory period of the loan. Then, the rate adjusts according to current market rates. This adjustment could raise or lower your interest rate depending on overall economic factors. As a result, your monthly payment might jump if interest rates spike in the future. The tradeoff is the lower rate at the beginning of the loan and the potential to keep a low rate if the market is favorable.
5. Compensating Factors for Applications
FHA loans help borrowers with suboptimal financial circumstances, such as a lower credit score or income. Compensating factors increase the likelihood of approval when you apply for a loan. Specifically, lenders consider your cash reserves, income from other sources, monthly debt payments, how much the loan increases your housing costs and your desired home's energy-efficiency. These aspects of your application can offset a DTI or credit score that isn't ideal as long as DTI is still within the product limits.
6. Repeated Use
FHA loans are advantageous for first-time home buyers because of the relaxed financial constraints. However, borrowers can use them as often as they wish. As a result, you can apply for an FHA loan whether you’re buying your first home or downsizing for retirement.
Drawbacks Of An FHA Loan
FHA loans also have several potential pitfalls that can increase costs and create stricter requirements.
1. Stricter Appraisal Rules
The appraisal rules for FHA can be prohibitive when you’re looking for a home. FHA appraisals provide standards to help borrowers find safe homes and protect the government from investing in homes with damage and glaring problems. Here are the main aspects of a home that FHA appraisals consider:
- Lead paint
- Water damage
- Access to clean, hot water
- Electricity, lighting and power lines
- Proper sewage disposal
- Adequate heating
- Driveways and sidewalks
- Soil contamination
- Crawl spaces
Because the government requires homes to meet these minimum quality standards, borrowers must pay for an appraisal. The FHA appraiser will come to the home and spend a few hours inspecting it for issues. If they discover any, it’s up to the buyer to negotiate with the seller over fixing the problems. If they reach an agreement about doing the repair, the FHA loan will finance the purchase.
If you and the seller aren’t seeing eye to eye on repairing the problem, you’ll need to back out of the deal. This possibility is why it’s crucial to include an inspection contingency in your initial offer. Otherwise, you’ll lose your deposit when you back out of the deal.
2. Mortgage Insurance Premiums
FHA loans require borrowers to pay mortgage insurance premiums (MIPs) at closing and throughout the life of the loan. Specifically, you’ll pay 1.75% of the loan amount at closing as your upfront MIP. Then, you’ll pay MIPs of 0.15% to 0.75% of the loan amount every year. For example, a $200,000 mortgage with a 0.5% MIP would cost $1,000 spread over the year. This expense would increase your monthly mortgage cost by about $83 monthly.
The upfront MIP can be daunting because of the down payment and other closing costs due when you purchase the home. If you can’t afford this upfront cost, you can roll it into your loan amount instead. Doing so allows you to pay for it over time along with the rest of your loan. However, it will also increase your monthly payment and overall loan costs.
3. Adjustable-Rate Interest Fluctuations
If you choose an adjustable-rate FHA loan, your interest rate won’t be consistent. Instead, your loan will adjust periodically once your introductory rate expires. The adjustment might occur every 6 months or once annually, depending on your loan terms. Each adjustment is a chance for your interest rate to climb, increasing your monthly payment. This scenario could lead to an unaffordable house payment, putting you in danger of defaulting.
The Bottom Line
An FHA loan allows borrowers, particularly first-time home buyers and those with low to moderate incomes, to achieve homeownership. The appeal of FHA loans lies in their lower financial requirements, including a reduced down payment, more flexible credit score criteria and less strict debt-to-income ratio requirements. These features make homeownership more accessible to a broader range of individuals who may face challenges qualifying for conventional loans.
The decision to opt for an FHA loan depends on individual financial circumstances, preferences and the specific trade-offs a borrower is willing to make. As with any financial decision, prospective homeowners should thoroughly explore the pros and cons, considering their unique situation to make an informed choice that aligns with their homeownership goals. If the advantages of an FHA loan sound appealing, you can learn more about FHA loan rates and requirements before applying.