The Downsides of FHA Loans You Should Know About

FHA loans can seem very attractive to homebuyers because of their low down payment requirements and flexible credit standards. However, there are some significant downsides to be aware of before taking out one of these government-backed mortgages. In this article, I’ll explain the major drawbacks of FHA loans that you should factor into your decision.

Higher Mortgage Insurance Premiums

One of the biggest negatives of an FHA loan is that you have to pay mortgage insurance premiums for the life of the loan. With a conventional loan, you can usually stop paying private mortgage insurance once you reach 20% equity in the home.

But with an FHA loan, you have to pay an upfront mortgage insurance premium of 175% of the loan amount at closing Then you have to pay an annual mortgage insurance premium that gets added to your monthly payments. This premium varies between 0.45% and 1.05% depending on your down payment amount and loan term.

Over the life of the loan, you could end up paying tens of thousands in mortgage insurance. This additional cost can make FHA loans more expensive than conventional financing over time.

Tighter Loan Limits

Another drawback of FHA loans is that they come with lower maximum loan limits than conventional mortgages. The highest FHA loan amount you can borrow is based on a percentage of the conforming loan limit set by the Federal Housing Finance Agency.

For 2023, the baseline conforming loan limit is $726,200. But the highest FHA loan limit is only $1,089,300 for high-cost areas. In moderate cost areas, the max you can borrow is around $500,000. So if you need a jumbo loan above these amounts, you’ll have to look at non-FHA options.

Stricter Appraisal Guidelines

When you apply for an FHA loan, the property you want to buy needs to pass a stringent appraisal process. FHA appraisals evaluate the home’s structural integrity, safety, soundness, and overall condition. Even minor issues like chipped paint or a cracked driveway can cause a property to fail.

If the appraisal uncovers problems that need to be fixed, you’ll have to pay for repairs before closing on the home. And if the issues are too costly or extensive, you may be denied financing altogether. This stricter appraisal process makes closing on a home with an FHA loan trickier.

Limitations on Non-Owner Occupants

FHA loans come with restrictions regarding non-owner occupants that you won’t find with conventional loans. Non-owner occupants are people who will live in the home but aren’t on the mortgage, like parents, children, or siblings.

With an FHA loan, you can only have one non-owner occupant. Additionally, that person can’t be your spouse or domestic partner. These limitations make FHA loans less fitting for multi-generational households or properties with accessory dwelling units.

Ineligibility for Streamlined Refinancing

Once you have an FHA loan, refinancing to a lower rate can be more difficult compared to a conventional mortgage. FHA streamline refinancing lets you refinance without undergoing income verification or an appraisal. But you need to have made at least six consecutive payments on your current FHA loan to qualify.

With a conventional loan, you can do a limited cash-out or “no cash out” refinance anytime you want. The FHA’s stricter refi requirements mean you may miss out on savings if rates drop during your first 6 months of homeownership.

Lengthier Closing Timelines

Closing on an FHA loan tends to take longer than closing on a conventional mortgage. FHA loans require more paperwork and have more rigid underwriting standards. Lenders need to closely verify your income, assets, employment, and credit history.

The FHA appraisal process can also delay closing if repairs need to be made. And FHA loans require second reviews from underwriters before approval. Altogether, expect the FHA loan process to take around 60 days from application to closing.

Lower Loan-to-Value on Cash-Out Refis

If you want to do a cash-out refinance to tap your home equity, FHA loans max out at a lower loan-to-value ratio. With an FHA cash-out refinance, you can only borrow up to 80% of your home’s appraised value.

Meanwhile, conventional cash-out refinancing goes up to 85% loan-to-value in some cases. So you may be able to get more cash from the equity in your home with a non-FHA loan.

More Difficult to Remove PMI

As mentioned earlier, you have to pay mortgage insurance for the life of your FHA loan unless you make a 10% down payment. With conventional financing, you can request to cancel private mortgage insurance once you build 20% home equity.

Removing PMI from an FHA loan is possible but challenging. First, you need to have paid the annual mortgage insurance premium for at least five years. Then your loan-to-value ratio has to be 78% or lower. And you’ll need an appraisal proving your home value has increased.

Very few borrowers actually succeed in canceling FHA mortgage insurance. So it’s safe to assume you’ll pay it until you pay off the loan.

Alternatives to Consider

If the downsides of FHA loans outweigh the benefits for you, here are a few alternatives worth looking into:

• Conventional 97 Loan – Only 3% down and more flexible credit requirements than standard conventional loans. However, mortgage insurance is required.

• VA Loan – No down payment needed if you’re an eligible veteran or service member. Also no monthly mortgage insurance.

• USDA Loan – 100% financing available in designated rural areas for low-to-moderate income borrowers.

• Down Payment Assistance Programs – State and local programs provide grants or loans to cover your down payment and closing costs.

• Piggyback Loan – Combines a first mortgage with a second HELCO or home equity loan to avoid private mortgage insurance.

The Bottom Line

FHA loans provide a valuable pathway to homeownership for buyers who may not qualify through conventional means. However, the trade-off comes in the form of higher long-term costs and stricter borrowing guidelines. Carefully weigh the pros and cons before choosing an FHA loan as your mortgage option.