3 Drawbacks of FHA Loans

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Before you take out an FHA loan, consider the downside involved.

Not everyone who borrows money to buy a home takes out a conventional mortgage. Depending on your situation, you may be interested in getting an FHA loan.

FHA loans are those backed by the Federal Housing Administration, and they differ from conventional home loans in a number of ways. For one thing, conventional mortgage lenders often require a 10% down payment on a home (though some will take less). With an FHA loan, you can buy a home with as little as 3.5% down.

Furthermore, the minimum credit score required to take out a conventional mortgage is 620. With an FHA loan, you can get approved with a credit score as low as 580 if you're putting down less than 10% of your home's purchase price at closing. (Technically, the minimum credit score for an FHA loan is 500, but in that case, you'll need a 10% down payment or more.)

But while FHA loans may be more flexible than other loans, there are some drawbacks involved in taking one out. Here are three you should be aware of.

1. Costly mortgage insurance premiums

When you borrow via an FHA loan, you're required to pay an upfront mortgage insurance premium that equals 1.75% of your loan amount. On top of that, you'll be liable for ongoing mortgage insurance premiums, the cost of which will hinge on your loan amount and length.

Now in some ways, this is similar to private mortgage insurance (PMI), which applies to conventional loans when borrowers don't put down at least 20% of a home's purchase price at closing. But the difference is that PMI can be canceled eventually once homeowners gain enough equity in their home. FHA mortgage insurance premiums generally cannot be canceled.

2. Less equity to start with

Being able to make a down payment as low as 3.5% of your home's purchase price may seem like a good thing. But it also means you start out with little equity in your home. And that could prove problematic if your home value happens to decline quickly. In that case, you may reach a point where you're underwater on your mortgage, which means you owe more to your lender than what your home could sell for.

Being underwater on a mortgage isn't necessarily a terrible thing if you can keep up with your home loan payments and intend to stay put. But if you start falling behind on your mortgage payments when you're underwater, you could end up in a pretty bad financial situation -- one where you're forced to pursue a short sale or risk foreclosure. Both of these options can cause credit score damage and make it difficult to borrow money for years.

3. Seller pushback

Because FHA loans come with stricter guidelines than traditional mortgages, some home sellers may not want to work with a buyer who's taking out an FHA loan. If a home being sold winds up getting appraised at a lower price, that could kill the deal in question, leaving a seller to have to find a new buyer.

Now a low home appraisal could be an issue with a conventional mortgage, too. But FHA loans come with certain appraisal guidelines that effectively force appraisers to look for defects. Those guidelines don't necessarily apply to appraisals performed for conventional mortgages.

Along these lines, in today's housing market where inventory is so limited, bidding wars have been springing up all over the place. So if it's you against another buyer vying for the same home, and you're coming in with an FHA loan while your competition is getting a conventional mortgage, that could give the other buyer an automatic edge.

While there are benefits to getting an FHA loan, it's important that you understand the flipside. Consider your borrowing options carefully when deciding which type of mortgage it ultimately makes sense for you to take out.

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