If you're looking to finance a home purchase, FHA loans come with a few advantages that make them quite desirable:
- They have low credit score requirements.
- They require only a small down payment.
- They are fairly easy to qualify for.
But they aren't without fault. In fact, the list of FHA loan drawbacks is actually quite lengthy.
For one, they require costly mortgage insurance, both upfront and annually, and often for the entirety of the loan term. They're also not available for investment purchases unless you plan to live on the property, and they usually come with higher interest rates than other loan programs out there, too.
- They require mortgage insurance premiums upfront and annually.
- They often come with higher interest rates.
- They're not for use on investment properties.
- Homes must meet stringent property requirements.
- They don't give sellers much confidence in a buyer.
Let's take a look at each of these FHA loan drawbacks in depth.
FHA loan drawbacks to know
As you can see above, there are quite a few drawbacks to using an FHA loan. One of the biggest is the mortgage insurance premium they come with.
Mortgage insurance is non-negotiable
On FHA loans, a mortgage insurance premium (also called MIP) is required at the time of closing -- dubbed an upfront mortgage insurance premium -- and on an annual basis. The annual fee is spread across 12 months and lumped in with your mortgage payment.
The cost of mortgage insurance varies depending on your down payment, loan term, and loan amount, but you'll usually pay anywhere from 0.80% to 1.05% of your loan amount upfront, and then somewhere between 0.45% and 0.95% annually.
On a $200,000 home purchase, that would mean $1,600 to $2,100 upfront and then $900 to $1,900 per year.
They usually mean higher interest rates
FHA loans often come with higher interest rates than other loans, simply because they're riskier. Since their credit score requirements are lower, there's a bigger chance the borrower will default on the loan. To protect themselves from this added risk, lenders will charge a higher interest rate. Keep in mind, a higher interest rate means a higher monthly payment as well.
You can't use them on most investment properties
FHA loans can only be used to buy a house that will be your primary residence. They're not intended for use on investment or income-earning properties. With that said, there is a small loophole. If you're willing to live in the home you're buying with an FHA loan, that's allowable. The house just needs to be four units or smaller, and you need to move into the home within at least 60 days.
Your property needs to pass muster
In order to qualify for an FHA loan, a property must meet certain health and safety standards established by the Department of Housing and Urban Development (HUD). The home will also need to go through the FHA's strict appraisal process before your loan can be approved.
Most large-scale fixer-uppers simply won't qualify for a traditional FHA loan. If you're looking to buy and rehab a property, the FHA's 203k loan might be a better choice for you.
They won't help you win a bidding war
If you find yourself up against other bidders, an FHA loan likely won't help your case much. Compared to an offer with a conventional loan, for example, an FHA-backed offer means a stricter appraisal of the home and, in many cases, a buyer with worse credit and a higher chance of their loan falling through. Both are disadvantages to a seller.
FHA loans do have advantages, though
Make no mistake: FHA loans aren't all bad. There are some major perks to using these loans, including their 3.5% minimum down payment and their low credit score standards (you might be able to qualify with a score as low as 500).
But as with any financing product, it's important to weigh both the pros and cons before moving forward. You should also think long term. While a small down payment may be nice, it will also mean a larger monthly payment and higher interest rates. Try to take all factors into account and see the bigger picture before choosing which loan is best for your real estate purchase.
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