You may have heard that FHA loans can be a great mortgage option because they offer lower interest rates and are easier to qualify for.
But remember that easiest doesn’t always equal cheaper or better.
FHA mortgages allow down payments as low as 3.5 percent and have less stringent underwriting guidelines than conventional loans because they are insured by the Federal Housing Administration.
But they come at a price that sometimes can be significantly higher than what you would get with a conventional loan.
“It seems like FHA is really close to a subprime loan,” says Kristen Martinez, president of Assai Funding in La Quinta, Calif.
That doesn’t mean FHA loans are bad and you should stay away from them, she says. They can be a great opportunity for many potential homebuyers, but you have to make an informed decision.
When an FHA may be the right option
If you don’t have at least 5 percent for a down payment or if your credit score is not high enough to qualify for a conventional loan, an FHA loan may work for you.
For instance, a borrower with a 620 credit score may qualify for an FHA loan with 3.5 percent down payment, Martinez says. By contrast, to qualify for a conventional mortgage, a borrower generally needs a minimum credit score of 680 and at least 5 percent down. Many lenders require at least 10 percent down.
Unlike with conventional loans, FHA allows you to receive your down payment money as a gift from a relative. In conventional loans, you must demonstrate that at least 5 percent came from your own savings.
Those who went through bankruptcy or foreclosure recently may also be able to benefit from an FHA loan, says Jack Guttentag, a professor finance emeritus at the Wharton School of the University of Pennsylvania. If two years have passed since your bankruptcy or foreclosure, you may qualify for an FHA loan. With conventional loans, you have to wait five years before you can qualify, he says.
When FHA is not for you
In general, if you qualify for a conventional mortgage and have the sufficient required down payment, you should stick to the conventional loan.
If you can put 20 percent down on a home and have a credit score above 720, there is no question that an FHA loan would be the wrong choice, says Matt Hackett, underwriting manager at Equity Now in New York City.
The rule of thumb to decide whether an FHA loan is your best option is simple: Ask for a comparison, says Michael Moskowitz, president of Equity Now.
Your mortgage broker or loan officer should be able to give you a detailed comparison of an FHA loan versus a conventional loan, including upfront fees, mortgage insurance costs and monthly payment estimates.
On the surface, FHA loans may seem to offer interest rates slightly lower than conventional loans, but they can end up being more expensive. That’s because of mortgage insurance costs, which are included in the borrower’s monthly mortgage payments. Mortgages loans with less than 20 percent down generally have to carry mortgage insurance, but the insurance on FHA loans is more expensive than the insurance on conventional loans. In addition, FHA borrowers are charged an upfront fee of 1 percent of the total loan that often is added to the total amount borrowed.
For instance, in the example outlined in the chart below, a borrower makes a 10 percent down payment on a $198,000, 30-year fixed mortgage. In early May, the interest rate would be about 4.5 percent with an FHA loan compared to 4.875 percent with a conventional loan. Because of the higher mortgage insurance costs for FHA loans, the monthly payment would actually be $47 less with the conventional mortgage, Hackett says. In this example, the FHA loan has a $1,980 upfront mortgage insurance premium added to the total loan amount.
|Monthly principal & interest||$1,013||$1,048|
|Monthly mortgage insurance||$182||$102|
|Monthly principal, interest, mortgage insurance||$1,195||$1,150|
“The comparison has to include everything,” Moskowitz says. “And if your broker or your lender doesn’t want to do a comparison you shouldn’t deal with them.”
Avoid getting steered into an FHA
Some brokers or lenders may try to steer you into an FHA loan for various reasons.
Up until recently, some brokers may have pushed borrowers into FHA loans because they made more money on them, Moskowitz says. New regulation that governs how brokers get paid went into effect in April and will help prevent the problem, he says.
“They made 30 (percent) to 40 percent more on an FHA,” he says. “So there was a concern that people were steering borrowers into FHA loans because they were making more on them but in many cases, FHA was the wrong way to go for the borrower. But that shouldn’t be happening anymore, at least not based on commission.”
Some brokers, however, may try to persuade a borrower to opt for an FHA loan simply out of “laziness” or “ignorance,” Moskowitz says.
“If you go to an FHA shop and that’s all they do, most likely that’s what they’ll offer you because that’s what they know.”
Since the crash of the housing market after subprime loans evaporated, an increasing number of lenders have obtained approval to offer FHA loans. FHA’s market share has increased from about 5 percent before the crisis in 2006 to about 30 percent.
“Everyone is doing FHA these days,” Moskowitz says. “But that doesn’t mean they are for everyone.”