If you stumbled upon this article as a result of an Internet search you did, it’s quite possible that you are that excited home buyer who just found out that an FHA loan might help you buy that home for which you did not meet the requirements with a regular, conventional loan.
If you are that person, what you heard is right. An FHA loan does offer you that advantage.
“It does? Even if I don’t have very good credit?” Yes, absolutely.
That’s too good to be true. What’s the catch?
Well, you are one smart home buyer. The fact that you are trying to do more research, by reading this article, confirms that.
The not-so-smart ones are probably already submitting an FHA loan application to their lender. Without understanding the nuances and the downside that comes with it.
“Wait. Nuances? Can you please explain in more detail?”
Most certainly. That’s why we even bothered to write this. Let’s start with the basics of an FHA loan and then get into the fine print so you make a very informed decision.
What is an FHA loan?
Most of us dream of buying a home. While that is a desire we all have, not every one of us meets all the requirements that most lenders impose for us to qualify for a loan. Things like credit, income, minimum down payment etc.
As a result, to help such people buy a home, the US Department of Housing and Urban Development (HUD) runs a program called the FHA Loan program.
The way this program works is that within the HUD, there is an agency called the Federal Housing Administration (FHA).
The main role of this agency is to ‘insure’ the loans made under the program so the FHA-approved lenders feel more comfortable making loans to borrowers that don’t qualify some of the requirements.
Without its advantages, the FHA loan program wouldn’t even exist. And there are plenty.
But just like all other good things in the world, they come with their share of downsides. We’ll go through each of those in detail.
Advantages of an FHA loan
Let’s discuss the advantages first:
Low down payment
One can get an FHA loan with a down payment as low as 3.5% of the value of the property. This includes 2 to 4 unit properties, where one of units is occupied by the owner.
Now you may have heard that one can get a conventional loan for an even lower minimum down payment of 3%. But that comes with multiple caveats:
Firstly, for you to be able to qualify for a conventional loan with a 3% down payment, your median FICO® 5 credit score has to be greater than 620. If your score is lower than 620, you may not qualify.
Secondly, for you to get a conventional loan with a 3% down payment, you either have to be a first time home buyer or your median income has to be below 80% of the Area Median Income (AMI). Without those, you’ll have to put at least 5% down.
Lastly, the subject property has to be a one-unit property. If you are looking for an owner-occupied 2-4 unit multi-family property (duplex/triplex/quadruplexes), the minimum down payment required for conventional loans is 15%.
Buying an owner-occupied multi-family house using an FHA loan can help you become a homeowner and a landlord with just 3.5% down payment.
Easier credit requirements
The minimum credit score required for a conventional loan is 620. The loan cannot be approved if the score is below that.
The FHA loan, on the other hand, allows a credit score that is as low as 580 with a 3.5% down payment. What’s more. If you can make a down payment of 10% or more, you can qualify for an FHA loan even with a score below 580 (to as low as 500).
Even for borrowers with FICO® 5 credit score exceeding 620, depending on the actual FHA vs. conventional rates offered by a lender, an FHA loan can be a compelling choice (Remember to shop for mortgage options!).
Lower mortgage rates
The mortgage rates for FHA loans are typically lower than conventional loans. The main reason is that FHA loans are insured by the Federal Housing Administration (FHA). This reduces the risk for lenders and hence they are able to offer lower rates.
While rates for FHA loans are lower, one word of caution is that because FHA loans have a monthly mortgage premium, when comparing with a conventional loan option, always take that into account to see which one costs them less overall.
Assumability essentially implies that an FHA loan taken by a borrower can be transferred to another person (provided the new borrower qualifies of course).
Because loans are assumable, in a rising rate environment, this can be very beneficial to the buyer of the property who will also be ‘assuming’ or taking over the loan.
And here is the reason. If the buyer were to get a completely new mortgage, their rate would be higher (since rates have increased). By assuming the existing FHA loan, they can get the favorable, lower rate that the loan has. That is because that loan originated in the past when rates were lower.
Since this is a big incentive to the buyer, the seller can sell the property much faster and more easily. Maybe even at a premium.
Most conventional loans don’t allow assumability, thereby making assumability a big advantage for FHA loan borrowers.
Easier refinance options
If a borrower has an FHA loan and wants to take advantage of lower rates by refinancing, there is a great product called ‘Streamline refinance’.
With a streamline refinance, the ease of refinancing goes up dramatically. No income or credit verification is required and no appraisal is required either. Closing costs are also slightly lower.
With a conventional loan, such an option is not available typically.
Higher limit on gift funds
Gift funds are funds allowed as a gift to the borrower (by close family members) to help them with their down payment or closing costs.
With conventional loans, there are limits on how much money can be allowed as a gift. With an FHA loan on the other hand, the borrower can borrow the full down payment.
Cheaper effective mortgage insurance for lower credit scores
The mortgage insurance premium with a conventional loan will go up as the credit score becomes lower. With an FHA loan, for a specific loan amount, the premium is the same (irrespective of credit scores).
So if the borrower has a lower credit score with an FHA loan, the premium will be the same as someone with a higher credit score.
Higher seller credits allowed
FHA loans allow sellers to contribute up to 6% of loan amount in the form of seller credits.
This can be a big advantage compared to conventional loans where the typical limit is only 3%.
While an FHA loan offers a lot of advantages, it is not without some disadvantages. One should seriously consider these when making the decision.
Mortgage Insurance Premium (MIP)
This is the single biggest drawback of getting an FHA loan. Since FHA loans tend to be riskier, borrowers are required to buy mortgage insurance to protect the lender.
There are two components of this: Upfront (UFMIP) and Monthly (MIP)
The upfront component is 1.75% of the loan amount and is a one-time fee paid at the time of origination.
The monthly premium is payable every month. The rates for those vary depending on different factors such as down-payment, loan amount, term of the loan. You can read more details on HUD.gov website.
Mortgage insurance may not be cancelable
A 3.5% down payment makes the FHA loan an attractive option. But when your down payment is less than 10%, the MIP cannot be canceled for the life of the loan.
For a down payment that is higher than 10%, the mortgage insurance can be canceled after 11 years, depending on the down payment. Refer to HUD’s website for any specific scenario.
Lower loan limits
In some counties, the FHA loan limits are similar to conventional loans. In a large number of counties though, the FHA loan limits tend to be lower.
As an example, see a comparison of loan limits for Conventional and FHA across different counties in the state of New Jersey. To find out FHA loan limits for your own county, please check the HUD.gov website
Only available for owner-occupied properties
With its lower down payment and easier credit score requirements, an FHA loan can be a great option for many.
But if you are someone who is planning on buying an investment property using an FHA loan, you are out of luck. FHA loans are only available for owner-occupied homes unfortunately.
The one exception is a 2 to 4 unit property where the borrower can rent out some of the units. But the borrower has to live in one of the units as their primary residence.
Home quality needs to meet stricter standards
FHA loans fall under the purview of the HUD, which is a department of the US government. For that reason, there are even stricter guidelines on structural soundness and security.
Not only that, the home has to meet minimum health and safety standards. Fixer-uppers, for instance, may not be approved as easily. It’s a good idea to check with your lender.
Because of these restrictions, sellers are not as keen when the buyer will finance the purchase of the property with an FHA loan. The reason is that sellers are then responsible for making more extensive repairs.
Lower DTI (Debt-To-Income) ratio
With conventional loans, one’s DTI ratio (ratio of all-monthly-debt-payments to gross-income) can be as high as 50%.
This DTI limit is allowed only when using Fannie Mae or Freddie Mac’s AUS (Automated Underwriting system). Fortunately, that is the case with most conventional loans these days.
For FHA loans, on the other hand, the overall DTI has to be below 43%, which is a drawback compared to a conventional loan.
With other compensating factors, lenders may allow higher DTI limits for FHA loans, but that may not be applicable to everyone.
Fewer FHA-approved Condos
Not all condominiums are FHA approved. For a mortgage on a condo unit to be eligible for FHA, the corresponding condominium project must be approved through either the HUD Review and Approval Process (HRAP — review performed by FHA staff) or the Direct Endorsement Lender Review and Approval Processing (DELRAP — review performed by an FHA approved lender).For instance in New Jersey, out of 2,317 condos listed, only 410 condominium projects where FHA approved as of 03/16/2021.
So many things to consider? How do you decide?
To help borrowers make an informed decision, we have provided a list of advantages and disadvantages above. Itt should cover a number of factors to consider when deciding between getting an FHA loan and a Conventional loan.
The big drawback of that is when one has to take into account so many factors in the decision, the decision itself becomes harder to make.
If you are feeling that way, here is something to consider:
- Go through each of the two lists above (advantages and disadvantages).
- In each list, mark the factors that are applicable to you (not all of them will be).
- Forget about all the others.
- Put the curtailed lists side by side.
- Now weigh on both sides and see which one matters to you more.
Let’s review some common scenarios
|Scenario||Is an FHA loan a good choice?||Is conventional mortgage a good choice?|
|Do you have a median credit score lower than 620?||Yes|
|Are you seeking to buy multi-family property with <15% down payment?||Yes|
|Are you looking to refinance an existing FHA loan?||Yes|
|Is your desired loan amount above your county’s FHA loan limit?||Yes|
|Are you a first time home buyer?||Contact Us||Contact Us|
We are here to help
At Stem Lending, our goal is to provide you as much knowledge as we can to help you make a great decision.
But sometimes, a home buyer’s situation can be very unique or unusual. We are there to talk to you and guide you whenever that happens.If you have a question for us, you can call us at 833-600-0490 . Or share a quote request and we’ll reach out to you right away: stemlending.com/quote. All the best with your mortgage.
NMLS#1648699 STEM Lending, Inc. Ph: 833-600-0490, 1648699, Mortgage Broker only, not a mortgage lender or mortgage correspondent lender, 1648699, STEM Lending, Inc., 101 Hudson Street Suite 2100, Jersey City, NJ, 07302-3929, (201) 800-6700, licensed by the N.J. Department of Banking and Insurance, broker will not make any mortgage loan commitments or fund any mortgage loans. Broker arranges loans with third-party providers., 1648699, STEM Lending, Inc., 1648699, (nmlsconsumeraccess.org).
The Principal and Interest payment on a $400,000 30-Year fixed-rate loan at 2.750% and 97% loan-to-value (LTV) is $1,632.96. The Annual Percentage Rate (APR) is 2.936% with estimated finance charge of $9,500. The Principal and Interest payments, which will continue for 360 months until paid in full, do not include taxes and home insurance premiums, which will result in a higher actual monthly payment. Rates current as of 3/1/2021. Subject to borrower approval.