Is an FHA Loan Right for You?

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Updated on Wednesday, January 30, 2019

If you’re exploring home loan options but don’t have a sizeable down payment or stellar credit, an FHA loan may provide you with a path to home ownership. That’s because unlike conventional loans, FHA loans are backed by the federal government, allowing for slightly looser qualifications.

“FHA loans have a lower credit score requirement, lower down payment requirement and often a lower interest rate because it is subsidized by the government,” said Tendayi Kapfidze, chief economist at LendingTree, which owns MagnifyMoney.

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FHA stands for Federal Housing Administration, the government organization that insures home loans made by FHA-approved lenders. The FHA has insured over 47.5 million properties since it was established in 1934, according to the U.S. Department of Housing and Urban Development (HUD).

The FHA essentially aims to motivate lenders to give loans to those who wouldn’t otherwise qualify, said Andrew S. Weinberg, principal at Silver Fin Capital Group LLC, a mortgage brokerage in Great Neck, N.Y.

“I like to say FHA is a great choice, unless you have a better one,” Weinberg said.

Pros of an FHA loan

In general, the true benefit of the FHA loan program is its less stringent qualifications, but still favorable interest rate. Here’s a breakdown:

You can buy a home with a lower down payment. An FHA loan requires just 3.5% of the purchase price as a down payment. By comparison, most conventional loans require at least 5%, depending on the lender.

“There are a lot of first-time home buyers who don’t have large down payments,” Weinberg said. Without an FHA loan, they might have to save for another few years to buy, he added.

You can get away with a mediocre credit score. Lenders are very interested in the credit scores of their applicants. Credit scores are used to measure creditworthiness by looking at credit payment history,credit utilization (how much available credit you’re using) and other factors that lenders are interested in.

“A lower credit score is one of the things that would push a borrower toward FHA,” Weinberg said.

For instance, if your FICO score is 620 or below (out of 850), the FHA will still consider your application, while most conventional loan programs may not. Even borrowers with a 500 credit score might qualify for an FHA loan.

You can have a slightly higher debt-to-income ratio (DTI). The FHA looks at two different debt-to-income ratios, sometimes expressed as 31/43. The first is front-end DTI: your monthly housing payments divided by your monthly gross income. That should be no higher than 31%.

Back-end DTI is your monthly total debt divided by your monthly gross income. That usually can’t be higher than 43% to qualify.

What sets FHA loans apart is that they allow some DTI wiggle room on a case-by-case basis if borrowers have strong credit scores, significant cash reserves or other compensating factors.

For a complete look at all of the qualifications to be approved for an FHA loan, refer to the FHA Single Family Housing Policy Handbook.

Cons of an FHA loan

An FHA loan will likely cost you more in the long run, and the application process can be more intricate. Here’s a closer look at some of the disadvantages:

There are limits. FHA loans generally follow Federal Housing Finance Agency (FHFA) guidelines when it comes to loan limits. FHFA recently announced that it was increasing the conforming loan limit for 2019 to $484,350 from $453,100, a nearly 7% increase.

To reflect that change, HUD has also increased FHA loan limits for low-cost and high-cost areas. Low-cost limits for 2019 will be $314,827 and high-cost loan limits will be $726,525.

But your limit depends on the geographical area where you’re buying. You can use FHA’s online tool to see what your lending limits would be.

You have to pay mortgage insurance premiums, both upfront and throughout the loan term. The reason that FHA is able to back loans is because borrowers pay insurance. At the very start, you have to pay 1.75% of the loan amount, although that can be financed.

“That’s almost like adding another percent to your interest rate,” Weinberg said.

You’ll also have to pay a monthly MIP (mortgage insurance premium). For borrowers who have an LTV (loan-to-value) ratio of greater than 90% (meaning they made a down payment of less than 10%), MIP payments will be collected during the entire 30-year loan term, or until the mortgage is paid off. For those who can put down more than 10%, MIP will be collected for 11 years, or until the end of the loan term, whichever comes first.

FHA may be stricter regarding the condition of the property. “FHA appraisers are more likely to require repairs in order for the sale to go through,” Weinberg said.

If the property is well-maintained and meets code, it’s shouldn’t be an issue, he added. But if it’s a fixer-upper, it could delay the approval or make it more challenging, unless the home is brought up to HUD’s standards.

FHA vs. conventional loans

FHA and conventional loans are quite similar in many ways — both have fixed-rate 30-year terms and similar underwriting factors, for example. But there are some key differences:

The burden of mortgage insurance lasts longer for FHA borrowers. Conventional borrowers who put down less than 20% on a down payment have to pay PMI (private mortgage insurance), which is similar to MIP. However, once the LTV reaches 80% — meaning the borrower owns 20% or more equity in the home — PMI can usually be removed.

Down payment requirements are higher for conventional loans. Whereas an FHA requires just 3.5% down, the typical conventional loan calls for a minimum of 5%, although Weinberg noted that some conventional lenders allow you to put down less.

Credit score requirements are typically higher for conventional borrowers. While FHA borrowers may have scores below 600 and still qualify, conventional loans will usually require a score of at least 620.

Remember, underwriters for both types of loans review your application as a complete package, including your income, debt-to-income ratio, credit score, cash reserves and more. That’s why it’s important to work with a mortgage professional who can help you find the right option for your unique situation, said Kapfidze of LendingTree.

How to convert from an FHA to a conventional loan

If you decide to get an FHA loan, there may come a point when you want to switch to a conventional loan. It could be that interest rates have decreased below the rate on your current loan, or perhaps a few years in, you have enough equity to avoid paying mortgage insurance.

Though you can’t technically cancel FHA mortgage insurance, you can refinance your FHA loan to a conventional loan. Like any other refinance, you’ll want to crunch the numbers to see if it’s in your best interest, and you’ll have to meet the lender’s qualifications.

“Most people who refinance are looking to lower payments,” Weinberg said. “See where rates are today and find the best option. If you’re only a few years into your FHA and interest rates are up, it might not pay to refinance.”

Making the right choice

As a prospective homeowner, there are a lot of factors to consider when it comes to choosing the right home loan. FHA loans are an important option for every borrower to consider, Kapfidze said. “It increases access to home loans and home ownership for people who might not otherwise quality for a conventional loan.”

This article contains links to LendingTree, our parent company.

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