FHA home loans are a popular mortgage option for first-time homebuyers and other borrowers with limited financial resources or less-than-perfect credit. With lower credit score and down payment requirements than most other mortgages, they're easier to qualify for, while competitive rates make them affordable.
While there's a lot to like about FHA home loans, they may not be the best choice for everyone. Here's a look at some of the main pros and cons of FHA loans to help you see if they're right for you.
Advantages of FHA loans
• One of the biggest attractions is that FHA loan down payment requirements allow you to put down as little as 3.5 percent of the purchase price. This puts FHA loans within reach of borrowers with limited financial resources, who may not have a lot of savings on hand.
• FHA mortgage guidelines have more lenient credit requirements than conventional mortgages do, so someone who may have had a few credit problems or a short credit history may have an easier time obtaining FHA financing. Many FHA lenders will now approve mortgage applications for borrowers with credit scores as low as 580, and some may even go lower.
• FHA mortgage rates are very competitive, particularly for borrowers with less-than-perfect credit. Unlike Fannie Mae and Freddie Mac, the FHA doesn't charge gradually increasing rates for lower credit scores, so someone with a lower credit score can get the same rate as a borrower with perfect credit.
• The FHA 203(k) loan program allows you to borrow money for home improvements as part of the same mortgage used to buy or refinance a home. In addition, the amount you borrow can exceed the purchase price or current value of the home – the limit is based on the value of the home plus improvements.
• FHA refinance guidelines are more lenient than for most mortgages, which can make it easier to qualify if you have limited credit or home equity. If you already have an FHA loan, an FHA Streamline Refinance makes refinancing almost automatic as long as you've kept up with your mortgage payments, regardless of your current income, credit score or home equity.
• Sellers are allowed to make a larger contribution toward your closing costs with FHA loans, up to 6 percent of the selling price of the home, compared to 3 percent on a conventional mortgage. So you might be able to negotiate for a motivated seller to cover all of your FHA loan fees.
• The FHA allows you to qualify for a mortgage relatively soon after bankruptcy. While a bankruptcy itself will remain on your credit report for at least 7 years, the FHA allows you to qualify in as soon as two years after the discharge of a Chapter 7 bankruptcy, or after one year of making payments on a Chapter 13 bankruptcy.
More information: FHA program allows quick rebound from foreclosure
• Finally, FHA home loans are assumable, meaning that if you sell the home the new buyer can simply take over the mortgage payments rather than obtain a new loan. This can be a major selling point if you bought the home at a time of low mortgage rates.
Downsides of FHA mortgages
FHA loans aren't the perfect mortgage for everyone. There are certain limitations and conditions that may affect whether they'll be the right choice for you.
• For starters, there are limits on how much you can borrow with an FHA mortgage. These vary by county, depending on local real estate prices. FHA county loan limits range from $271,050 in most of the country to as much as $625,500 in high-priced areas for a single-family home. Higher limits apply for multi-unit dwellings.
• You also have to pay for FHA mortgage insurance, which can increase the overall cost compared to other home loans. It comes in two parts, a mandatory upfront premium of 1.75 percent of the loan amount, plus an annual premium paid as part of your monthly payments. That annual premium may be higher or lower than what you'd have to pay on other mortgages.
• You need to carry FHA mortgage insurance for the life of the loan if you make a down payment of less than 10 percent. Other types of mortgages let you cancel mortgage insurance once you reach 20 percent home equity. If you put 10 percent or more down on an FHA mortgage, you can cancel it after 11 years.
More information: FHA mortgage insurance explained
• FHA loans have stricter property eligibility requirements. Dwellings must pass an inspection to verify that they are safe, secure and structurally sound. Possible problems might include might include a leaking roof, sagging foundation, bad wiring, signs of decay, contaminated soil and the like. If found, such problems must be corrected before the loan can be approved. Note that this is different from the home appraisal, which only determines the value of the property and not its condition.
• Some sellers may be leery of buyers using FHA loans. They may assume that someone who intends to use an FHA mortgage is less well-qualified financially. Or they may assume the home inspection will be more stringent than it is. Either might cause them to prefer offers from buyers who aren't using FHA financing.
• FHA loans cannot be used to buy investment property, with one exception. You may use an FHA loan to buy a 2- to 4-unit dwelling for rental purposes, as long as one unit is used as your primary residence.
• Finally, FHA loans cannot be used to buy a second or vacation home. They can only be used to buy a property you will use as your primary residence. However, there is an exception for cases where you must relocate to a new primary residence that is further from your current home than you can reasonably commute. In that case, you may purchase the new home with an FHA loan without having to sell the first one.