While there’s a lot to like about FHA loans, they may not be right for everyone. Before you make a major financial commitment, it’s important to understand the pros and cons of FHA loans. Only then can you truly decide whether it’s right for you.
Getting approved for a mortgage can be tricky, especially if you have less-than-perfect credit or limited funds for a down payment. This is where FHA loans come in. Backed by the Federal Housing Administration (FHA), these government-insured mortgages make homebuying possible for more borrowers with flexible credit and down payment options.
But FHA loans aren’t perfect. While they provide more access to homeownership, FHA mortgages also come with some distinct disadvantages you need to consider. As you weigh your options, it’s important to understand these potential FHA loan drawbacks.
In this article, we’ll explore the top 10 disadvantages of FHA loans to be aware of if you’re considering this financing option. Understanding the limitations can help you make the most informed decision when seeking a mortgage.
1. Strict Borrowing Limits
One major disadvantage of FHA loans is the limit on how much you can borrow Known as the “conforming loan limit”, the maximum FHA loan amount varies by county but typically ranges from around $300,000 to $600,000 In more expensive areas, you may be able to borrow up to around $800,000.
These county-specific limits are much lower than what you may be able to get with a conventional loan. If you need to finance an expensive or luxury home, an FHA loan likely won’t cover the full purchase price. The limits make FHA mortgages impractical for many high-cost housing markets.
2. Required Mortgage Insurance
All FHA loan borrowers must pay mortgage insurance, called MIP, for the life of the loan. With a down payment under 10%, you pay an annual MIP premium added to your monthly payments. Even with over 10% down, MIP is still required for at least 11 years.
This insurance protects the lender, not you Conventional loans let you cancel PMI once you reach 20% equity. The lifetime MIP requirement causes you to pay more in the long run compared to conventional mortgages
3. Limitations on the Type of Home
FHA loans can only be used to finance single family homes, condos, and units in small multifamily buildings up to 4 units. You cannot use an FHA loan to purchase investment properties, vacation homes, manufactured homes, cooperative units, or other unique property types.
If the home you want doesn’t meet FHA’s definition of an eligible property, you’ll need to seek alternative financing. The strict property standards limit the options for buyers who want something outside the traditional single family home.
4. Inspection and Appraisal Requirements
Before approving an FHA loan, the property must pass both an appraisal and a separate home inspection looking at safety and structural soundness. If issues are found, you may have to pay for repairs before closing. This inspection process creates an extra hoop not present with conventional mortgages.
Problems uncovered during inspection could also make your deal fall through altogether. This risk could cause you to lose a home you love. The strict appraisal and inspection regime can complicate or derail an FHA purchase.
5. Lower Loan-to-Value Ratios
The maximum loan-to-value (LTV) ratio allowed with FHA financing is lower than what conventional lenders may offer. This ratio compares how much you can borrow against the total appraised value. The lower the ratio, the more cash or equity you need upfront.
For example, FHA limits LTV to 96.5% for purchases. But many conventional lenders will go up to 97% or higher, allowing you to put even less money down. The lower LTV ratios result in higher cash requirements compared to conventional alternatives.
6. Limitations on Cash-Out Refinancing
The benefits of cash-out refinancing are more limited with FHA loans compared to conventional options. Cash-out lets you tap equity by refinancing into a larger mortgage payment to access the difference in cash.
But FHA has stricter regulations, including a seasoning requirement and lower maximum loan amounts for cash-out refis. You may only be able to pull out enough to cover closing costs. The cash you can access is much lower than what conventional lenders may allow.
7. Slower Processing and Approval Times
Due to added red tape and requirements, FHA loans typically take longer to process, underwrite, and approve versus conventional mortgages. From the initial application to closing day, you can expect the FHA loan process to be lengthier.
These delays could cause problems if you’re up against contract deadlines or need to close quickly to get moved in. Depending on your timeline, the slower pace of FHA approvals could present an issue.
8. Not Ideal for Repeat Homebuyers
One big FHA loan disadvantage is they aren’t the best option for repeat buyers. The main perks of FHA loans apply to first-time buyers with credit or down payment constraints. If you have great credit and equity from selling a previous home, a conventional mortgage likely makes more sense than using an FHA loan again.
While FHA mortgages can be used by any qualifying repeat buyer, you lose out on benefits like better rates and flexible terms offered by conventional alternatives better suited to your improved financial profile.
9. Requires Upfront Mortgage Insurance Premium
On top of monthly MIP, all FHA borrowers must pay an upfront mortgage insurance premium (MIP) at closing of 1.75% of the loan amount. This upfront fee isusually rolled into the loan balance. With a $200,000 loan, you would pay $3,500 upfront.
This added cost hurts your equity position right out of the gate. No upfront MIP is required with conventional loans. This closing day fee is an extra headache you have to deal with when getting an FHA mortgage.
10. Prepayment Penalties Apply
Finally, FHA loans come with prepayment penalties that don’t exist with most conventional mortgages. This penalty kicks in if you refinance or sell the home within the first few years of getting the original FHA loan.
The prepayment penalty could limit your flexibility and cause you to incur added costs if your situation changes shortly after purchasing your home. This restriction could deter you from refinancing even when interest rates drop.
Should You Still Consider an FHA Loan?
As you can see, FHA loans come with some distinct disadvantages you need to keep in mind. From stricter requirements to higher costs, there are many drawbacks to these government-backed mortgages. However, don’t let the downsides scare you away completely.
Despite their limitations, FHA loans still offer benefits that help borrowers with limited funds or credit challenges who may not qualify through conventional channels. If you have minimal savings or past credit troubles, an FHA mortgage likely remains your best option and the only path toward homeownership.
While not ideal for every buyer, FHA loans fill an important niche that provides more access for underserved groups. The disadvantages may be worth it for the home financing opportunities gained. Just go in with eyes wide open about the potential pitfalls ahead of time.
Understanding the pros and cons of FHA loans allows you to determine if this type of mortgage makes sense for your individual home buying situation. Carefully weigh both sides as you evaluate if an FHA-insured mortgage is your best choice on the journey to owning your dream home.
Pros of FHA Loans
An FHA loan is designed to help potential homebuyers with less-than-perfect finances buy a home. It offers many potential benefits that you may not be able to get when applying for a conventional mortgage. Here’s a closer look at some of the most important advantages of an FHA loan.
If you don’t want to wait forever to buy a home, the lower down payment requirement is one of the biggest FHA loan advantages. Most FHA loans allow you to put down as little as 3.5% of the purchase price. This is a huge advantage for buyers who dont have a large savings account or have limited financial resources. Other mortgage products may have down payments closer to the 20% mark.
Taking advantage of this opportunity can help you get into a home many years sooner than you could if you had to save up a larger amount.
Lower Credit Score Requirements
Many people with bumps in their credit history worry that they wont be able to qualify for a home loan. Luckily, FHA loans are available to borrowers with less-than-ideal credit.
Most lenders will write FHA-backed loans for borrowers with credit scores of 580 or higher. If you’re in the 500-579 range, don’t despair. You can also qualify for an FHA loan, but you may need to come up with a 10% down payment instead of the standard 3.5%.
Note: Paddio currently looks for credit scores of 620 and above.
FHA loans are also sometimes a good option for people who have recently gone through a foreclosure or bankruptcy. Depending on your circumstances, you may be able to qualify for an FHA loan within one to two years after the incident.
FHA loans don’t have any minimum or maximum income requirements. This is a unique benefit not found in many other mortgage products, aside from the USDA loan. This means that higher-income earners with credit problems can still qualify for FHA loans. Even if you make a substantial salary each year, you can still benefit from the lower down payment and relaxed approval requirements.
You can use an FHA loan to purchase multiple types of properties. This includes single-family homes, condominiums on permanent land, manufactured homes on permanent land and multifamily homes with up to four units – though you may have a hard time finding a lender willing to do a manufactured loan.
This gives you plenty of options and some room to get creative. For example, you could buy a multifamily home and use the rent you would charge on the other units to qualify for the loan, as long as you live there as well.
Note: Paddio does not offer FHA financing for manufactured homes
If you put less than a 20% down payment, most conventional loans require you to carry Private Mortgage Insurance (PMI). This insurance provides the lender protection in case you fail to repay your loan. The premiums for PMI are often much higher if you have bad credit. With an FHA loan, however, you’ll pay the same insurance premium regardless of your credit score. If you’re credit-challenged, this could save you a significant amount of money over the lifetime of your loan.
The Good and BAD of FHA Loans | NEW FHA Loan Requirements 2023
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