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Pros and Cons of FHA-Backed Mortgages

By Paula Pant – Jan 17, 2014 at 2:05PM

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Thinking about buying a home and wondering what type of mortgage to take out? Just 0.25% on your mortgage interest rate can make a difference of thousands of dollars over a 30-year loan. Learn more about the FHA-backed mortgage.

Thinking about buying a home? The mortgage you select will make a tremendous impact on your long-term finances. The difference of just 0.25% on your mortgage interest rate can compound into tens of thousands of dollars over the span of a 30-year loan. 

In other words: Think carefully about which mortgage you choose. Your mortgage selection is one of the most important financial decisions you'll make.

You may be wondering whether or not you should get an FHA-backed mortgage. Let's explore that question further.

What's an FHA Loan?
First, let's clarify something: The U.S. Federal Housing Administration, or FHA, doesn't actually issue any loans.

The FHA insures loans on qualifying residential homes. The lender, however, is a financial institution such as a bank or credit union. (Many people, however, commonly use the shorthand "FHA loan" or "FHA mortgage" to refer to an FHA-insured loan.)

The purpose of an FHA-insured loan is to encourage home-ownership, even among people who may have small down payments or poor credit. It does so by federally insuring the loan, which defrays some of the risk from the lending institution.

The FHA will insure up to 115% of the median single-family home price in a particular geographic area, up to a national maximum of $625,500. In low-cost-of-living areas, the FHA has capped the maximum at $271,050.

The U.S. Department of Housing and Urban Development, or HUD, hosts a "calculator" on its website with which people can get an idea of the maximum FHA limit in their area.

There are no income limit qualifications for an FHA-insured loan.

Advantages of getting an FHA-backed loan
The benefits of an FHA-backed loan include:

  • Smaller down payment. The FHA requires only a 3.5% down payment, while many conventional mortgages look for higher down payments. In fact, the FHA is the nation's largest insurer of low-down-payment mortgages.
  • Bad credit qualification. The FHA will insure loans for people with low credit scores who may not be eligible for conventional loans.The FHA requires a minimum credit score of 580 for a 3.5% down payment mortgage, while many lenders choose to impose a higher minimum score of 670. 
  • No prepayment penalty. FHA loans do not penalize borrowers for repaying the loan early. In contrast, some -- but not all -- conventional loans carry prepayment penalties.
  • Potentially covered closing costs. The FHA will allow sellers to cover a portion of the buyer's closing costs, such as title insurance or an appraisal. However, it should be noted that closing costs are negotiable, which means even people who are obtaining non-FHA-backed loans can negotiate with their sellers on closing costs.

Disadvantages of getting an FHA-backed loan
That said, here are some of the drawbacks of taking out a mortgage that's FHA-insured:

  • Mortgage insurance premium. The FHA requires borrowers to pay a "mortgage insurance premium," or MIP, which is based on their up-front payment. Borrowers who offer a down payment of 5% or higher must pay an annual insurance premium of 1.3% of their outstanding balance, while those who put down less than 5% must pay a 1.35% premium. This is due within 10 calendar days of the mortgage closing date or the disbursement date, whichever is later. 
  • Lifetime insurance premiums. Borrowers who pay less than 10% down must also pay an ongoing monthly premium over the life of the loan. From 2001 until 2013, the FHA allowed borrowers to cancel those premium payments once their debt fell below 78% of the principal balance. However, the FHA announced a policy change in 2013, stating that most borrowers must pay insurance premiums throughout the life of the loan. 
  • Loan limits. As stated above, FHA-insured loans are limited to houses that cost 115% of the median home price in the area, up to a national maximum of $625,000.
  • Must use an FHA-approved lender. Not every lender will participate in the FHA program. If you're going to obtain an FHA-backed loan, you must work with a lender who will process an FHA-insured mortgage.The HUD website offers an approved-lender list
  • Additional paperwork. Not only will you endure the paperwork of a traditional mortgage, but you'll add a further layer of paperwork on top. This may slow down the process and add to your frustration.

Should I get one?
An FHA-backed mortgage may be a great opportunity for an aspiring homeowner who doesn't have a large down payment. If you believe home prices in your area may rise rapidly, and you want to lock in a home at today's prices -- despite the additional mortgage insurance that you'll need to pay -- an FHA-backed mortgage might be a strong option.

And if you have tarnished credit and struggle to qualify for a conventional mortgage, an FHA-insured loan can be a good option.

If, however, you have good credit and a substantial down payment, you might be better served by forgoing the FHA-insured mortgage (and its pricey mortgage insurance premium) and opting for a conventional loan instead.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Paula Pant is a contributor to WiserAdvisor.

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