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 an FHA loan can be a great option for many homebuyers, especially first-time buyers. With more flexible credit and down payment requirements than conventional loans, FHA loans provide a pathway to homeownership for those who may not otherwise qualify. However, FHA loans also come with some drawbacks to consider. In this article, we’ll break down the key pros and cons of FHA loans to help you decide if this type of mortgage is right for your situation.
What is an FHA Loan?
An FHA loan is a government-backed mortgage insured by the Federal Housing Administration (FHA). Because the FHA is part of the United States Department of Housing and Urban Development (HUD), FHA loans are a type of government loan.
The FHA was originally created to encourage lenders to offer mortgages to borrowers who may not qualify for conventional loans. FHA loans typically have lower credit score and down payment requirements than conventional mortgages. However borrowers have to pay mortgage insurance premiums to benefit from the program.
Now that we’ve covered the basics, let’s dive into the main pros and cons of FHA loans.
The Pros of FHA Loans
Lower Down Payment Requirements
One of the biggest benefits of FHA loans is the ability to get financing with a low down payment. Borrowers only need a 3.5% down payment on an FHA loan. This down payment could be as low as $10,500 on a $300,000 home purchase.
With a conventional loan, you typically need at least 5-20% down. For many buyers, saving up 20% for a down payment can take years. So being able to buy with just 3.5% down makes homeownership more accessible.
Gift funds and down payment assistance programs can also be used for an FHA down payment.
More Lenient Credit Requirements
To qualify for an FHA loan, you need a minimum credit score of just 580 if you put down 3.5%. The minimum goes up to 620 for a 3% down FHA loan. With a score in the 500-579 range, a 10% down payment is required.
Meanwhile, conventional mortgages usually require a credit score of at least 620 So FHA loans provide more wiggle room if you have less-than-perfect credit They can be a good option if you went through financial hardships like a foreclosure or bankruptcy in the past few years.
Lower Monthly Mortgage Insurance
Conventional loans with less than 20% down require private mortgage insurance (PMI). On an FHA loan, you pay mortgage insurance premiums (MIP) instead of PMI. The MIP rates for FHA loans are typically lower than PMI rates for borrowers with lower credit scores.
So if your credit is far from perfect, an FHA loan could save you money on mortgage insurance premiums.
Flexible Debt-to-Income (DTI) Ratio Requirements
Your DTI ratio compares your total monthly debt payments to your gross monthly income. FHA guidelines allow DTIs as high as 43% in some cases. On a conventional loan, DTIs over 45% often lead to denial.
So FHA loans provide more wiggle room if you have a moderate to high amount of existing debts. Adding a non-occupant borrower to your loan application can also increase DTI flexibility.
Multiple Property Types Eligible
You can use an FHA loan to buy a single-family home, townhouse, condo, or 2–4 unit multifamily property. The home just has to meet FHA minimum property standards.
With a conventional loan, multifamily homes with more than 2 units are often ineligible. So FHA loans provide more options if you’re interested in a small multifamily property.
The Cons of FHA Loans
Upfront Mortgage Insurance Premium
On an FHA loan, you have to pay an upfront mortgage insurance premium (UFMIP) of 1.75% of the loan amount. This premium is usually financed into the loan amount. But it means you’re immediately starting out with a slightly higher loan balance.
With a conventional loan, you don’t have to pay any upfront fees for PMI.
Ongoing Mortgage Insurance Premiums
In addition to the UFMIP, you’ll need to pay an annual mortgage insurance premium (MIP) on an FHA loan. The MIP runs between 0.45% – 1.05% of the loan amount per year.
On a conventional loan, PMI can eventually be canceled once you build 20% home equity. But on an FHA loan, you pay the MIP for the entire loan term if your down payment is under 10%.
So mortgage insurance costs are often higher with an FHA mortgage in the long run.
Lower Loan Limits
The maximum FHA loan amount you can borrow varies by county, ranging from around $300,000 – $900,000. In more expensive areas, FHA loan limits may be below the cost of available homes.
Conventional loans often have higher limits, especially for borrowers with excellent credit. So in high cost-of-living areas, an FHA loan may not provide enough buying power.
Stricter Home Appraisal Guidelines
To get an FHA loan, the home you buy needs to meet FHA minimum property requirements. FHA appraisal guidelines are more stringent than conventional loans.
Issues like cracked foundations, faulty electrical systems, or leaky roofs could make a property ineligible for FHA financing. With a conventional loan, minor repairs may not hold up a loan approval.
Owner-Occupancy Requirements
FHA loans require you to move into the home as your primary residence. You can’t use an FHA mortgage to buy a vacation home or investment property.
Conventional loans are more flexible – you may be able to buy a second home or investment property with 5-20% down.
So if you’re not planning on living in the home, an FHA loan won’t work for your situation.
Who Should Consider an FHA Loan?
FHA loans can be a great option for:
- First-time homebuyers with minimal cash savings
- Buyers with past credit issues or foreclosure
- Buyers with moderate to high amounts of existing debt
- Buyers interested in low down payment options
- Buyers looking to purchase a small multifamily home
Conventional loans may be a better fit for:
- Repeat buyers or those with 20% or more to put down
- Buyers with stellar credit (720+)
- Buyers interested in jumbo loan amounts
- Buyers looking to purchase a vacation home
Shop around and compare mortgage options. Look at interest rates, fees, and lender requirements to decide if an FHA loan is your best bet. Reach out to a trusted mortgage lender who can guide you through pros, cons, and pre-approval.
The Bottom Line
FHA loans provide a great avenue for qualified buyers to purchase a home with less cash and credit than what conventional loans require. But higher mortgage insurance costs and stricter borrowing guidelines are tradeoffs to consider.
Think about your financial situation, home needs, and plans for the property. Look closely at loan costs, terms, and requirements as you decide between FHA and conventional financing. This helps ensure you choose the optimal loan program to make your homeownership dreams a reality!
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 |
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
FAQ
What is a downside to an FHA loan?
Is getting an FHA loan a good idea?
Why would someone choose an FHA loan?
Why do people not accept FHA loans?