If you’re a recent college graduate, newly married, or just haven’t had the income to save up for a 20% down payment on your first home, you might have been told to look into an FHA loan. If you’re also new to the world of real estate and mortgages, like me, you might be wondering what an FHA loan is and what makes it such an attractive option for many first-time home buyers.
What are FHA-Insured Loans?
FHA stands for the Federal Housing Administration, a government agency that’s been around since 1934. Although the term “FHA loan” is commonly used, the FHA doesn’t lend money — it’s just the world’s largest mortgage insurer. The FHA insures high-risk home loans provided by certain lenders.
To help you determine if an FHA loan is the best option for you, let’s look at some of the basic advantages and disadvantages it comes with.
The Appeal of FHA Loans
First, an FHA-insured loan might be your only option if you have low income or bad credit since the requirements are easier to meet and they have more flexible qualification standards. Getting an FHA-insured loan on a home so you can start building equity is better than nothing, in many cases.
Still, the greatest appeal of an FHA-insured loan for first-time homebuyers is the lower down payment requirements. Most FHA loans only require 3.5% down (if your credit is good enough). Since the loan is backed by the government, lenders are more willing to risk financing a greater percentage of a home’s selling price.
FHA loans are also more forgiving of lower credit scores. As of writing, you need a credit score of 500 to qualify, and a score of 580 to qualify for the lowest down payment percentage (3.5%). However, your individual lender may require a higher score to be willing to finance you.
Third, FHA-insured loans allow closing costs to be covered by the lender, seller, or builder. If your seller is eager enough to sell the house, they may be willing to negotiate these expenses, which range from 2 to 5 percent of the home’s selling price.
Finally, FHA loans are also appealing because they do allow some hardship relief if disaster strikes and you get behind on your mortgage.
Now that we’ve looked at the appeal, let’s consider the disadvantages.
Why You Might Not Want an FHA-Insured Mortgage
Before discussing the loan’s features, there’s some basic math to consider. The smaller your down payment, the more you’ll be financing. That means paying more interest over the lifetime of the loan. With a down payment as low as 3.5 percent, you’ll pay significantly more interest than if you could swing 20 percent (not to mention the effect of recently raised interest rates).
The second biggest thing to consider is that FHA-insured loans come with PMI (private mortgage insurance). Conventional loans with less than 20% down still require PMI in most cases, but an FHA loan’s PMI is especially costly. You’ll need to pay (or finance) 1.75 percent of the loan amount up front, plus an annual premium that’s divided into your monthly mortgage payment. The yearly insurance rate depends on your loan amount, length, and other factors, but it often exceeds 1 percent. What’s more, you won’t be able to drop PMI for at least 11 years, if not the lifetime of your loan.
Finally, FHA-insured lenders are pickier about which houses they’ll finance, so you’ll have a more limited choice of houses, regardless of whether you’re willing to buy a fixer-upper. When it comes time to have the home inspected, you’ll have to use an FHA appraiser, as well.
So, what’s the bottom line?
If you can’t wait until you’ve saved more money for a down payment, have especially bad credit, or have no other options, an FHA-insured loan can help you buy a home. On the other hand, if you can qualify for a traditional loan and have time to save up for a 20% down payment, do it. Don’t let the appeal of paying less at the start fool you – you’ll be paying much more in the long run.