Relaxed restrictions can make FHA loans appealing, but beware these potential pitfalls that can cost you over time.
If someone told you there was a loan designed to make it easier for you to qualify for financing to purchase that dream home for sale in Austin, TX, what would you say? We’re guessing something along the lines of “sign me up.”
FHA loans present a unique borrowing option to potential homebuyers. First established during the Great Depression in the 1930s, FHA loans are mortgages insured by the Federal Housing Administration (FHA). Because of their relaxed restrictions, they can sometimes offer borrowers a better deal than conventional home loans.
But before deciding whether an FHA loan is right for you, it’s important to ensure you understand how this type of loan works — and what pros and cons come with it.
Advantages of FHA loans
Simply put, FHA loans may make homeownership more accessible. That’s because you can qualify with a down payment of just 3.5%. You can also get approved with a low credit score (although you’ll still need two lines of credit and proof that you’re paying off any credit card debts) — and still get a good, low interest rate.
It’s also easier to use money gifted to you for the down payment on an FHA loan. Some states even offer grant programs that will help you with the down payment.
Sam Farrington, a financial planner and founder of Sound Mind Financial Planning in Omaha, NE, notes that FHA loans allow borrowers to have higher debt-to-income ratios than conventional lenders will accept.
Understand how FHA loans work
There’s a catch (of course!). The Federal Housing Administration insures FHA loans. That means that if a borrower defaults, the FHA promises to pay back the bank that made the loan.
That’s why FHA loans have fewer (or more relaxed) restrictions than other loans, because the lenders aren’t taking on the risk. But the government isn’t insuring these loans because it thinks it’s a nice thing to do. As with any insurance, the borrower will need to pay a premium — and that is where FHA loans can get costly.
You need to understand the downsides before considering an FHA loan. Farrington says fees can bog down borrowers looking for FHA loans.
“FHA loans are notorious for being expensive,” he explains. “The initial mortgage rate might look competitive, but it’s the underlying insurance fees that add major expenses to the loan.” That insurance fee currently costs borrowers 1.75% upfront with an ongoing monthly fee of 0.85% for a mortgage of 15 years or more, with a loan-to-value ratio of more than 95.01%, according to senior loan officer Joe Parsons of Dublin, CA. If the loan-to-value ratio is less than 95%, the monthly fee is reduced to 0.80%.
“Usually, a borrower could remove the mortgage insurance as early as five years,” Parsons says, noting that with FHA loans, the insurance is with you for the life of the loan. “This permanent insurance is one thing that makes FHA loans far less attractive to buyers than conventional loans.”
So is an FHA loan right for you?
When looking at loans, you may want to consider going the FHA route to avoid strict requirements that often come with conventional mortgages. A conventional lender will demand a higher credit score, larger cash down payment, and a lower debt-to-income ratio.
“As a general rule, anyone who wants to make a down payment of less than 5%, regardless of their credit history, should consider an FHA loan,” advises John David Crowe, president of Southeast Mortgage in Georgia.
FHA loans might also be right for those in a buyer’s market. The reason? Under FHA, the seller is allowed to pay up to 6% of the closing costs, while with a conventional loan, a seller may be restricted to paying only 2% of the closing costs.
But before deciding, remember the potential pitfalls. Maintaining your loan for many years can end up costing you a lot. In many situations, private mortgage insurance on a conventional loan is less expensive in the long run than the various insurances you will be on the hook to pay with an FHA loan.
“Anyone with a credit score below 700 should compare both FHA and conventional financing,” says Crowe. “But [most people] with a credit score in the low to mid-600s or below would be better served with an FHA loan.”