The Federal Housing Administration (FHA) Loan: The Benefits, Drawbacks & 5 Types

By Chika

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Last Updated: April 29, 2022

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Life is filled with choices and it’s usually our own experiences and circumstances that will influence what we choose. The same could be said about choosing the right kind of mortgage – because not all mortgages are beautiful in the eye of the beholder. 

While some mortgage options might be a good fit for your financial situation, others may not. You could hire professional to advise you on the best mortgage option. However, you could also conduct your research and make informed decisions on your own without paying someone else to do so. 

In your search for the right mortgage option, definitely, the Federal Housing Administration loan will come up in your list. If you're trying to figure out what the FHA loan is, and if its the right choice for you, we'll go over that in this article.

Let's explore what a FHA loan is, including its pros and cons so that you can make the most informed choice that suits your finances. 

 

What is an FHA loan?

A Federal Housing Administration (FHA) loan is a mortgage backed by the government. FHA loans are popular among first-time home buyers who have little funds or have credit issues. This is because they require only a 3.5% down payment for borrowers with a credit score of 580 or higher.

The FHA guarantees mortgages provided by lenders such as banks, credit unions, and nonbanks.

Because the insurance protects lenders in the event of default, FHA lenders are prepared to be more forgiving with borrowers who may not otherwise qualify for a house loan based on other factors like credit score and debt-to-income ratio (DTI). An FHA-insured loan can only be issued by an FHA-approved lender.

For some, the additional loan qualification flexibility may be enough to help them ultimately become homeowners. For others, a traditional loan may be sufficient. Let's take a closer look at what FHA loans have to offer their customers, and when an FHA loan could be the best option for you.

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5 Types of FHA Loans

The Federal Housing Administration (FHA) offers a number of financing choices. These range from typical purchase loans to solutions tailored to fit very particular needs. Here's a rundown of FHA loans that are widely utilized to purchase a home.

Basic Home Mortgage 203(b): This FHA loan can be used to purchase or refinance a primary residence with a low minimum down payment. Its limitation is that it can’t be used to buy a house that needs more than $5,000 in repairs.

203(k) Rehab Mortgage: This loan can be used to finance fixer-uppers. It can be used for homes whose rehab costs exceed $5,000. But, repairs must be executed by a qualified professional and completed within six months.

Title 1 Property Improvement Loan: This can supplement a 203(k) loan if you want to finance home improvements, and can be gotten without refinancing. However, you can only borrow up to $25,000 for a single-family property (or $25,090 for mobile homes that include land) and $60,000 for a multifamily home.

Construction Loan: This loan is used to finance the purchase of land or building of a new home. Its major shortcoming is its qualification process which is difficult and time-consuming.

Energy Efficient Mortgage: If you want to make your home more energy efficient but can't fund it, then the energy efficient mortgage got you covered. However, to qualify, your home must be professionally assessed to qualify. Also, the improvements on energy efficiency must be deemed cost-effective.

 

Benefits Of FHA Loans 

Lower Down Payment 

The low down payment requirement of an FHA loan is one of its most appealing features. Finding a lump sum of cash large enough to make the down payment on a house – which is typically 20% – may be a daunting task for many people, and it is commonly the largest impediment to homeownership.

Borrowers with a credit score of 580 or higher, on the other hand, can make a 3.5% down payment with an FHA loan. 

If you produce a gift letter to sufficiently document the transfer of cash and receive permission throughout the underwriting process, you can utilize gift funds toward your down payment.

You might potentially take advantage of a down payment help program, provided you follow your lender's verification and documentation procedures as well as the rules and regulations in your state or location.

 

Lower Credit Score Requirement 

Requirements for obtaining FHA loans are more relaxed when it comes to down payments and borrower's credit history when compared with traditional mortgage. While most other loan types demand a credit score of 620 or more, an FHA loan may be obtained with a credit score of 580.

Credit scores as low as 500 are acceptable with a 10% down payment. If you're a first-time home buyer with little credit history or have a lower credit score as a result of a financial setback, the FHA loan may be the right choice for you. 

 

Lower Interest Rates 

Mortgage interest rates are fluid and influenced by the overall status of the economy, but that doesn't mean you can't do anything to lower them. When compared to other loan forms, FHA loans often provide superior fixed interest rates. There are also adjustable-rate loans available.

Your interest rate will be set by the general market interest rate at the time you apply for your loan, but it will also be influenced by factors such as your income, credit score, the amount you expect to borrow, your down payment, term, and more.

 

Low DTI Requirements 

Your debt-to-income ratio (DTI) compares your monthly debt to your income. The rule of thumb implies that the lower your DTI, the safer your lender will view you as a borrower. FHA mortgages allow applicants to have a 43% debt-to-income ratio, which can make qualifying for a loan considerably simpler.

Not to add, based on other compensating variables like your down payment, credit score, and cash on hand, this 43% might be bargained even lower.

You can use a co-borrower's income to get accepted for an FHA loan, even if that person will not be living in the house. Adding a non-occupant borrower, such as a family member or spouse, can help you qualify for an FHA loan and provide you even more financial freedom.

 

Cons Of FHA Loans

Mortgage Insurance Premiums 

Although FHA loans are more flexible than conventional loans, lenders will need you to pay mortgage insurance as a safety net. Mortgage insurance premiums (MIPs) are the FHA's counterpart of private mortgage insurance (PMI). This protects the lender in the event that you default on your payments .

Regardless of how much money you put toward your down payment, FHA loans require upfront and yearly MIPs from borrowers. Unless you make a down payment of 10% or more, you'll have MIP throughout the life of your loan. After this, it will be removed after 11 years. 

The amount of mortgage insurance premiums you pay will be determined by the size of your loan, with your MIP set at 1.75% of the entire value of your loan. This amount is required at closing or it can be added to the overall balance of your loan.

While this may appear to be a significant disadvantage for FHA loans, bear in mind that PMI for a conventional loan is likely to be prohibitively expensive unless you have excellent credit. Make careful you compare the costs of private mortgage insurance and FHA MIPs to ensure you're making the best financial option possible.

 

Less Attractive Offers 

Buying a home is already a stressful and competitive process, so it's critical to understand what you can offer a seller.

Unfortunately, because the qualifications for FHA applicants are less stringent than those for conventional loans, FHA financing has a more negative connotation. Make a plan with your real estate agent to uncover other strategies to be a competitive buyer in the perspective of your seller.

 

Restriction on amount of loan you can obtain

An FHA loan may or may not be good for you, depending on how much you want to borrow. For a single-family home loan in a high-cost location, the FHA ceiling, or the maximum amount a borrower can borrow via the FHA loan program, is currently set at $970,800.

The FHA floor for single-family houses in low-cost areas was set at $420,680 in 2022. You should explore your location and the FHA lending limitations accessible to you to get a better idea of how much you may borrow with an FHA loan.

Photo by RODNAE Productions

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