Pros and Cons of FHA Loans

Like any financial product, FHA loans have pros and cons.

Pros

• No requirement for large down payment. FHA loans are famous for requiring down payments as low as 3.5%. This might be the single biggest contributing factor to FHA’s importance in helping to realize the dreams of home ownership to less-than-qualified households.
• No requirement for high credit scores. As a matter of fact, the FHA approves loans for households with credit scores of 580 or even lower.
• No prepayment penalties.
• No expectation for income must be met. As long as borrowers can show that they can repay the loan (either through a history of payments or large savings), even the lowest income households can qualify.
• Certain scenarios where FHA loan borrowers are allowed to spend up to 57% of their income on all monthly debt obligations, which can be considered exceedingly high compared to the debt-to-income ratio requirements of other mortgage loans.

Not only do they have very appealing incentives for borrowers, but for certain mortgage lenders also; because they are a federal entity upheld by tax dollars, FHA loans basically guarantee the ability to take over any remaining loan payments when borrowers happen to default.

Cons

With as many benefits as they come with, there are reasons why they haven’t been adopted as the universal method for mortgage loans.

• The MIP and subsequent payments contribute to why FHA loans tend to be more expensive than conventional loans. Also, unlike the latter, FHA insurance premiums cannot be canceled once 20% of home equity is reached; this is a very expensive and important cost to account for. When people speak the good virtues of FHA, it is usually coupled with the ‘catch’ afterward – the insurance payments. FHA insurance is often unavoidable without paying off the loan entirely.
• They hand out relatively smaller loans than otherwise. People seeking more expensive home purchases may want to look at conventional loans instead.
• Borrowers with excellent credit are more likely to get better rates from conventional loans.
• There are certain limitations to properties that can qualify for FHA loans because they must meet standards such as basic health and safety.
• As a general assumption, potential buyers that finance using FHA loans may raise eyebrows from sellers. As compared to conventional mortgage loans, FHA loan borrowers carry rash generalizations associated with low-income demographics.

As with any other big financial decision, take the time to evaluate all options. While FHA loans are a viable choice, conventional loans may be better for some people, such as when the down payment is over 20% or they have excellent credit scores. Veterans and similarly applicable individuals should consider VA loans. Compare rates offered by different lenders.

Home Affordability

The Department of Housing and Urban Development (HUD) is the organization that sets specific guidelines for FHA debt-to-income ratios and formulas used to manage the risk of each potential household that borrows FHA loans for home purchases. To determine the house affordability of an FHA loan, please use our House Affordability Calculator. In the Debt-to-Income Ratio drop-down selection, there is an option for FHA loan.

It becomes immediately apparent that FHA loans have the most stringent debt-to-income ratio requirements. After all, the FHA was essentially created to absorb the risk inherent in handing out many loans that could be defaulted at any time.

However, there are exceptions that can be made for borrowers who cannot adhere to the front or back-end ratios of 31% and 43%, respectively. The HUD can give mortgage lenders leeway to approve borrowers as long as lenders give evidence of significant compensating factors. One or more is typically sufficient to qualify borrowers. These compensating factors include:

• A higher down payment than the minimum requirement of 3.5%, which most FHA loan borrowers take advantage of.
• Applicants showing dutiful mortgage payments in the past equal to or greater than the new potential loan.
• Excellent credit scores (however, people with great credit scores will probably get more enticing offers from conventional loans).
• Proof of substantial savings, usually three months’ worth of mortgage payments in the bank.

Prepayment

There is no prepayment penalty for FHA loans, so it can make financial sense for some FHA borrowers to supplement an FHA loan with additional payments. However, we recommend it only when the financial situation allows for it, and our calculator can help. Inside the More Options input section of the calculator is an Extra Payments section to input monthly, yearly, or single payments. Use the results to see how much the length of the loan is cut short.

FHA 203K Loans

An FHA 203(k) loan allows borrowers to finance both the purchase and renovation of a primary residence or to finance the renovation of their existing home. Basically, it allows borrowers to buy and refinance a home that needs work and roll the renovation costs into the mortgage.

FHA 203k loans carry many of the same aspects as the regular FHA loan, such as ease of qualification for loans, high insurance premiums, and a small ongoing fee. The completion of improvements must be finished within six months. FHA loan funds are transferred into an escrow account and paid to contractors as improvements occur. A minimum of $5,000 must be borrowed and maximum limits are set by the FHA that differs according to locations. Similar to regular FHA loans, they tend to be enough for most families purchasing homes that aren’t decked-out mansions. Funds can also be used for temporary housing while improvements are being made for up to six months.

There also exists a mini version of the FHA 203k called the Streamlined FHA 203k made specifically for lower borrowing amounts that are processed much more easily.