FHA Loan Pros and Cons
The Federal Housing Administration (FHA) is a government agency created to stimulate the housing industry and make homeownership more accessible. One of the primary ways it accomplishes those goals is to insure mortgages for approved lenders. There are significant FHA loan pros and cons to help you determine whether they might be a good fit for you.
When an FHA borrower defaults, the lender can claim a significant portion of the unpaid principal balance from the government agency. That reduces the risk to the lender, so it’s often easier to get an FHA loan than a conventional mortgage.
That said, no mortgage option is the right choice for everyone.
Pros of FHA Loans
As government-backed mortgages, FHA loans have significant advantages. Most of them make it easier to qualify for FHA loans than other home loans. Here are the ones you should know.
Low Down Payment and Credit Score Requirements
FHA loans have lower credit score requirements than most other mortgages. To get a loan from an FHA-approved lender, you only need to have a FICO Score 8 of 500, where most mortgages require at least 620.
However, be aware that your credit score impacts the size of your minimum down payment. If your score is between 500 and 579, you’ll have to put down at least 10%. If it’s 580 or above, you can put down 3.5%.
FICO scores range from 300 to 850, so a 500 credit score should be attainable for most prospective homeowners. FICO considers anything below 579 a poor credit score.
If you have bad credit, a credit builder loan like Credit Strong’s can help you increase your score to prepare for a future mortgage. There’s no credit check to apply, and you’ll finish with a nice chunk of change to use as a down payment. Give it a try today!
If you don’t have time to improve your score before buying your home, you can still get a mortgage. Find out How to Buy a House With Bad Credit.
Higher Debt to Income Ratio Is Acceptable
Your debt-to-income (DTI) ratio equals your monthly debt payments divided by your gross monthly income. For example, if you have a $500 monthly payment for your car and make $4,000 a month, your DTI ratio is 12.5%.
Mortgage lenders use the ratio to assess whether your income is high enough relative to your monthly obligations for you to reasonably afford your prospective mortgage payment.
They’ll consider your DTI before your mortgage, but the more important measurement is the ratio with your mortgage’s monthly payment included, known as your back-end DTI ratio.
The DTI ratios for VA loans, USDA loans, and conventional loans are 41% (VA and USDA) and 43% (Conventional), respectively. However, you can get away with a DTI ratio of 50% with an FHA loan.
Can Be Applied to Multiple Housing Types
While you can generally only use an FHA loan for your primary residence, you have some flexibility on the property type. In addition to traditional single-family homes, you can use FHA financing to buy properties with up to four units.
That means you can use FHA loans to get into properties with multiple units, live in one, and rent out the rest. That’s a great way to start investing in real estate without going through the typical hurdles involved in financing an investment property.
In addition to the standard FHA loan program, there are options for condos, new constructions, and rehabs, such as the FHA 203(k) loan. You can use them to finance other types of properties and projects.
No Income Limits
The last reason FHA loans are easier to qualify for than other mortgages is that there are no income limitations. You can’t earn too little or too much to receive an FHA loan.
Contrary to popular belief, lenders don’t generally have minimum income requirements. As long as you earn enough to pay for your monthly mortgage payments and other debts, they’ll be happy.
However, some government-backed loans have maximum income limits to reserve their loans for lower-income households.
For example, United States Department of Agriculture (USDA) loans limit you to 115% of the median income in the surrounding area. If the median income is $40,000 in your town, earning more than $46,000 disqualifies you.
FHA loans don’t have those kinds of restrictions, so you can still qualify with an above-average income.
Cons of FHA Loans
FHA loans have benefits that make them an attractive option for many prospective homebuyers, especially those that might struggle to qualify for other types of home loans.
However, they have some drawbacks that might make them less useful for people with other options. Here are their most significant downsides.
Higher Down Payment Requirements
While lenders and sellers generally want you to put down at least 20%, you can often get away with much less. Conventional loans only require 3%, and you may not have to put down anything for USDA or VA loans.
Unfortunately, FHA loans require a minimum of 3.5% down. That’s still not very much, but it’s higher than the requirements of other financing options available.
You’ll also need to have a credit score of at least 580 to qualify for that option. If your score is between 580 and 500, you can still get an FHA loan, but you’ll need to put down at least 10%.
Down payments are the most significant obstacle to homeownership, which means FHA loans may be unusable for some would-be homebuyers.
If you don’t have the money for a deposit, you can still get a mortgage, even with bad credit. Find out How to Buy a House with No Money Down and Bad Credit.
Higher Total Mortgage Insurance Costs
If you don’t put down at least 20%, you’ll have to pay some form of mortgage insurance for conventional loans, and most government-insured loans require it regardless. VA loans are an exception, letting you put as little as 0% down without penalty.
Unfortunately, you can’t say the same for FHA loans. Even if you put more than 20%, you’ll pay upfront and recurring mortgage insurance premiums (MIP).
The upfront fee is 1.75% of your loan amount, which you’ll pay at closing. The recurring costs vary depending on your loan amount, down payment, and loan term, but they range from .45% to 1.05% per year.
For comparison, a USDA loan only costs 1% upfront and .35% per year. In both cases, the fastest way to get out of your recurring payment is usually to refinance into a conventional loan at 20% equity.
Note that the FHA streamline refinance loan program lets you rapidly refinance your FHA loan into another FHA mortgage with a lower rate, but it won’t get you out of MIP.
Limited to Primary Residence
FHA loans make homeownership accessible to many people who might not be able to qualify otherwise. However, they’re completely unusable for anyone that isn’t looking to live in their property for at least the entire first year.
In other words, FHA loans aren’t typically beneficial for investors looking to finance their next deal or anyone that’s looking to buy a second home.
Living somewhere else during the first year of your FHA loan is occupancy fraud, and you’ll face fines and possibly even jail time if someone catches you.
Limited Principal Balance
FHA loans restrict their maximum principal balances, which may prevent you from buying the house you want. The FHA loan limits depend on where you live and the property type.
In 2022, the maximum FHA loan limit for a single-unit property is $420,680 in low-cost areas. In high-cost areas, the maximum is $970,800.
The higher the cost of living in your area and the more units in your prospective property, the higher those numbers become.
You can look up the FHA mortgage limits near you using the Department of Housing and Urban Development’s online database.
FHA Loans vs. Conventional Loans
FHA loans and conventional loans are two mortgage types that people often have to choose between. To help you determine which one’s right for you, here’s a high-level overview of some of the most significant differences between them.
FHA Loans vs. Conventional Loans
|Mortgage Type||Minimum Credit Score||Minimum Down Payment||Maximum DTI Ratio||Mortgage Insurance||Principal Limit (2022)|
|FHA loans||500 or 580||10% or 3.5%||50%||1.75% upfront plus .45% to 1.05% annually||$420,860 to $970,800|
|Conventional loans||620||3%||43%||.56% to 1.86% annually depending on credit score||$647,200 in most counties|
As you can see, FHA loan requirements are generally less restrictive than conventional mortgage loan requirements. They have lower credit score minimums and allow for higher DTI ratios.
However, a conventional loan may offer better terms if you qualify for one. You can provide a lower down payment and pay less in private mortgage insurance as a result. In addition, they may have a higher borrowing limit in areas with a low cost of living.
Is It Good To Buy a House With an FHA Loan?
Whether it’s good or bad to buy a house with an FHA home loan depends on your circumstances and the other financing options available to you.
FHA loans are one of the most accessible mortgage types. If it’s the only type of home loan you can qualify for, then there’s nothing wrong with using one to buy your house.
However, if you could qualify for another mortgage type, then an FHA loan might not be your best choice. Other home loans may have superior terms, though they probably won’t have lower interest rates.
For example, if you can qualify for a VA loan, it’ll almost always be superior to an FHA loan. You can put down 0% and pay no mortgage insurance, while FHA mortgage insurance would cost you 1.75% upfront and up to 1.05% every year of the loan term.
Why Are FHA Loans Bad?
FHA loans aren’t a bad financing option, but they’re not ideal for everyone. Their primary drawbacks are:
- Higher down payment requirements: You must put down at least 3.5%. If your credit score is less than 580, you’ll have to put down at least 10%. Meanwhile, you can put down as little as 0% with other options.
- Increased mortgage insurance costs: If you put down less than 20%, you’ll pay 1.75% upfront and up to 1.05% annually. VA loans, USDA loans, and conventional loans are all potentially less expensive.
- Property limitations: You can only use FHA loans for your primary residence. There are also upper limits on FHA loan principal balances that vary by location and property size.
All that said, FHA loans can still be a great borrowing option, especially for people who would struggle to qualify for the alternatives. They may even have a lower interest rate than you could get otherwise.
What Is the Catch With an FHA Loan?
FHA loans have lower credit score and debt-to-income ratio requirements than other home loans. However, while that makes them more accessible for a less qualified home buyer, their terms aren’t quite as competitive.
You’ll usually need a higher down payment to qualify than you would with other types of loans. At a minimum, you have to put down 3.5% with an FHA loan. If your credit score is between 500 and 580, you must put down 10%.
Meanwhile, VA and USDA loans let you put down 0%, and conventional loans only require 3% down. In addition, you’ll pay a higher mortgage insurance rate with an FHA loan than you would with another type of mortgage.
FHA loans charge mortgage insurance fees equal to 1.75% of the loan amount upfront and up to 1.05% each year. USDA loan mortgage rates are 1% and .35%, respectively, while VA loans charge nothing at all.
Conventional loans depend on your credit score, but you can request that your mortgage lender cancel it as soon as you reach 20% equity.
Finally, FHA loans have principal balances limitations, which may restrict your housing options.
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