In your search for a mortgage loan, you will inevitably come across the term FHA loans. You may also have heard that an FHA loan may be better for you if you are buying your first home, but is that still true today? If you don't understand a thing about FHA loans, don't fret. Here I will explain what an FHA loan is and run though its pros and cons so that you can decide if an FHA home loan is right for you.
- What is an FHA loan?
FHA stands for Federal Housing Administration and it offers mortgage insurance on loans that are made by FHA-approved lenders in the US and its territories. The FHA itself doesn't lend you the money, it insures the loan in order to minimize the lender's financial risk.
The FHA was created by the US Congress in 1934 and is currently the biggest mortgage insurer in the world with over 34 million properties insured. It became part of the HUD's (US Department of Housing and Urban Development) Office of Housing in 1965. An interesting fact is that FHA is the only government agency that functions with self-generated income - which means that it doesn't use taxpayers' money.
It is important to understand that an FHA mortgage insurance protects the lender against losses in the event of a homeowner failing to pay their mortgage loan. This reduces the lender's risk since the FHA will pay them in the event of a homeowner's nonpayment. FHA insures mortgages on both single family and multifamily homes which include manufactured homes and hospitals.
- What are the advantages of an FHA loan?
One of the main advantages is that you don't need to make a very big down-payment (which can be as low as 3.5% of the purchase price) for an FHA-insured loan. Most traditional loans require an initial payment of 20% of the property cost. College graduates, newlyweds, first-time homeowners and people with low income generally cannot afford a 20% down-payment.
Since an FHA-insured loan requires only a minimum cash investment, it is ideal for people who haven't been able to save enough money for the purchase. First-time home buyers and people who may have been denied for a conventional loan will definitely benefit from an FHA-insured loan. Also, if you can't apply for conventional loans because of bankruptcy or foreclosure, you may still be able to qualify for an FHA loan.
FHA loans are very popular since they allow greater flexibility in calculating payment ratios and household income. In general, to be eligible for an FHA loan, you must have a valid social security number, be a US resident, and old enough to get a mortgage in your state.
- What credit score do you need in order to qualify for an FHA loan?
Another plus is that there are no minimum credit score requirements in order to qualify for an FHA loan. However, since June 2013, the FHA requires lenders to manually sign and accept liability for loans to borrowers who have credit scores lower than 620 as well as total debt-to-income ratios higher than 43 percent.
On the other hand, having no credit history is generally not a problem since lenders will check other payment-history records in order to complete their evaluation. People who have been in a credit counseling program for a year or more and have made all their payments on time are also eligible for FHA loans.
- FHA loans - What's the catch?
First of all, the properties have to be appraised by an FHA-approved appraiser, and they must meet certain conditions. However, the biggest disadvantage is the mortgage insurance premium (MIP). There are two kinds of MIPS, and both are required: one is the upfront mortgage insurance premium (UFMIP), which is financed into the mortgage (it increased from 1% to 1.75% in 2012), and the other is the annual MIP (which is actually paid monthly).
As of June 2013, mortgage insurance premiums must be paid for 11 years in loans which the original loan-to-value (LTV) is 90% or less. If the loan's starting balance is higher than 90% of the appraised value, the MIP will last the lifetime of a loan.
- What are the disadvantages of an FHA loan?
Since an FHA has a very low down-payment (which can be as low as 3.5%), you will end up paying more interest than if you had a conventional loan with a 20% down-payment. This is a very important factor to consider when looking for a mortgage. If you are financially capable of paying 20% for a down-payment, then you should strongly consider opting for a conventional mortgage since it will save you a lot of money in the long run.
Plus, on top of the 1.75% upfront that you'll have to pay in insurance, you can't cancel the annual mortgage insurance premium, like you could before June 2013. In contrast, conventional loans let you cancel the insurance policy when you have enough equity.
- FHA 15-year vs FHA 30-year fixed rate mortgage
Paying your mortgage over a shorter time period is the best way to save on interest costs. For example, if you're paying back a loan of $250,000 with a mortgage rate of 5% and you pay it over 15 years, you would pay $104,815.47 in interest. If you pay the same loan over 30 years, you would have to pay a staggering $229,910.29 in interest which is more than twice the amount you would pay with a 15-year mortgage.
Of course, the monthly payments are also higher because you are paying the same amount in only 15 years. Nevertheless, if you can afford a higher monthly payment, you will be saving a lot of money by choosing a 15-year fixed rate mortgage as opposed to a 30-year fixed rate mortgage.
FHA loans are the easiest mortgage loans to qualify for. But, are they really the best? That would of course depend on your own personal situation. FHA-insured loans offer an easy solution for new homeowners and people who can't afford to make big down-payments on conventional loans. They also make it possible for people who don't have a very good credit score, or those with no credit history to be able to purchase a home. On the other hand, if you can afford to make a larger down-payment, you should definitely consider conventional mortgage loans since you will end up paying less interest and less mortgage insurance premiums, and could thus save a substantial amount of money in the long run.
- Shop around to save even more!
Since FHA mortgages are not loans by the FHA itself, but rather by lenders, it is important to shop around to compare different mortgage companies.