A new home is one of the biggest purchases you will ever make.
As a first-time homebuyer, there are plenty of things to consider, from making the right offer to choosing the right loan product. Trying to digest everything can get frustrating. However, it is not a stretch to say that the loan you accept today will have an impact on your finances for years to come.
Over 40% of all first-time homebuyer purchases are done with a federal housing administration (FHA) loan. These government back loans feature reduced payment options as well as lower credit score guidelines. As great as these programs are, they are not for every buyer. Like any other loan product, there are distinct pros and cons that must be considered. Here are the pros and cons of an FHA mortgage:
Reduced Payment.The first benefit of an FHA mortgage is the reduced down payment guidelines. With an FHA mortgage, you only need 3.5% of the purchase price. The funds can come from your personal assets or can be a gift from an approved source, including certain family members. Some lenders have started reducing their down payment requirement to 3%, but with those, the entire down payment plus closing costs must come from your own account.
Low Interest Rates.The interest rates for an FHA loan are on average a half point lower than conventional rates. This can vary based on the specific borrower, but in most cases FHA rates are significantly lower. This has a direct impact on the total monthly payment and can help get the monthly payment in your comfort zone.
Approval Guidelines.There are a handful of significant approval guidelines that make FHA loans attractive. For starters, the minimum credit score can be as low as 620 depending on the specific lender. Additionally, there are increased debt to income limits. With a conventional mortgage, you may be capped at a 45% debt to income, whereas an FHA loan can go as high as 50%, and in some cases even higher. Finally, the reserve requirement is reduced. An FHA buyer doesn’t need to have months of mortgage payment reserves on a single-family purchase.
Private Mortgage Insurance (PMI).On any loan where a buyer puts less than 20% down payment, they are required to pay a monthly PMI payment to the lender. This is used as a hedge against default on the loan. The difference with an FHA loan is that the PMI is for the duration of the payments. On a conventional loan, there is the ability to wipe this away once you have 20% equity. With an FHA loan, you make this payment if you have the loan regardless of the equity. This is by far the biggest downside of an FHA loan.
Condition Restrictions.Not every property will be approved for an FHA loan. There are a handful of guidelines regarding the condition that must be met. FHA requires hand railings on all entry ways, no chipped paint of any kind inside the house, and heating system minimum, just to name a few. Many sellers are hesitant working with FHA buyers because they know the appraisal will be heavily scrutinized.
Loan Limits.Not every buyer will get approved for an FHA loan. There are several restrictions on the allowable loan size. This number is based entirely on the zip code and can vary. It can be go from as low as $270,000 to as high as $625,000 in some areas.
Choosing an FHA loan comes down to your available down payment amount, the source of the down payment, and where you want your monthly payment. If you can afford the extra .5% down, a conventional mortgage makes more sense given the ability to eliminate the PMI down the road. If your capital is minimal and you need help getting into the property, an FHA can be your best, and only, way in. There is nothing wrong with either option, and it all depends on what appeals most to you.