What are the pros and cons of FHA loans?

When you’re in the market to buy a house, exploring all of your mortgage loan options can help you find the one that best suits your needs. Federal Housing Administration (FHA) loans represent one option that might pique your interest.

While FHA loans present a worthwhile opportunity for many, weighing the benefits and drawbacks of this mortgage loan can help you make this significant financial decision with your eyes wide open. This guide leans on Rocket’s expertise to explore the pros and cons of FHA loans to consider before applying.

What is an FHA loan?

An FHA loan is a government-backed mortgage option that’s insured by the Federal Housing Administration. The FHA was created to improve access to homeownership for those who may face barriers in qualifying for conventional financing opportunities.

Some key points of an FHA loan include:

• Often easier to qualify: Government backing makes the loans less risky to lenders.
• Lower credit score requirements: Approval is possible with a credit score as low as 500.
• Down payments as low as 3.5%: The required down payment is based on the credit tier. Those with credit scores of at least 580 face a 3.5% down payment requirement; those with credit scores between 500 and 580 must put down at least 10%.
• Flexibility from lenders: Generally, FHA loans come with more flexibility to work with borrowers who may have a higher debt-to-income ratio (DTI) or unusual income sources.

FHA loans offer a pathway to homeownership for borrowers with less-than-ideal credit scores and relatively low down payment funds on hand. But for borrowers with higher credit scores and more cash immediately available, a conventional loan might represent an equally valid homeownership strategy. The differences between FHA and conventional loans may help guide your decision about which loan is better for you.

Benefits of FHA loans

For the right home buyer, FHA loans come with a wide range of benefits. We’ll explore the advantages of FHA loans below.

A low down payment

Low down payment requirements are a standout feature of the FHA loan. After all, coming up with the money for a down payment often stands in the way of homeownership. Since the FHA loan lowers the minimum down payment requirement, buying a home might suddenly feel within reach.

For FHA borrowers with a credit score of at least 580, you’ll only need a 3.5% down payment. For FHA borrowers with a credit score between 500 and 479, the down payment requirement is raised to 10%.

For example, let’s say you plan to purchase a $300,000 home. With an FHA loan, the 3.5% down payment requirement would be $10,500. If required to put down 10%, that minimum down payment requirement would rise to $30,000.

In contrast, conventional loan down payment requirements typically fall between 3% and 20%, which would be $10,000 – $60,000 for this particular loan.

Notably, FHA loans allow home buyers to use gift funds and down payment assistance programs for the down payment. Although you’ll need to provide documentation that funds received from family or friends are indeed a gift, not a loan, this option makes obtaining a home loan possible for many.

Leniency with credit history

The same flexibility that FHA loans have with down payments applies to a borrower’s credit history. While most other loan types will require a minimum credit score of 620, you can qualify for an FHA loan with a credit score of 580, or even as a credit score as low as 500 with certain lenders.

The following table highlights credit score requirements across several loan types.

A better interest rate

Generally, FHA loans typically offer better fixed interest rates than most other loan types.

Although FHA loan rates tend to be lower, your exact interest rate will vary based on your unique situation. Factors like the mortgage market conditions, your income, credit score, the amount you plan to borrow, your down payment and the loan term can all affect your mortgage rate.

As with other loan types, you can potentially lower your FHA interest rates by buying mortgage points. Essentially, this involves paying a fee upfront in exchange for a lower interest rate.

Flexible DTI requirements

Your debt-to-income ratio (DTI) compares your monthly debt payments to your income.

You can calculate your DTI by taking your total monthly debt payments (including student loan, auto loan, credit card and mortgage payments) and dividing this amount by your gross monthly income. The number you get will be your DTI expressed as a percentage.

For example, if you have a $5,000 monthly income and $1,000 in monthly debt payments, your DTI would be 20%.

FHA mortgages tend to give borrowers more leniency with their DTI. According to the FHA, your DTI shouldn’t exceed 43% in certain situations. However, the DTI requirement for FHA loans may be higher or lower, depending on compensating factors like your credit score and cash on hand.

With an FHA loan, you can also add a co-borrower’s income to give yourself a better chance of loan approval, even if that person won’t be residing in the home. Adding a nonoccupant co-borrower, such as a family member or close friend, can give you even more financial flexibility.

Cons of FHA loans

As with all financial products, FHA loans also have some disadvantages to keep in mind. Some of these include the following.

Mortgage insurance premiums (MIPs)

FHA loans require both an up-front mortgage insurance premium (UFMIP) and an annual mortgage insurance premium (MIP) from borrowers, regardless of how much money you put toward your down payment.

These separate costs break down as follows:

• Up-front mortgage insurance premium: The amount you pay in mortgage insurance will depend on the size of your loan, with your UFMIP at 1.75% of your base loan amount. The UFMIP amount is due at the time of closing, or you can have it financed as part of the loan.
• Annual mortgage insurance premium: The annual premium for mortgage insurance is included as a portion of your monthly payment rather than an annual lump-sum cost.

If you make a down payment of 10% or more, the monthly cost of mortgage insurance will be removed after 11 years. Otherwise, the monthly cost of mortgage insurance will remain for the life of the loan. But you always have the option to refinance into a conventional loan, if you do so with 20% in equity, you’ll eliminate mortgage insurance premiums.

Property requirements

In order to qualify for an FHA loan, the home must meet the FHA’s minimum property requirements. These standards include:

• Safety: The house should be a safe and healthy environment for occupants.
• Security: The house should provide a secure place for residents.
• Soundness: The home should be sturdy without any structural defects.

When considering a condo purchase with an FHA loan, it must meet additional requirements. For example, it must be in a building with at least five dwellings and is ready for occupancy.

The lender assesses the property’s condition through a home appraisal after you and the seller sign a purchase agreement.

Typically, a professional appraiser carries out the process and determines whether your home meets the minimum property standards set by the FHA. The home appraiser also provides an opinion on the value of your home, which your lender evaluates when deciding the amount of your FHA loan.

This process can be stricter than home appraisals for conventional loans. If the home you’re interested in doesn’t pass the FHA’s appraisal standards, you won’t be able to secure financing on the house.

Loan limits

FHA loan limits are another factor you’ll want to consider when qualifying for an FHA loan. Depending on how much you want to borrow and where the property is located, an FHA loan may not be right for you.

Currently, the national loan limit on an FHA loan is $524,225 for a single-family home in a relatively low-cost area. High-cost cities have a higher limit, and you could potentially qualify for an FHA loan of up to $1,209,750.

If you want to find the loan limits for your particular area, consider using this Housing and Urban Development (HUD) tool. You can enter your location details to quickly determine loan limits for the area.

FAQ

Can I get an FHA loan with student loan debt?

Yes, student loan debt doesn’t prohibit someone from getting an FHA loan. But if your student loan debt pushes your DTI ratio too high, it could limit your mortgage prospects.

Can I get preapproved for an FHA loan?

Yes, FHA loans can be preapproved just like traditional loans.

Do I have to pay closing costs on an FHA loan?

Yes, FHA loans have closing costs that are due before the sale can be completed.

The bottom line: Weigh the pros and cons of FHA loans

Before applying for an FHA loan, considering the advantages and disadvantages can help you determine whether it’s a good fit for your situation. While the low down payment and lenient credit score requirements are undeniably attractive, the property standard requirements might limit your home search.

If you decide to move forward with an FHA loan, start the approval process today.