Don’t Get Burned: 8 Potential Downsides of FHA Loans to Know Before You Borrow

FHA loans make homebuying possible for many buyers who can’t qualify through conventional lending. Their flexible credit and down payment options open doors for purchasers who are still building credit or lack resources for a large down payment

But FHA mortgages also come with some potential negatives buyers should understand before they commit. While FHA benefits allow more access to financing the trade-off is often higher costs over the long run.

As you weigh FHA loan pros and cons, here are 8 potential downsides to consider:

1. Upfront Mortgage Insurance Premiums

All FHA borrowers must pay an upfront mortgage insurance premium (MIP) of 1.75% of the total loan amount. On a $300,000 loan, this premium is $5,250 upfront.

You can roll the MIP into your loan amount rather than pay upfront. But either way, it’s an extra cost you won’t find with conventional loans.

2. Ongoing Mortgage Insurance Premiums

In addition to the upfront premium, FHA borrowers must pay an annual MIP every month. This ongoing insurance ranges from 0.45% to 1.05% of your loan amount per year.

On that $300,000 loan, your yearly MIP could cost $1,350 to $3,150 annually. You pay this monthly premium as long as you have the loan or for at least 11 years.

3. Mortgage Insurance Lasts Longer

Speaking of ongoing MIP, FHA mortgage insurance typically lasts the full loan term if you put down less than 10%. With conventional loans, you can cancel PMI once you build 20% home equity.

But with an FHA loan, you’ll keep paying the monthly premium unless you refinance. For buyers who won’t build equity quickly, years of MIP can really add up.

4. Lower Loan Limits

FHA conforming loan limits max out at $647,200 in most counties for 2023. In pricier real estate markets, FHA caps stretch to around $1 million.

But conventional loans go higher – up to $970,800 in standard areas and exceeding $1 million in costly metros. If you need a jumbo mortgage above FHA limits, you’ll need a conventional loan.

5. Tighter Debt-to-Income (DTI) Allowances

FHA used to allow total debt ratios up to 55%. But since late 2021, they now cap DTIs at 43% like conventional loans.

If your total monthly debts exceed 43% of income, an FHA loan may no longer be an option. This tighter DTI allowance closes the door for some buyers who previously qualified.

6. Strict Credit Standards

FHA minimum credit scores are 580 or 500-579 with 10% down. But some lenders overlay stricter standards, like requiring scores of 620 or 640 to qualify.

If your score falls below a lender’s FHA floor, you can’t use their programs. Shop around for a lender with lower credit requirements if this affects your eligibility.

7. Limitations on the Types of Homes

FHA has strict property requirements and won’t finance homes that fail their minimum quality standards. Conventional loans are more flexible if you want to buy a fixer-upper requiring extensive repairs.

FHA also won’t finance non-traditional homes like houseboats, dome homes or buses converted to residences. Make sure the home you want fits FHA’s criteria.

8. Requirement to Be Owner-Occupied

You can only get an FHA loan for a primary residence you plan to live in. FHA doesn’t finance investment or second home purchases.

If you want to buy a vacation home or rental property, a conventional loan is your only option. Keep this FHA occupancy rule in mind for your plans.

Key Questions to Ask About FHA Cons

When weighing the potential negatives of an FHA loan, ask yourself:

• How long will I keep this mortgage until I refinance or move? The longer you stay, the more those MIP costs accumulate.

• Will I put down more than 10%? If so, you can drop MIP after 11 years instead of the full term.

• How quickly can I build 20% home equity? Conventional PMI goes away sooner once you reach 20% ownership.

• Does the home I want cost more than FHA limits in my area? Check your county’s max loan amount.

• Is my DTI over 43%? FHA may no longer work if your debts exceed 43% of income.

• Does my credit score fall below my lender’s minimum? Each lender sets their own FHA floor.

• What kind of property condition is the home I’m buying? FHA is stricter than conventional financing.

Asking these questions will reveal whether potential FHA disadvantages could be problematic for your situation.

Alternatives to Consider

If FHA loan cons have you reconsidering, here are some alternate options:

• Conventional 97 – Just 3% down with no PMI. But you need good credit.

• VA loans – Zero down payment option for veterans, but with a funding fee.

• USDA loans – 100% financing in rural designated areas if income eligible.

• Conventional loans – Best rates with 20% down and strong credit credentials.

Even if FHA has perks you want, run the numbers to see if another loan saves you more over time.

The Bottom Line

FHA borrowers trade lower credit and down payment requirements for higher long-term costs in most cases. But for many purchasers, FHA is their only path to homeownership.

Carefully weigh the potential drawbacks against the benefits before making your decision. An FHA loan can be the right choice as long as you understand and prepare for the negatives that may come with it.