FHA Home Loan Disadvantages and What You Should Know

FHA loans are popular because they make it relatively easy to buy a home. Still, these loans aren’t for everybody. Make sure you fit the right profile and that you understand the negative aspects of FHA loans before you sign up for one.

FHA Loan Highlights

First, a few highlights of FHA loans. Even with damaged credit and limited funds for a down payment, you can qualify for a home loan with a decent interest rate.

• Credit issues: Borrowers with a troubled credit history may have difficulty getting approved by conventional lenders. With FHA backing, you can often get approved with a low credit score and even a history of bankruptcy or foreclosure.
• Down payment: FHA loans allow you to put down as little as 3.5% if you have a credit score of 580 or better, or 10% if your credit score is between 500 and 579. That can potentially enable you to buy a home sooner or with less cash required. As a result, you can reserve funds for other financial goals.
• Home improvement: FHA 203(k) loans allow you to fund home improvement projects and purchase a house at the same time. Combined with other features of FHA loans, they make it relatively easy and inexpensive to qualify for certain properties.

Drawbacks of Using an FHA Loan

There are several reasons to avoid an FHA loan, including higher costs upfront and in every payment.

• Not being ready to take on a mortgage: A small down payment could be a red flag. Putting down 3.5% might be a sign that you’re not yet standing on solid financial ground, and taking on a home loan could be too risky for you at this time. Is it worth looking at less-expensive homes or waiting until you can save up a larger down payment? Remember that the more you borrow, the more interest you pay, which essentially makes your house significantly more expensive.
• Upfront insurance: When you put down less than 20%, you must pay for mortgage insurance. FHA loans come with two types of insurance. There’s an upfront charge of 1.75%, and some borrowers choose to wrap that fee into the loan balance. Again, the more you borrow, the more interest you pay, so you’re paying more than 1.75% unless you write a check at closing. A bigger loan also means you’ll have a larger monthly payment.
• Ongoing insurance: You’ll also pay ongoing (monthly) mortgage insurance. Ongoing mortgage insurance premium (MIP) amounts are between 0.80% and 1.05% of your loan balance, although they can go as low as 0.45% if you get an FHA loan with a term of 15 years or fewer. Private mortgage insurance can often be canceled once you get above 20% equity in your home. But with an FHA loan, you typically must pay monthly MIPs for the first 11 years of the mortgage’s term if you put 10% down or for the first 30 years (which means for the entire term of the loan if the term length is the maximum number of years allowed) if you put less than 10% down. To eliminate that cost earlier, you’ll have to pay off your loan or refinance it.
• Limited loan options: For better or worse, you’ve got only basic choices when using an FHA loan. For most borrowers, a standard 15-year or 30-year fixed-rate loan is an excellent choice, so the limited options may not be a problem. But there are some situations when an interest-only mortgage or an adjustable-rate loan would be a better fit.

• Property limitations: The property must meet basic health and safety requirements if you’re going to get approved for an FHA loan. If you’re looking for a fixer-upper or a major bargain, an FHA loan might not work. For properties that are move-in ready, an FHA loan should be fine. However, buying a condo can be challenging: If not enough of the units in your building are owner-occupied (or if other problems arise), an FHA loan might not be an option.
• Seller hesitation: In some situations, an FHA loan can be a disadvantage when buying a home. Sellers like to know about potential buyers (real estate agents may share this information), and an FHA loan does not signal strength. What’s more, the seller may fear that extra requirements are going to slow down (and potentially threaten) the deal. If you’re buying in a hot market, you may want to explore other forms of financing.

Alternative Loans

Standard home loans—which aren’t backed by the FHA—avoid many of those problems. Even if you have doubts as to whether you will get approved, it’s worth shopping around for a conventional loan just to see what offers are available.

For military borrowers, VA loans are also worth a look. You might be able to buy with 0% down and no monthly mortgage insurance.

Frequently Asked Questions (FAQs)