FHA Pros and Cons
TABLE OF CONTENTS
It’s worthwhile to consider FHA loan pros and cons to make sure they are right for you. We know, from the last chapter, that there are quite a few different programs available that cover a wide variety of home financing needs. FHA programs are not always the best option for folks; every borrower’s situation is unique. And that’s what makes the job of a loan officer pretty interesting; it’s fun to match the right loan our customer’s needs. Yep, there’s some creativity that goes into the mortgage business.
FHA HOME LOAN ADVANTAGES
To accommodate low and moderate income borrowers, mortgage programs regulated and designed by the Federal Housing Administration have flexible underwriting standards. In a lot of cases, this flexibility turns out to be a huge advantage. Below, we will cover the key benefits.
Smaller Down Payment
FHA purchase loans only have 3.5% down payment requirement – of the purchase price or appraised value (whichever is lower).
At this point, it would be good to familiarize yourself with the term Loan to Value (LTV) which is the ratio of the loan to the value of the home. In other words, what percentage of the home’s value does the loan amount represent?
Loan to Value = Home Value / Mortgage Amount
For example, if a property is worth $100,000 and the outstanding loan balance (known as the principal) is $90,000, thus the LTV is 90%. This is another way of saying there $10,000 worth of equity (or 10%).
When borrowers make big down payments, some of the lender’s risk is taken off the table. Let’s say you put 50% down ($50,000) on a $100,000 home. The next week, the market price of the home drops to $90,000. Well, that’s no big deal because there’s still large amount of equity remaining in the home (in this case $40,000 or 40%). There’s still plenty of value, or cushion in the home. It’s still fairly low-risk for the lender should they need to take possession of the home.
What’s cool about FHA loans is that borrowers only need to put down 3.5%. FHA’s insurance program picks up some of the slack up to 20% of the loan amount. To illustrate this, pretend you put a $3,500 down payment (3.5%) on a $100,000 house. FHA insures another 16.5%, adding up to a total of 20% (or $20,000 of the $100,000 loan). This puts lenders at ease, which is why they’re willing to do a deal even with a small down payment.
Less Strict Credit Score Requirements
580 is the minimum FICO credit score set by the FHA for borrowers who only want to pay 3.5% down on a home. But remember, the FHA is not the lender. The lender has the right to tweak things; they might have a different minimum score requirement. The credit score requirement could be lower (say 500) or higher (say 620). No matter what, your credit score won’t need to be “perfect” to get a FHA loan from any participating lender.
Scalable Credit Score Requirements
One of the ways lenders create some leeway for borrower qualification is by scaling (adjusting) the down payment requirement based on the borrower’s credit score. Requirements change from time to time as the FHA revises their policies. So, it’s best to check with a loan officer for the most recent requirements. But here’s a look at how credit scores and down payments can move together:
- Credit scores of 580 or better only require a 3.5% down payment
- Credit scores less than 580 require a 10% down payment
Said another way, risk is distributed between credit scores and down payments. Borrowers with lower credit scores are at higher risk of defaulting on their loan so their down payments need to be higher. More equity in the home at the beginning makes the lender more comfortable. Borrowers with higher credit scores are at lower risk of default so their down payments can to be lower. Less equity is needed to make the lender feel good about the deal. The bottom line is that FHA program guidelines allow this flexibility.
Allowances for an Imperfect Borrower Track Record
Another place FHA programs provide some grace is the view of one’s past. No one is perfect. We all know that. FHA guidelines are less punishing that other loan products if you’ve made a few financial mistakes in the past. For example, if your are three years out of bankruptcy and three years out of foreclosure, there is some forgiveness. A recent track record of paying bills on time and in full — especially your mortgage or rent payments — you stand a good chance of getting approved for a FHA loan.
Not Just for First-Timer: There Are Several FHA Loan Products
You’ve probably heard that FHA loans are very popular with first time-buyers. Indeed, that is true. However, there are many more programs available under the HUD/FHA umbrella Here’s a sample:
- Construction loans – build your dream home
- Energy efficient loans – decrease the cost of running a home
- Refinances – get a better interest rate
- Adjustable rate mortgages (ARMs) – you want a lower interest rate for a short period of time
- Home Equity Conversion Mortgage (HECM) – a reverse mortgage for senior citizens that converts built up equity into cash
FHA Loans are Assumable
If you sell your home, the buyer can “assume” or take over your loan and its payments (rate, payment period, principal balance, and other terms). Assumability is kind of like the hand-me-down of loans. In fact, FHA loans are one of only two kinds of mortgages that have this feature, the other being a VA loan.
Assumptions can help you sell their home faster. For example, when interest rates are rising and your existing loan’s interest rate is lower than current market rates, there’s a very attractive incentive for a prospective buyer to take over your existing loan. This can be a good deal for them, and for you if it means selling your house quickly and at a solid price. Furthermore, assumptions can help a prospective buyer if he or she has less cash for the down payment; they can just assume the loan without a big down payment that would be required on a brand new mortgage.
Lastly, an appraisal is typically not required for an assumption. Lenders still must approve the new borrower(s) via an underwriting process. Assumptions are not a slam dunk, but they do create an additional option for consideration.
FHA HOME LOAN DISADVANTAGES
As you know, the FHA aims to provide unserved populations with access to the housing market by providing lenders with insurance against losses. The insurance backstop allows lenders to make more loans to more people. Let’s cover what this is all about in more detail.
FHA Mortgage Insurance
Remember that low 3.5% down payment? It turns out that there’s flip side to that. Unless you put 20% down, FHA loans require that you obtain mortgage insurance.
So it turns out that there’s no such thing as a free lunch. Mortgage insurance is paid by you – the borrower. Premiums are added to your monthly mortgage payment which is pooled with other borrower’s payments in FHA’s Mutual Mortgage Insurance Fund. This is the fund is what sustains FHA programs.
There are two kinds of insurance: upfront and annual.
Upfront Mortgage Insurance Premium (UFMIP) is paid at the time of loan funding (closing) and is currently 1.75% of the total loan amount. The UFMIP can be rolled into the loan so that borrowers don’t have to pay out-of-pocket. Just to be clear, you still pay for it, just over time.
Mortgage Insurance Premium (MIP) is an annual insurance fee that is paid monthly for the life of the loan. The premium amount changes every few years but is currently 0.85% of the total loan amount (on 30-year, fixed rate loans).
There’s a little bit of silver lining because you can get out of paying MIP a few ways:
- Fork over a 20% down payment (hard to do).
- Borrow money from your retirement account (probably not the best option).
- Get the loan now but plan to eventually refinance out of the FHA loan down the road (the most popular option).
If your mortgage closed before June 3, 2014 your FHA MIP will cancel automatically depending upon your loan term. For a 15 year fixed rate loan, when the LTV reaches 78%. For a 30 year fixed rate loan, when the LTV reaches 78% and MIP has been paid for at least 5 years (60 months).
Due to the extra cost associated with MIP and UFMIP, conventional loans cost borrowers less than FHA loans over the lifetime of the mortgage. If you can get approved for a conventional loan, that’s typically your best bet.
The property must be occupied by the owner (not renters) as a primary residence (not as a second home or investment property). The dwelling cannot exceed four units or it becomes an apartment building. FHA allows loans for dwellings of 1 to 4 units only.
FHA programs don’t exist so that folks can buy massive luxury homes. There’s a price ceiling as well as price floor. Limits are covered in the next chapter.
Final Thoughts: FHA vs Conventional Loans
The insurance premiums added to the FHA monthly mortgage payments makes the total cost – over the lifetime of the loan – higher than conventional mortgages. But not everyone has enough for money for the down payment required for a conventional loan. Nor may they have the required credit scores.