Exploring the Downsides to FHA Loans You Should Know

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.

An FHA loan can be an excellent mortgage option for many homebuyers. The low down payment requirement flexible credit standards, and low monthly mortgage insurance make FHA loans very attractive. However, it’s important to understand there can also be some downsides to choosing an FHA loan that you should carefully consider.

While FHA loans offer many benefits, they aren’t necessarily the right fit for every borrower. Evaluating the potential drawbacks will ensure you make the most informed decision when choosing a mortgage. In this article, we’ll take an in-depth look at some of the key downsides of FHA loans that you need to keep in mind.

FHA Loan Limitations

One of the biggest downsides of an FHA loan is that it comes with borrowing limits that cap the maximum loan amount based on location. Here are some key facts on FHA loan limits:

FHA loan limits vary by county and are based on median home prices in each area. For a single family home in 2022, they range from $420,680 to $970,800
The limits are usually lower than what you can borrow with a conventional loan. Areas with higher home prices have higher FHA loan limits.
If the home you want exceeds the limit for your county you may have to make a larger down payment or use a different type of loan.
FHA limits on multi-unit homes are higher than single family caps, but it may be difficult finding a lender.

The FHA loan limits essentially put a cap on the maximum sales price or appraised value of the home you can purchase. This could be very limiting if you want to buy a high priced or luxury home, especially in more affordable areas with lower limits.

Mortgage Insurance Costs

FHA loans require you to pay mortgage insurance for the life of the loan if your down payment is under 10%. This insurance protects the lender if you default, but it comes at a cost to you as the borrower. Here are some mortgage insurance downsides with FHA loans:

You must pay an upfront premium of 1.75% of the loan amount at closing. This can add thousands to your upfront costs.
There is also an annual mortgage insurance premium built into your monthly payments. This is 0.85% for loans with under a 15 year term and 1.05% for loans over 15 years.
On a $300,000 loan, you may pay over $300 per month in mortgage insurance costs.
You pay this insurance for the life of the loan unless you refinance. With a conventional loan the PMI can be removed once you reach 20% equity.

The mortgage insurance costs can add significantly to the total interest paid over the loan term. This is one of the top drawbacks of FHA loans to consider if you plan on staying in the home long term.

Restrictions on the Type of Home

FHA has guidelines in place to minimize risk that put restrictions on the types of homes you can purchase. This includes:

The home must be your primary residence where you live at least 9 months per year. No second homes or investment properties.
FHA has minimum property standards. The home must pass an appraisal inspection evaluating its structural and safety conditions.
Condos and manufactured homes have additional FHA requirements to be eligible. Options are more limited.
Multi-unit homes with 2-4 units can be purchased but have added criteria as well.

These property restrictions could make it more difficult to buy certain types of homes with an FHA loan. If the home you want doesn’t meet the eligibility guidelines, you won’t be able to move forward with FHA financing.

Higher Interest Rates

Given the relaxed borrower requirements, FHA loans typically come with higher interest rates compared to conventional mortgages. Here’s how interest rates can be a downside:

Rates are often around 0.5 to 1% higher for FHA loans than rates for conventional conforming loans.
On a $250,000 loan amount, a 1% higher rate results in over $2,300 more in interest paid per year.
Over the full 30 year term, you may pay $50,000+ more in total interest costs.
Refinancing later to a lower rate often comes with thousands in fees to process the new loan.

The higher interest rate is one of the tradeoffs for easier approval standards. But it can really add up over time so be sure to run the numbers carefully.

Stricter Borrower Requirements

Despite being more flexible than conventional loans, FHA loans come with borrower requirements that could make it difficult for some to qualify:

Minimum credit score is generally 580. Those with scores below 500 may not be approved at all.
Total debt-to-income ratio must be below 43%. This includes all recurring monthly debt payments.
You must show at least two years of steady employment history. Self employed borrowers face additional rules.
Any collections or judgments must be paid off first before closing on an FHA loan.
Bankruptcies and foreclosures require multi-year waiting periods to qualify for a new FHA loan.

While not as strict as conventional loans, the FHA requirements could still result in loan denial for those with more credit or income challenges.

The Bottom Line

FHA loans can be a great option for many buyers, especially first-time homebuyers. But it’s wise to carefully weigh the potential downsides compared to other loan programs. Be sure to consider FHA loan limitations, mortgage insurance costs, home eligibility requirements, interest rates, and borrower qualification criteria before making a decision.

Getting pre-qualified and talking to an experienced loan officer will help you determine if an FHA loan is the optimal choice or if you’d be better served with a conventional or other government-backed mortgage option. Don’t let the downsides deter you – FHA may still be your best route to homeownership. But making an informed decision upfront will help set yourself up for long-term success.

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.

Advantages and Disadvantages of FHA Loans

Pros	Cons
Low Down Payment	Loan Limits
Low Credit Score Requirements	Higher Mortgage Insurance
No Income Limit	Strict Property Standards
Multiple Housing Options	Occupancy Requirements
Low PMI	Continuing Mortgage Insurance

The Good and BAD of FHA Loans | NEW FHA Loan Requirements 2023

FAQ

What are the downsides of an FHA loan?

More mortgage insurance paid: Because you are making a lower down payment, you will have to pay more private mortgage insurance (PMI) to make up the difference. With FHA loans, you also have to pay an upfront mortgage insurance fee.

Why do sellers avoid FHA loans?

Some reasons a seller might refuse an FHA loan include misconceptions about longer closing times, stricter property requirements, or the belief that FHA borrowers are riskier.

Why are people not accepting FHA loans?

Unfortunately, sellers often perceive the FHA loan approval process as risky because of the FHA’s relatively lenient financial requirements and stricter appraisal and property standards.

Is it a good idea to get an FHA loan?

In general, borrowers with good credit and strong financials will be better off with a conventional mortgage, while those with poorer credit and more debt, as well as would-be homebuyers who simply don’t have the cash for a larger down payment, can benefit from an FHA loan .