FHA loans are federally backed loans insured by the Federal Housing Administration. FHA loans are traditionally used by buyers who cannot come up with the larger down payments required on a Conventional loan which has a minimum down payment of 5% down on single family homes and 20% to 25% down on multi-family homes. The perception is that FHA loans are typically used more by lower to moderate income buyers, however not all buyers who use FHA are low to moderate income homebuyers.
The FHA loan program started during the Great Depression of the 1930s, when the rate of foreclosures and defaults rose sharply, and the program was intended to provide lenders with sufficient insurance to encourage them to lend. FHA does not lend the money to homebuyers, they insure the lenders that lend the money against loss.
FHA loans fell out of favor during the real estate boom of 1998-2006, as sellers did not want to be exposed to the more marginally qualified buyers that were usually attached to an FHA loan, nor did they want to hassle with the more stringent appraisal requirements of an FHA loan.
However, in a buyer’s market, FHA loans are commonly accepted in most markets, and FHA loans have become a savior for many home buyers in some eras. If it were not for the FHA loan, some real estate transactions would not occur.
FHA loans have more relaxed underwriting standards, below is a sample:
-credit scores are more lenient on FHA loans than for Conventional loans.
-a down payment as small as 3.5% is acceptable (for a Conventional loan at least 5% is required).
-on an FHA loan the seller can pay all closing costs (this is also usually the case on most Conventional loans as well).
The downsides to FHA loans:
-The mortgage insurance cost on an FHA loan is more expensive than on a Conventional loan. On an FHA loan as of 2015 it may be as follows: monthly payments based on 0.85% of the loan amount divided by 12, where as on a Conventional loan that may only be 0.41% of the loan amount divided by 12. On a $400,000 loan this means that an FHA loan would be $146/month more expensive for monthly mortgage insurance.
-On an FHA loan there is a 1.75% up front mortgage insurance premium (UFMIP) based on the loan amount which is financed into the loan, for a Conventional loan this is $0. On a $400,000 loan this means that an FHA loan would be $7,000 more expensive in UFMIP.
-On a 3.5% minimum down payment FHA loan the mortgage insurance is never able to be canceled, whereas on a Conventional loan you can potentially drop the PMI at some point in the future.
-On an FHA condo loan FHA requires that 51% or more of the condo building be occupied by primary residents versus tenants (called the investor level) and the condo must be on the FHA “approved list”. On a Conventional loan the investor level can be much higher and there is no “approved list” that condos need to worry about being on for Conventional loans.
As a buyer if any of the above advantages are appealing or fit your financial circumstances then an FHA loan is worth looking into. Carefully weigh the costs of an FHA loan and also consider coming up with a larger down payment and going with a Conventional loan. And realize that in a sellers market that your offer may be considered less favorably than other offers, due to some of the above perceived and real disadvantages by sellers who are weighing your offer.
*The above is accurate as of December 2017 but is subject to change at any time.