Federal Housing Administration (FHA)

FHA Loans: The Pros and Cons

With housing prices skyrocketing in major cities across the country, lots of prospective homeowners are moving their timeline up — way up. So many markets seem to be on the cusp of booming, everyone is trying to get their foot in the door before it gets slammed in their face.

But as eager as some are to buy, their finances might not reflect it. Low credit and insufficient savings for a down payment continue to squash the homeownership dreams of people all over the country. That’s where FHA loans come in.

An FHA loan is a mortgage insured by the Federal Housing Administration, designed to help disadvantaged homebuyers secure a mortgage. They often come with low interest rates, looser guidelines for qualifying and other perks.

FHA loans can be a dream come true — for the right buyer. They also come with fees you won’t encounter with a regular mortgage and could encourage some to bite off more than they can chew. Here’s a breakdown to help you figure out whether an FHA loan is right for you.

Pros of FHA loans

What makes FHA loans attractive is they only require a down payment of 3.5%. This is one of the easiest ways to qualify for a mortgage. Most conventional loans require applicants to put down at least 5%, and more commonly 20%. For borrowers looking at a $200,000 home, that’s a difference of $3,000.

Saving for a down payment is hard for most consumers, especially if they’re dealing with high rent, student loans, and credit card debt. A low down payment makes homeownership accessible to more people and speeds up their homebuying timeline. Dating back to the Depression, FHA loans have helped people who struggle to save for the oft-recommended 20% down payment.

FHA loans are also perfect for low-income earners or those with less-than-perfect credit scores because the program is designed to work with financially disadvantaged consumers. Many of those people will have trouble qualifying for a conventional mortgage, so an FHA is their only option. Buyers usually need a credit score of 620 or higher to be approved for a conventional mortgage but need a minimum score of 580 for an FHA loan.

Also, FHA loans typically have better or similar interest rates to other mortgages. The current interest average for a 30-year fixed rate FHA loan is 4.5% while a conventional loan is 4.125%.

Cons of FHA loans

Because FHA loans only ask that their borrowers put down 3.5%, consumers have a higher monthly payment. Many lenders also give out lower interest rates if buyers put down a bigger down payment.

Some financial experts worry the lower down payment means people take on more than they’re comfortable with.

“FHA loans are great because they can help you get into a home with a lower down payment and interest rate, but don’t let that put you into a home you can’t afford,” said Eric Rosenberg of Personal Profitability.

FHA loans also come with their own mortgage insurance premium (MIP), an annual cost of 0.8% to 1.05% of the loan. Homebuyers who pay less than 20% down with a conventional mortgage must pay private mortgage insurance (PMI), but it after 20% equity is reached on the house. FHA’s mortgage insurance premium stays on for the life of the loan. Only people who refinance their loans can get rid of this insurance.

FHA funding fee

Not only do FHA loans come with mortgage insurance premiums, they also require a one-time fee of 1.75% of the home’s value. That amount can be paid upfront in cash or financed as part of the mortgage. For a $200,000 house, this would be $3,500. That doesn’t include any other fees, such as closing costs or origination fees.

“The rules changed in the last few years to make FHA loans not as much of a deal as they once were,” said Lee Huffman of Bald Thoughts. “Previously, you could eliminate the mortgage insurance premiums once your balance was paid down to 78% of the original loan amount.” For originations on or after June 3, 2013, FHA requires MIP to be paid for 11 years if your original loan-to-value ratio is 90% or lower, and for the life of the loan if it’s more than 90%.

FHA mortgage insurance also costs much more than PMI, which is usually .5% to 1% of the loan. This difference can cost homeowners thousands of dollars more if they get an FHA loan.

If an FHA loan is right for you

While FHA loans have many perks, they also carry fees that don’t come with conventional mortgages. First-time homebuyers should consider applying for a conventional mortgage first. If they don’t qualify, then they can look into an FHA loan.

“Make sure you understand how the payments are affected by a lower down payment and what the lower interest rate means,” Rosenberg said. “If you could afford the same home with a bigger down payment, you will have a lower monthly payment and lower interest charges over time.”

Most lenders are qualified to offer FHA loans. However, rates, fees, and terms vary widely from one lender to another. Check out the rates and terms of leading mortgage lenders before you make a choice.

Still have questions about FHA loans? Check out our comprehensive FHA FAQ.