FHA Home Loan Pitfalls
FHA Home Loans Aren't Perfect
FHA loans are popular because they make it easy for almost anybody to buy a home. Homeownership is a reality for more and more people, but these loans aren’t for everybody. Make sure you fit the right profile and that you understand the disadvantages of FHA loans before you fall in love with them.
FHA Loan Highlights
Even with damaged credit and limited funds for a down payment, you can qualify for a home loan with a decent interest rate.
Down payment: FHA loans allow you to put down as little as 3.5%. This allows you to buy a more expensive home with less money, and you can reserve funds for improvement projects or other goals.
Credit issues: borrowers with a troubled credit history have a hard time getting approved with conventional lenders. With FHA backing, you can get approved with a low credit score.
Home improvement: FHA 203k loans allow you to fund home improvement projects and buy a house at the same time. Combined with other features of FHA loans, they make things easy and inexpensive.
Drawbacks of Using an FHA Loan
When purchasing a home, it’s wise to evaluate whether or not an FHA loan will actually help you. Look at the big picture and consider all of your financial goals.
Low down payment: a low down payment could be a red flag. Putting down 3.5% might be a sign that you’re not yet on solid financial ground, and taking on a home loan could be risky.
Is it worth looking at less-expensive homes or waiting until you can save up a larger down payment? Remember that the more you borrow, the more interest you pay (which essentially makes your house more expensive).
Upfront insurance: putting down less than 20% means you’ll have to pay mortgage insurance, and FHA loans come with two types of insurance that you’ll pay for the entire life of your loan.
There’s an upfront charge of 1.75%, and many borrowers choose to wrap this fee into the loan balance. Again, the more you borrow, the more interest you pay – so you’re paying more than 1.75% unless you write a check at closing. A larger loan also means you’ll have a larger monthly payment.
Ongoing insurance: you’ll also pay ongoing (monthly) mortgage insurance. Ongoing mortgage insurance premium (MIP) amounts are between 0.80% and 1.05% of your loan balance, although they can go as low as 0.45% if you get a 15-year FHA loan. That extra cost means you’ll pay more each month. Unlike private mortgage insurance, which can be canceled once you get above 20% equity in your home, FHA insurance cannot be canceled (unless you got your loan before June 3, 2013). In other words, you’ll have to pay off your loan or refinance to eliminate that cost.
Loan choices: for better or worse, you’ve got limited choices when using an FHA loan. For most borrowers, a standard 15-year or 30-year fixed loan is a perfect choice – so there’s no problem here. However, there are some situations when an interest-only mortgage or an adjustable rate loan is a better fit. Don’t just use those products for the lower payment – make sure you’ve got a larger plan.
Property limitations: getting an FHA loan approved requires a property that meets certain standards. For example, basic health and safety requirements must be met. If you’re looking for a fixer-upper, a major bargain, or certain foreclosures, an FHA loan isn’t going to work. For properties that are move-in ready, an FHA loan should be fine. However, buying a condo can be challenging: if not enough of the units in your building are owner occupied (or other problems arise), an FHA loan might not be an option.
Qualifying: FHA loans don’t always get approved. You still might need a minimum credit score, and you will need to document sufficient income to repay the loan. To qualify for the lowest down payment, you’ll need a FICO score above 580, but you can get approved with lower scores if you’re planning to make a larger down payment.
Seller hesitation: in some situations, an FHA loan can be a disadvantage when buying a home. Sellers like to know about potential buyers (real estate agents may share this information), and an FHA loan does not signal strength. What’s more, the seller may fear that extra requirements are going to slow down (and potentially threaten) the deal. If you’re buying in a hot market, try for another form of financing.
Standard home loans (that aren’t backed by the FHA) solve many of the problems above. Even if you think you won’t get approved, it’s worth shopping for a conventional loan – just to see what offers are available. With conventional loans, you’ll have more flexibility, and you still might be able to buy with as little as 5% or 10% down.
For military borrowers, VA loans are also worth a look.
HUD policies and FHA loan features change regularly. This article might not reflect the most recent changes, and you might miss out on important financial benefits. To get up-to-date information, speak directly with a HUD representative or a HUD-approved housing counselor. For contact information, visit HUD.gov.