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The best way to buy a house is to pay 100% in cash. 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). Watch out, though. It can get pretty tricky.
What Is an FHA Loan?
An FHA loan is a type of loan from the Federal Housing Association for first-time buyers and for folks who might have a hard time getting approved for a conventional mortgage when buying a home. It offers:
Minimized credit qualifications
Reduced down payment requirements
Cheaper closing costs1
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, you’ll find other differences between an FHA loan and a conventional one. Let’s unpack those differences by taking a closer look at FHA loans.
How Do FHA Loans Work?
To get an FHA 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.
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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? Nope. 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).
FHA Loan Requirements
Remember, an FHA loan is typically an alternative for buyers who have a hard time getting approved for a conventional loan. While each 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 requirements:
- 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.2
Advantages of FHA Loans
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. Here are some of the advantages:
Low credit score requirements. You can qualify for an FHA loan with a credit score as low as 580, or even 500 (depending on how much you put down).
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. You could buy that 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 for 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 so you can combine the purchase of a home and the cost of its rehabilitation into a single mortgage.3 This means the loan amount is based on the projected value of your home after repairs are done. There’s also Limited FHA 203(k) insurance—previously called Streamline 203(k)—for an easier process with less extensive improvements, like kitchen, paint or carpet updates.4
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.5
Disadvantages of FHA Loans
Now, let’s look at the other side of the fence. We found a few things that seem to suck the life right out of the FHA option:
- 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 table below).
Notice a pattern in the "advantages" 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 actually come up, because we all know they will.
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 Loan Limits
The FHA has set limits on the size of the loans they’re willing to guarantee. In an effort to be fair, the loan maximums are adjusted annually based on the local cost of living and fluctuations in the U.S. housing market.
Each year, the FHA looks closely at the sale prices of homes in each county in the United States. Then, they label each one as either a “floor” county (low-cost area), a “ceiling” county (high-cost area), or a “between the ceiling and floor” county.
Next, the county’s maximum loan limit is set at 115% of the median home price for the previous year.6 Remember, their goal is to offer loans to those who might not be able to get one someplace else. Obviously, those who are buying more expensive homes don’t need any help, because they have other places to find a loan.
And that’s how each county has its own maximum amount the FHA can loan. Visit the HUD website to find out your county’s FHA limit.
FHA vs. 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|
|Down Payment||3.5% (with at least a 580 credit score)
10% (with a 500–579 credit score)
|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.|
Should I Get an FHA Loan?
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, consider total cost.
To get an accurate perspective, check out the chart below that uses our mortgage calculator to compare total costs between a 15-year, fixed-rate conventional loan and an FHA 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%)|
|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)|
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!
If you don’t qualify for a 15-year, fixed conventional mortgage just yet, hang in there and keep saving!
Make sure you’re debt-free, then spend a few more years socking away those dollars for a good down payment (we recommend 20%). The best idea is to rent for just a little while longer so you don’t have those crazy expenses to cover before you’re ready—like roof repairs and replacing the AC. Stuff happens!
Once you finally have a house of your own and are pocketing that cash instead of spending it, you’ll be able to really enjoy your house as a home—not a money pit.
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.