FHA loans are a consistently popular type of loan, with roughly 20% of all loan applicants going that route. The loans offer a flexible option for those with debt, low savings or credit challenges and is a great option for first time home buyers. They can be beneficial in many circumstances.
It is a government loan. The down payment with an FHA loan can be as low as 3.5% of the home's value, even if the buyer has a low credit score. It also allows a higher debt to income ratio than a traditional conventional mortgage.
With a conventional loan, homeowners must put at least 20% of the home's cost as a down payment to avoid payment of private mortgage insurance, or PMI, and you must have at minimum a 620 credit score. Conventional loans also have stricter debt to income ratios.
One reason why a homebuyer may want to go with an FHA loan, particularly those with good credit, is simply because of the lenient guidelines. A buyer may be able to get pre-approved for much more on an FHA loan than a conventional loan.
Because FHA requires only between 3.5% of their purchase price as a down payment and 10% for those with credit scores between 500 to 579, it's a good option to buy a home more quickly than saving 20% of the purchase price.
Read more: Saving for a down payment
Despite the multitude of benefits, it's not without challenges.
It can be more expensive in the long run. Every FHA loan requires a mortgage insurance premium (MIP) on top of the loan amount. The MIP is rolled into the loan and is currently a flat percentage at 1.75% for all loans. There is also PMI (private mortgage insurance) that needs to be paid on a monthly basis.
Because the PMI is for the life of the loan, it's a good reason to consider refinancing as soon as possible.
There is also a required upfront mortgage insurance premium (UFMIP) which is 1.75% of the loan amount. The UFMIP is due in full at closing or it can be rolled into the mortgage amount. 99% of the time borrowers choose to roll it into the loan.
Even if a 20% down payment is made, FHA would still require the monthly PMI, the expense of the MIP and PMI can negate any potential savings. PMI and MIP are not calculated based on credit scores, so those with good credit will pay the same as someone with lower credit.
Usually, FHA loans have competitive interest rates to conventional loans, but sometimes the rate can be higher, particularly for those with a low credit score. It's worth investigating all financial implications before deciding on an FHA loan.
It must be used for a primary residence. One benefit is the ability to use it for multifamily homes or condominiums in addition to single-family homes. But regardless of the home type, it must be a primary residence. Anyone purchasing a second home or rental property cannot utilize an FHA loan.
Some financial struggles are acceptable; significant struggles are not. An FHA loan is flexible in allowing those who have poor credit scores a chance to still purchase a home if they have a low debt to income ratio and if they have money to cover a portion of the down payment. It's also a viable option for those who have high credit scores and high debt or for homebuyers who have high credit and low debt but very little money for a down payment.
But it isn't an option for those with all three challenges of a poor credit score, high amount of debt, and no cash for a down payment. In that case, the only choice is to improve one of those three circumstances, ideally taking time to improve a credit score while simultaneously chipping away at any debt.
An approved FHA appraisal must take place. While most homes should have an inspection and appraisal before closing, an FHA loan requires that the appraisal be done by a HUD-approved property appraiser. This ensures that a home being purchased is safe in terms of structural stability, hazardous materials, and roofing. It must also have adequate heating, water and electricity. It's possible that a home will be denied based on area-related issues, such as being too close to an airport or no access for emergency vehicles.
Those wishing to purchase a low-priced fixer-upper may not be able to use an FHA loan if it doesn't meet these basic standards. The standards were put into place because the Federal Housing Administration backs the loans and wants to ensure the home will be in good condition if it has to be seized due to non-payment. It also protects the buyer by ensuring the home is in reasonable living condition.
Generally speaking, a home appraisal determines the value of the home. The FHA appraisal is not a home inspection, although the appraiser will make determinations about basic home safety. Because the FHA appraisal does not go into the same detail as a true home inspection, a separate home inspection is strongly recommended at an additional expense.
Usually, the buyer pays for the FHA appraisal with a cost of at least $400 - $800, depending on property size and location.
Sellers may be hesitant to accept buyers with FHA loans. Considering that the appraisal has specific guidelines, sellers may prefer to consider offers from buyers with conventional loans. Sellers may be leery because they feel they will have to make additional changes or upgrades if there are issues with the FHA appraisal.
There are limits to loan amounts. In areas with higher costs of living and high home prices, it can be challenging to find an affordable home to buy, particularly with an FHA loan. For 2021 the loan cap has been increased to $822,375. This is specific only to high-cost areas such as Los Angeles County, San Francisco County, Orange County, and Santa Cruz County.
For lower-cost areas, the limit is $356,362 for a single-family home. Many California counties have limits somewhere in between. Because California's cost of living and home prices are significantly higher than the rest of the country, it still may be a challenge to find housing within these limits.
FHA loans have many benefits and are a great option in the right circumstances. Knowing the pros and cons of each type of loan - and the financial implications of each one - is the best way to ensure your home purchase is less stressful in the long run.