FHA mortgages can be a real boon for first-time homebuyers. With low down payments and relaxed credit requirements, they can make home ownership possible for many who otherwise might not be able to qualify for a mortgage.

But they aren't for everyone - and aren't necessarily the best choice for you even if you're a first-time homebuyer. On the other hand, you don't want to exclude them from consideration just because you're a repeat buyer either, or are refinancing.

It all depends on your particular situation and what you need out of a mortgage. To help sort through your options, here are the major advantages and disadvantages of an FHA mortgage.

First, the pluses of an FHA home loan.

1 - Low down payment

This is their best-know feature. The FHA allows you to get a mortgage with as little as 3.5 percent down, which makes them a great choice for first-time borrowers who may not have a lot of savings on hand.

Not only that, but you don't need great credit to qualify for that down payment. The FHA doesn't require a larger down payment unless you have a FICO credit score below 580, at which point 10 percent down is required.

It's true that both Fannie Mae and Freddie Mac have recently begun to approve mortgages with as little as 3 percent down. However, the credit requirements are stricter than for FHA loans, the loans are limited to first-time homebuyers and you'll likely pay a higher interest rate unless you have very good credit.

2 - Easier credit

You'll generally find that it's easier to get approved for an FHA loan if you have less-than-perfect credit. The FHA officially has no minimum credit score requirement, though individual lenders will have their own standards. Many will go as low as a FICO score of 600 and a few will approve FHA loans with scores even lower than that.

The FHA also doesn't require higher mortgage rates for lower credit scores, although individual lenders will determine their own guidelines. Still, that means you could get the same mortgage rate with a 650 credit score as another borrower would obtain with a score of 780.

While you can technically get approved for a Fannie/Freddie mortgage with a FICO score as low as 620, you'll find that lower scores result in higher mortgage rates and down payment requirements. Debt-to-income ratios are more restrictive as well. That makes it more difficult for borrowers with lower scores to get approved for Fannie/Freddie mortgages.

3 - Lower mortgage rates

Not linking mortgage rates to credit scores means that borrowers with less-than-perfect credit can get significantly lower rates on an FHA loan. Fannie Mae and Freddie Mac employ pricing guides that charge gradually increasing rates for lower credit scores. So a borrower with a credit score in the 680-699 range may pay a rate a full percentage point higher than one with "perfect" credit of 740 or more, while a borrower with a score below 640 could pay a rate 3 percentage points higher.

While individual lenders may adopt their own risk-based pricing for rates on FHA loans, they don't have the built-in increases that Fannie/Freddie mortgages require. So borrowers with scores in the 600s will likely find better deals with the FHA.

4 - Fixer-upper mortgage

Many people don't realize that you can use an FHA loan to not only buy a home, but renovate it as well. The FHA 203(k) program allows you to use a single mortgage to buy a home and borrow additional money to make needed repairs or improvements.

The amount you can borrow is based on the project value of the home after the improvements are done. So if you're buying a fixer-upper for $150,000 and the repairs will add another $30,000 to its appraised value, you can borrow an additional $30,000 above the purchase price to pay for repairs.

There's also a streamlined 203(k) option that lets you borrow up to $35,000 for non-structural improvements, such as painting, replacing appliances or fixtures, or re-doing a kitchen or bath.

Fannie Mae does offer a similar program called a HomeStyle Rennovation Loan, but you generally will need excellent credit and 10 percent down to qualify. However, the overall costs will likely be lower on a Homestyle loan and you can use it to make luxury improvements, which you cannot do with the FHA 203(k).

5- Help with closing costs

The FHA is more flexible when it comes to financing closing costs than you can be with a conventional mortgage backed by Fannie Mae or Freddie Mac. The FHA will allow the seller, lender or builder to contribute up to 6 percent of the home purchase price toward the buyer's closing costs, while Fannie/Freddie set a maximum of 3 percent.

Of course, that's assuming the seller, lender or builder will be willing to go that high. In most areas, certain closing costs are traditionally covered by the buyer and others by the seller, and it can be hard to get them to budge from that formula. But anything is negotiable in a real estate deal and the contribution you can actually get will mostly depend on how eager they are to sell.

The other nice thing about FHA loans is that your closing costs can be totally covered through a gift, such as from a parent or other relative who is helping you buy the home. Fannie/Freddie loans will often require that a certain amount come from your own funds.

6 - FHA loans are assumable

This is an angle that's frequently overlooked. When you sell your home, you can sign over the remainder of your mortgage to the new buyer. They can then pay you the difference, either in cash or take out a second mortgage to cover the gap between the balance on the mortgage and the price of the home.

The big advantage of this is that you can pass onto the buyer the low interest rate you locked in when you bought the home - which could be a considerable factor if rates return to historical norms a 5-10 years down the road.

At the same time, your lender holding the loan has to approve your buyer as well - you can't simply transfer the mortgage without their permission. So it's not a slam dunk.

Downsides

So those are some of the main upsides of an FHA mortgage. But there are disadvantages as well.

1 - Higher costs for mortgage insurance

The big downside on a FHA mortgage is that you have to pay fairly high fees for mortgage insurance. This is what allows the lender to recoup part of the cost of the mortgage if you should default and is required on mortgages with less than 20 percent down (VA and USDA loans excepted).

For an FHA mortgage, you pay an upfront mortgage insurance premium of 1.75 percent of the purchase price at the time of closing. Unlike other closing costs, this fee can be rolled into the mortgage balance. There's no equivalent fee on Fannie/Freddie mortgages.

In addition, you have to pay an annual mortgage insurance premium as well. For most FHA borrowers, who put down 3.5 percent on a 30-year fixed-rate mortgage, this annual fee is 0.85 percent of the loan balance, broken down into 12 payments as part of the monthly mortgage statement.

That's comparable to what you'd pay on a Fannie/Freddie loan with 3 percent down. However, the big downside with FHA mortgage insurance is that you have to carry it for the life of the loan if you put less than 10 percent down on a 30-year mortgage. By contrast, you can cancel PMI on a Fannie/Freddie mortgage once you reach an 80 percent loan-to-value ratio (20 percent equity).

That only takes about eight years through regular amortization, so the cost differences over the life of the loan can be considerable.

2 - More costly for borrowers with good credit

The higher costs for mortgage insurance are generally offset by the lower interest rates FHA mortgages offer borrowers with sub-700 credit scores. But if you've got good to excellent credit, it's a killer.

Mortgage rates for borrowers with scores around 720 and above are pretty similar on both FHA and Fannie/Freddie loans. But you don't pay the upfront mortgage insurance premium on Fannie/Freddie loans and you can cancel your PMI eventually. So that's a huge savings over the life of the loan.

In addition, borrowers with good credit can pay less for PMI than they would for FHA annual mortgage insurance - a rate of about 0.5 percent of the loan amount if they can put 5 percent down, versus 0.85 percent for FHA loans.

PMI premiums are tied to your credit score, so you can actually pay more per month for PMI than you would for FHA mortgage insurance if you've got weak credit. But if your credit is good to excellent, a Fannie/Freddie mortgage will cost less over the loan run.

3- Inspections can be more stringent

Though they aren't as strict as they were a few decades ago, FHA home inspections can be more demanding than for conventional loans. They particularly had that reputation in the past, where a seller might be required to repaint a room that was merely faded or make other cosmetic improvements before the sale.

FHA inspection standards are still a bit stricter than for Fannie/Freddie mortgages - such as if peeling paint is found in a home built during the lead paint era, for example. However, as a buyer, the issue for you is that some sellers may be reluctant to accept offers based on an FHA mortgage because they assume the standards of 30 years ago are still in effect. So you could lose out to an offer by a non-FHA bidder as a result.

Remember - Each lender is different

In making comparisons between FHA and conventional mortgages, it's important to note that individual lenders will have their own rules and what are called "overlays" for mortgages. This can affect the mortgage rates they'll offer on FHA vs. conventional loans, and other terms as well.

So you may find significant differences among FHA lenders in the mortgage rates they'll offer based on your credit score, the debt-to-income ratios they're willing to allow, the minimum credit score they'll allow and so forth. But the overall comparisons between FHA and conventional loan products will still hold up.

Published on February 15, 2008