The Downsides of FHA Loans You Should Know About

The Federal Housing Administration’s mortgage insurance program has helped millions of buyers purchase homes. FHA loans allow buyers to qualify with lower credit scores and smaller down payments than conventional mortgages. However, FHA loans also come with some significant drawbacks that buyers should understand before choosing this financing option.

What is an FHA Loan?

An FHA loan is a mortgage insured by the Federal Housing Administration The FHA does not lend money directly to home buyers but instead insures loans made by private lenders. To qualify for FHA backing, the loan must meet certain criteria set by the FHA

Some of the key features of FHA loans include

• Lower Credit Score Requirements – You can qualify with a minimum credit score of 580 if you put down at least 3.5% of the purchase price. The minimum score is 500 with a 10% down payment.

• Low Down Payments – FHA allows down payments as low as 35% of the home’s purchase price

• Relaxed Debt-to-Income Ratios – Your total debt payments, including the mortgage, can be as high as 43% of your gross income.

• Mortgage Insurance – All FHA borrowers must pay mortgage insurance premiums (MIP) for the life of the loan.

While these features make FHA financing attractive to buyers who may not qualify for conventional loans, FHA mortgages also come with some distinct disadvantages.

The Cons of an FHA Mortgage You Should Know

If you’re considering an FHA loan, it’s important to understand the key downsides:

1. Mortgage Insurance Premiums

The biggest drawback of FHA loans is the required mortgage insurance premiums. There are two separate premiums you must pay:

• Upfront Mortgage Insurance Premium (UFMIP) – This is a one-time fee equal to 1.75% of the base loan amount. It is typically financed into the loan amount.

• Annual Mortgage Insurance Premium (MIP) – The ongoing annual premium is 0.45% to 1.05% of the loan amount. It is included in your monthly mortgage payments.

For example, on a $200,000 loan amount, you would pay a UFMIP of $3,500 at closing plus an annual MIP of $900 to $2,100 per year. Over the life of the loan, mortgage insurance can cost tens of thousands of dollars.

With a conventional loan, you can usually cancel private mortgage insurance once you reach 20% equity in the home. But with an FHA loan, you’re stuck paying the premium for the entire loan term, unless you refinance.

2. Strict Underwriting Guidelines

FHA loans come with stricter underwriting standards compared to conventional mortgages. Here are some key areas where FHA is less flexible:

• Debt-to-Income Ratio – While FHA allows total DTIs up to 43%, most lenders impose stricter limits between 31% and 36%. Over 43% is hard to qualify for.

• Credit History – FHA scrutinizes your entire credit report, not just your score. Any major derogatory marks could lead to a denial.

• Employment History – You must have at least two years of steady employment in the same line of work. Self-employment income can be difficult to document.

• Funds to Close – Lenders want to see your down payment and closing costs come from your own savings, not gifts or borrowed funds.

As a result, some borrowers who think they qualify for an FHA loan end up being denied after submitting a full application. The underwriting process is stricter than expected.

3. Lower Loan Limits

In most parts of the country, FHA mortgages come with lower loan limits than conventional loans backed by Fannie Mae and Freddie Mac. Here are the 2023 FHA loan limits by region:

• Floor: $356,362
• Ceiling: $726,525
• High-cost areas: $1,089,787

In comparison, the 2023 limits for conventional loans are:

• Floor: $702,000
• Ceiling: $1,089,300
• High-cost areas: $1,089,300

If you need a jumbo loan above $726,525, you’ll have to look at non-conforming jumbo programs or take out a portfolio loan from a community bank. You can’t get FHA financing at those higher amounts.

4. Restrictions on the Type of Property

The FHA has strict requirements when it comes to the types of properties it will insure. Here are some key limitations:

• Primary Residence Only – Investment properties and second homes don’t qualify. You must live in the home as your primary residence.

• Single Family Homes – The property must be a one-unit single family residence. Two-four unit properties may qualify in some cases. Condos and townhouses are eligible subject to FHA approval.

• Condition of the Property – The home must meet the FHA’s minimum property standards and be “acceptable” condition. Homes with structural or safety issues may not qualify.

As a result, FHA loans are not a good fit for fixer-uppers or unique properties like dome homes. And you can’t use FHA financing to buy your vacation home or investment property.

5. Limitations on Cash-Out Refinancing

The FHA does allow cash-out refinancing, where you take equity out of your home in the form of cash. However, FHA has strict cash-out limits:

• Maximum loan-to-value ratio of 80%
• Maximum amount of cash that can be taken out is limited
• Cash-out refinances require full appraisals

This makes it harder for FHA borrowers to tap into their home equity compared to conventional loan programs. You may be able to take out more cash or get away with a more limited appraisal using a non-FHA refinance.

6. Slower Processing Times

FHA loans typically take longer to process and close than conventional loans. There are a few reasons:

• More paperwork and documentation is required upfront
• Appraisals may take longer due to FHA appraiser assignment rules
• The underwriting process is lengthier and stricter

According to data from the National Association of Realtors, the average time to close an FHA-insured purchase mortgage is 46 days compared to 36 days for conventional loans. So you need to plan for a lengthier mortgage process if using FHA.

When Do the Cons Outweigh the Pros of FHA Loans?

FHA loans provide a valuable option for buyers who may not otherwise qualify for financing. But in some cases, the drawbacks outweigh the benefits.

Here are a few examples where you may want to consider other mortgage programs:

• Higher Income Borrowers – If you make enough to qualify for conventional financing, the mortgage insurance and stricter credit guidelines of FHA loans may not be worth it.

• Large Loan Amounts – Due to lower loan limits, FHA is not a good fit if you need a jumbo mortgage over $726,525.

• Strong Credit History – Those with credit scores above 740 and low debt should qualify for lower interest rates with a conventional mortgage.

• ** repeating terms…
  Mortgage insurance
  Lower credit score
  Conventional mortgage
  Loan limit
  Appraisal
  credit score

• ** repeating entities…
  FHA: 76
  Conventional: 31
  mortgage: 54
  credit: 18
  score: 16
  loan: 119
  fha loan: 54
  down payment: 17
  insurance: 31