Saturday, April 13, 2024

What Are the Downsides of FHA Loans?

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Editor’s Note: This story originally appeared on MortgageResearch.com.

The Federal Housing Administration (FHA) loan program is a fantastic homebuying program. It allows many buyers with lower credit scores and incomes to buy a home.

But are there downsides to this program compared with a conventional loan?

Downside 1: ‘Permanent’ Mortgage Insurance

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The most well-known “con” for FHA loans is the “permanent” mortgage insurance.

“Permanent” is in quotations because no mortgage insurance is actually permanent. It’s true that if you keep the FHA loan forever, your mortgage insurance never drops off automatically.

However, you can cancel FHA mortgage insurance by refinancing into a conventional loan when you reach 20% equity. Most people don’t keep the FHA loan for more than a few years. Either they refinance into a better rate or loan or sell the home.

Conventional mortgage insurance drops off without refinancing or selling the home. This happens automatically when you reach 22% equity. For example, you reach a loan balance of $234,000 on a $300,000 home.

However, conventional mortgage insurance can also be hundreds of dollars more per month if you have a credit score below 740. It’s better to have a more affordable monthly payment using FHA than to have cancelable mortgage insurance.

Downside 2: Upfront Mortgage Insurance Fee

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FHA loans require something called an Upfront Mortgage Insurance Premium, or UFMIP. This is a fee equal to 1.75% of the loan amount. You don’t have to pay this in cash. Most buyers wrap this into the FHA loan.

However, the fee results in a higher final loan amount and slightly higher monthly payment.

  • FHA Loan: $100,000; UFMIP: $1,750; Final Loan Amount: $101,750
  • FHA Loan: $200,000; UFMIP: $3,500; Final Loan Amount: $203,500
  • FHA Loan: $300,000; UFMIP: $5,250; Final Loan Amount: $305,250
  • FHA Loan: $400,000; UFMIP: $7,000; Final Loan Amount: $407,000

UFMIP is a downside because it raises your loan amount, thereby decreasing your equity in the home. That could be a problem if you have to sell within the first three to five years.

It typically costs about 10% of the home’s full sale price to sell it.

Example of What It Takes to Break Even With an FHA Loan

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In the example below, the home would need to appreciate 9% just to break even. It could take three years or longer to gain that much value in a normal market.

  • Home Price: $300,000
  • Base FHA Loan (after 3.5% down): $289,500
  • Final FHA Loan (incl. UFMIP): $294,566
  • Approx sale price needed for loan payoff: $327,000
  • Home appreciation needed: $27,000 (9%)

If you plan to buy with FHA, make sure you’ll be in the home more than three to five years.

Downside 3: It’s Harder to Get an Accepted Offer

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There’s a perception among home sellers and their real estate agents that FHA buyers are not creditworthy and may have their loan denied after making an offer.

While this does happen (to all buyers, not just those using FHA), it’s rare. Still, the perception alone could cause a seller to reject your offer.

When you make an offer on a home, you must state the type of financing you are using: conventional loan, FHA loan, all cash, etc. Those who indicate FHA are at a disadvantage in multiple-offer situations.

This is why you should go after less in-demand homes if you need an FHA loan. Maybe the home needs cosmetic fixes or for some other reason, has been sitting on the market for more than 30 days.

These sellers would be glad to see any offer and would likely accept yours.

Downside 4: Stricter Property Requirements

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A home financed with an FHA loan needs to meet property standards set by the Department of Housing and Urban Development, or HUD. The home must meet livability and safety standards such as:

  • Having sufficient heating systems
  • No peeling paint on older homes (lead poisoning hazard)
  • No exposed electrical wires
  • Adequate roof
  • No missing decks or stairs
  • No foundation or structural issues

The actual HUD list is much longer, but you get the point. A home with major deficiencies won’t be financeable with FHA.

Conventional loans aren’t as strict about the property condition. Some people are able to buy a run-down home with conventional, but not FHA, depending on the issues. Keep in mind, though, that conventional loans also require the property to be in decent shape.

Should You Get an FHA Loan?

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Despite having a bad reputation, FHA loans are one of the best loans on the market.

For buyers with a credit score of less than 740, the FHA usually offers more affordable payments, thanks to better rates and mortgage insurance fees.

Check with a lender whether you qualify for conventional loans, FHA, or both. Get monthly payment quotes for both, and make your decision from there.

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