mortgages

What Is an FHA Loan?

11 Minute Read

The best way to buy a house is to pay 100% in cash. Yes, it is possible! But if you’re struggling to save up enough cash just for a down payment, then you might be tempted to get a loan that’s backed by the Federal Housing Association (FHA).

An FHA loan makes purchasing a home easier for first-time buyers and folks who might have a hard time getting approved for a conventional mortgage. It does this by providing looser guidelines like:

  • Minimized credit qualifications
  • Reduced down payment requirements
  • Cheaper closing costs(1)

The problem is, an FHA loan can cost thousands more in the end. That’s why the only loan we recommend is a 15-year fixed-rate conventional mortgage, which you can get through a smart lender who actually encourages you to pay off your house fast—at the lowest total cost possible.

Besides total cost, there are many differences between an FHA loan and a conventional one. Let’s unpack those differences by taking a closer look at the FHA.

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How Do FHA Loans Work?

The Federal Housing Association, part of the U.S. Department of Housing and Urban Development (HUD), is a government agency that has insured over 47.5 million home mortgages since it was established during the Great Depression in 1934.(2)

To take out this type of loan, you’d have to work with an FHA-approved lender, which could be a bank, credit union or mortgage company. Then, the FHA provides a guarantee on the loan so your lender doesn’t lose money.

In other words, if you default or fail to keep up with your mortgage payments, your lender will repossess the house, which is known as foreclosure. At that point, the FHA will pay your lender the remaining balance of your loan in exchange for ownership of the house. Without the FHA’s guarantee, a loan like this would be too high of a risk for the lender—which should throw up a red flag for you as the borrower.

Where does the FHA get the funds to pay for the house? Since it’s a government agency, the money must come from tax dollars, right? Wrong. The FHA actually holds an account of money funded by a mortgage insurance premium (MIP) that the borrower (you) must pay for the life of the loan—depending on the down payment amount (more on that later).

How to Qualify for an FHA Loan

Remember, an FHA loan is typically an alternative for buyers who have a hard time getting approved for a conventional loan. While each individual FHA-approved lender might add their own restrictions, the essential requirements for an FHA loan aren’t as strict as the ones for a conventional loan.

Here are some basic qualifications:

  • If your credit score is 580 or higher, you only need at least a 3.5% down payment.

  • If your credit score is between 500 and 579, you need at least a 10% down payment.

  • You’re required to pay an upfront and annual mortgage insurance premium (MIP).

  • If you pay a 10% or higher down payment, you only need to pay MIP for 11 years.(3)

Pros and Cons of an FHA Loan

All of that makes an FHA loan a pretty attractive option if you’re having trouble saving a down payment or qualifying for a conventional mortgage. But FHA loans have a downside as well. It’s worth weighing the pros and cons of an FHA loan.

Pros:

  • Low credit score requirements: You can qualify for an FHA loan with a credit score as low as 580, or even 500 (depending on your down payment amount). But don’t be fooled here; credit scores just indicate how well you manage debt. A low credit score should be a warning sign that you have some life to straighten out before you make one of the biggest investments you’ll likely ever manage.

  • Down payments as low as 3.5%: You can get an FHA loan with as little as a 3.5% down payment. Let’s say you want a $200,000 home. That means you could buy a $200,000 home with just $7,000 down ($200,000 x 3.5% = $7,000). The FHA will also accept a down payment from assistance elsewhere like a charitable organization or bank—with some restrictions.

  • Potential covered closing costs: The FHA allows home sellers, real estate agents, builders or developers to cover your closing costs—up to 6% of the sales price. But look out! This might be offered as a way to convince you to buy.

  • Cash for home repairs and updates: If you’re planning to buy a home that needs structural work, the FHA offers Section 203(k) insurance which lets you combine the purchase of a home and the cost of its rehabilitation into a single mortgage.(4) This allows the loan amount to be based on the projected value of the home after the repairs are done. There’s also Limited FHA 203(k) insurance—previously called Streamline 203(k)—for an easier process and less extensive improvements like kitchen, paint or carpet updates.(5)

  • Assistance to avoid foreclosure: If you get an FHA loan and struggle to make payments, the FHA offers a special forbearance period that can reduce or suspend your mortgage payment for up to a year—if you qualify.(6)

Cons:

  • Upfront MIP: In order to protect the lender from loss, the FHA requires you to pay an upfront mortgage insurance premium. This fee is due at closing and costs 1.75% of your FHA loan. That’s $3,378 on a $193,000 mortgage ($193,000 x 1.75% = $3,378).

  • Annual MIP: In addition to the upfront MIP, the FHA requires you to pay an annual MIP for the life of the loan—or for 11 years if your down payment is 10% or more. This fee is collected each month and ranges between .45% and 1.05% depending on factors like your loan amount and term. (See how that impacts the overall cost of your home in our calculations below.)

Notice anything in common in the "pros" list? They’re all designed to get you into a house with as little upfront money as possible. Sounds nice—but if you’re really that strapped for cash, imagine what will happen when home emergencies come up.

Plus, this plan doesn’t consider long-term costs. In the end, the extra fees you pay for the MIP and the larger amount you pay in total interest make FHA loans way more expensive than conventional loans!

FHA Loans Versus Conventional Loans

Before we break down total costs, take a look at this chart to compare the basic differences between FHA loans and conventional loans.

Conditions FHA Loans Conventional Loans
Interest Type Fixed rate Fixed or variable rate
Terms 15–30 years 10, 15, 20, or 30 years
Credit Score 500 620
Down Payment 3.5% (with at least a 580 credit score)
10% (with a 500–579 credit score)
3%–20%
Loan Limits $294,515–$679,650 $453,100
Mortgage Insurance Mortgage Insurance Premium (MIP): This includes an upfront payment at closing that’s 1.75% of your loan amount and a recurring payment that costs .45%–1.05% of your loan amount per year—for the life of the loan. You can remove MIP after 11 years if your down payment is 10% or more. Private Mortgage Insurance (PMI): This costs .5%–1.5% of your loan amount per year—for the life of the loan. You can avoid PMI with a 20% down payment, or it can be removed after you own 20% of your home.

Why We Don’t Recommend FHA Loans

Simply put, we don’t recommend FHA loans because they’re one of the most expensive types of mortgages. You might not realize this if you only look at how much money the FHA "saves" you on the front end. But if you want to win with money, you have to consider total cost.

To get an accurate perspective, check out the chart below that uses our mortgage calculator to compare total cost between a 15-year fixed-rate FHA loan and conventional loan for a house priced at $200,000. (To keep things simple, we left out property tax, homeowner’s insurance and HOA dues on both examples.)

15-Year Fixed-Rate Loan for $200,000 House FHA Loan Conventional Loan
Down Payment $7,000 (3.5%) $40,000 (20%)
Amount Borrowed $193,000 $160,000
Interest Rate 3.49% 3.76%
Monthly Payment $1,492 (includes .7% monthly MIP payment) $1,164
Total Mortgage Insurance $23,643 ($20,265 lifetime MIP + $3,378 upfront MIP) N/A (20% down payment cancels PMI)
Total Interest $55,179 $49,583
Total Cost $278,822 $249,583

It’s obvious here that if you strap in and save longer for a larger down payment—and avoid the ridiculous MIP of an FHA loan—a conventional loan could save you nearly $30,000!

Get a Smart Mortgage

There’s nothing evil about an FHA loan. It’s just more expensive. That’s why we recommend the cheaper total cost of a conventional loan. When you save money on your home—one of the largest purchases you’ll probably ever make—you have a better chance of paying it off fast and freeing up money to tackle other financial goals. If you like the sound of that, get a smart mortgage with our friends at Churchill Mortgage.

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