Homeownership has been the American dream for some time, and the government has made valiant efforts to make owning a home an attainable goal for many people. However, the most common way to finance a home, other than a traditional mortgage, is with a loan insured by the Federal Housing Administration, or FHA.
While there are some benefits to an FHA loan, like being able to qualify for a mortgage without a large down payment or an excellent credit score, the reality is that these loans can often be too expensive to justify. Let's take a look at the perks and hidden costs of FHA loans and why you'd likely be better off renting.
The allure of an FHA loan is simple – it's simply much easier to qualify for than conventional financing.
Many lenders will approve FHA loans for buyers with credit scores as low as 600, while conventional financing generally requires a score of 700 or above. In fact, the average credit score for those consumers rejected for a mortgage is 724, which is well within the realm of "very good" credit.
Some conventional lenders will approve lower scores, but want a large down payment and low debt-to-income ratio in order to do so.
Additionally, an FHA loan can be had with a very low down payment of 5%, or even 3.5% for first-time buyers. There are conventional financing options with low down payments, but you'll need fantastic credit.
The interest rate seems low, so how can it be expensive?
However, the easier qualification comes at a price. Not only are you financing more of the home's purchase, which already makes your loan payments higher, you'll have to pay FHA mortgage insurance as well.
The FHA's mortgage insurance premiums have increased significantly over the past few years. At closing, you'll have to pay 1.75% of the loan amount upfront. So, on a $250,000 mortgage, you're looking at another $4,375 tacked on to your closing costs.
You'll also have to pay an annual premium, which is divided among your monthly payments. For most 30-year loans the rate is currently 1.30% per year, so on that $250,000 mortgage, add an extra $270 to each payment.
So, let's compare two monthly payments, on a $300,000 home, one with a conventional mortgage and one with an FHA loan. Both have 30-year terms and both have an interest rate of 4.25%. Since the conventional loan requires 20% down, the buyer only finances $240,000, which translates to a monthly payment of about $1,180.
The FHA buyer only puts 5% down, so the loan amount is $285,000. And mortgage insurance adds $309 to the payment, resulting in a total of $1,711, or 45% more than the conventional loan's payment – for the same house. Over the life of the FHA loan, the payments add up to more than $615,000, more than twice the cost of the house. The conventional loan's payments add up to just $425,000.
FHA loans vs. renting – you may be surprised
According to industry experts, for a relatively expensive home (over $200,000), you can expect to pay about 0.8% of the home's value in rent. So, for our $300,000 example, you can expect to pay about $2,400 per month.
While the FHA loan payment in the example was just $1,711, this doesn't take taxes and insurance costs into account, which renters don't need to worry about. Adding in those expenses should bring the payment to about $2,100 depending on what area of the country you live in.
When you add in maintenance, which costs the average homeowner between 1-4% of the home's value per year ($3,000-$12,000 on a $300,000 home), owning a home through an FHA loan can easily be more expensive – and more stressful – than renting a similar home.
The bottom line is that an FHA loan is usually not worth the extra costs. Buying a home with a conventional mortgage can easily be cheaper than renting, and if you can't obtain a loan for either credit or down payment reasons, you're probably better off renting and focusing your efforts on building up your credit and savings.