Much has been written about the potential benefits of using an FHA loan to buy a house. (Google it, and you’ll see what I mean.) But less has been written about the potential downside of using this program.
In truth, there are some real disadvantages of FHA loans. Mortgage insurance is chief among them. If you are considering this type of mortgage loan, you need to weigh all of the pros and cons.
Downside: Possible Disadvantages of Using an FHA Loan
Before we discuss the downside of this program, let’s briefly look at the upside. FHA loans are well suited for borrowers who have little cash saved up for a down payment. That’s because the program offers a 3.5% down payment option for borrowers. Generally speaking, it’s easier to qualify for an FHA-insured mortgage loan, when compared to a conventional loan that’s not insured by the government.
That’s the upside. But there are some disadvantages to using an FHA loan as well. Here are three of them…
1. You’ll pay a mortgage insurance premium. Two of them, actually.
This is arguably the biggest downside of the FHA program. Borrowers who use this type of home loan have to pay for mortgage insurance. This insurance protects the lender in the event of default, and is required by the Department of Housing and Urban Development (HUD), which manages the program.
You actually have to pay two different insurance premiums when using an FHA loan.
- There’s an upfront mortgage insurance premium (MIP), which is usually 1.75% of the base loan amount.
- Borrowers must also pay an annual premium, which can vary. The annual premium for most FHA borrowers is 0.85% of the base loan amount.
These premiums can be rolled into the loan, which reduces the borrower’s out-of-pocket expense. But it still inflates the monthly payment and the total amount paid over time.
So that’s one clear disadvantage or downside of FHA loans. You have to pay extra for mortgage insurance that protects the lender. In contrast, borrowers who use conventional home loans and put down at least 20% can avoid mortgage insurance altogether.
2. You’ll encounter some property restrictions.
The FHA program is managed by HUD, and HUD has some pretty specific rules about the types of properties that can be purchased. Forget about buying a vacation home with an FHA loan. That’s generally not allowed. There’s also a fairly strict appraisal process, during which a HUD-approved appraiser will visit the property to ensure it meets all program requirements (particularly safety requirements).
HUD also has specific guidelines regarding condominiums. In fact, many condos do not meet FHA approval standards for one reason or another. If you want to buy a condo with an FHA loan, the condominium project must be on HUD’s approved condo list, which you can find on their website. We will talk more about condo purchases in a separate article.
3. Some home sellers shy away from FHA loans.
Another possible disadvantage of FHA loans is that some sellers avoid buyers who use them. This happens more often in hot real estate markets where sellers receive a lot of competing offers. This kind of stigma is often based on the advice — possibly bad advice — from real estate listing agents.
Some agents steer their clients away from FHA offers in favor of conventional mortgage loans. Why? Because of the appraisal process mentioned earlier. The “logic” here is that the seller will endure a stricter inspection and appraisal process, as a result of working with an FHA buyer.
In the past, sellers were also required to pay some of the buyers’ closing costs, in cases where an FHA home loan was being used. But this rule has changed over the years. Today, buyers can cover almost all of their own closing costs, if negotiations go that way.
The bottom line is that there’s still a lot of bias against FHA loans. It may be unjustified bias — but it’s still out there. And it’s a possible downside you must consider.
Takeaway: Every type of mortgage loan has certain pros and cons associated with it, and FHA is no different. Before choosing this type of product, consider the advantages as well as the disadvantages. Speak to a real estate agent in your area who has helped FHA home buyers in the past. He or she will be able to tell you whether or not it might work against you. Also, consider speaking to a HUD-approved housing counselor about the program.