The High Costs of an FHA Loan -- and Why You Might Want to Use One Anyway

FHA loans have some drawbacks, but the benefits might work for you. Find out why.

When you decide to buy a home, there are two broad categories of mortgages you can choose from.

You could choose a conventional loan. These are originated by mortgage lenders. They're either bought by one of the major mortgage agencies (Fannie Mae or Freddie Mac) or held by the bank for investment purposes.

Or, you can choose to pursue an FHA home loan. This type of loan is guaranteed by the Federal Housing Administration (FHA).

There are other, specialized types of loans such as VA mortgages and USDA loans. However, conventional and FHA mortgages are the two types everyone can apply for, regardless of whether they served in the military or where the property is physically located.

FHA loans allow borrowers easier access to homeownership. But there's one major downside -- they are expensive. Here's a primer on FHA loans, how much they cost, and why you might want to use one to buy your first (or next) home regardless.

What is an FHA loan?

An FHA loan, or FHA mortgage, is designed to help borrowers with lower credit scores or less cash than would ordinarily be needed for a down payment.

FHA loans are always fixed-rate mortgages, and have loan terms of either 15 or 30 years. These types of loans are designed only for primary residence purchases. In other words, you can't use an FHA loan to buy an investment property or a vacation home.

Who can qualify for an FHA loan?

FHA loans are considerably easier to qualify for than conventional mortgages. Here are a few factors lenders look at when deciding whether you qualify for an FHA loan.

Here's a quick rundown of the qualifications as of the publishing of this article:

Credit score

You'll need a minimum FICO® Score of 500 to qualify for an FHA loan.

If you have a FICO® credit score of 580 or higher, the minimum down payment required for an FHA mortgage is just 3.5% of the purchase price. If your credit score is below 580, you'll still qualify -- but you'll need a 10% down payment.

Lenders generally pull your FICO® scores from all three credit bureaus (Equifax, Experian, and TransUnion) and use the middle score for loan approval purposes. In other words, if your three FICO® scores are 588, 602, and 611, your FICO® score for loan qualification is 602.

Employment history

You'll also need to document an employment history for the last two years to qualify for an FHA loan.

You don't necessarily need to have worked in the same job for the entire two-year period, but you can't have any significant employment gaps. And if you were in school for some of the time, that's okay, too.

Income

To get an FHA loan, you'll need sufficient income. The general rules are that your new loan payment shouldn't be more than 31% of your gross monthly income and that the total of all your debts (including the new mortgage payment) shouldn't exceed 43%.

These are known as your front-end and back-end debt-to-income (DTI) ratios, respectively. Lenders may stretch these, allowing an overall debt-to-income ratio of as high as 50% in some cases. For this step, be sure that you can document your income and that your employment history can be readily verified.

What can you expect for your monthly mortgage payment? Use our mortgage calculator to estimate the payments for different mortgage amounts.

Property

Finally, the property itself needs to appraise for an acceptable value by an FHA appraiser, and must meet the FHA's minimum property standards for safety, security, and structural integrity.

FHA Loan costs

FHA loans are guaranteed by the Federal Housing Administration, and this guarantee isn't free. It comes in the form of FHA mortgage insurance.

This insurance is required of every borrower who obtains an FHA loan -- regardless of how strong or weak their qualifications might be.

Mortgage insurance is a standard component of most home loans where the borrower puts less than 20% down. Most mortgage insurance simply requires an ongoing mortgage insurance premium, and can be cancelled once you've paid off most of your mortgage. But FHA loans have two different mortgage insurance expenses -- and FHA insurance cannot be cancelled.

Ongoing insurance premium

The ongoing FHA mortgage insurance premium ranges from 0.45% to 1.05%. This is paid in 12 monthly installments each year and depends on how much the borrower puts down, the amount of the loan, and certain other factors.

For example, if you obtain an FHA loan for $200,000, you can expect an annual mortgage insurance premium ranging from $900 to $2,100.

Upfront insurance costs

In addition, FHA loans require an upfront mortgage insurance premium equal to 1.75% of the initial loan amount.

Continuing our example of a $200,000 FHA loan, this adds another $3,500 to the cost of your home.

Length of coverage

There's another major (negative) difference between FHA mortgage insurance and private mortgage insurance (PMI).

PMI can be canceled once the loan-to-value, or LTV, ratio reaches 80% or less. With FHA mortgage insurance, you're generally stuck with the premium for the entire term of the loan (especially if you put less than 10% down), unless you decide to eventually refinance it into a conventional mortgage. The cost of FHA mortgage insurance is in addition to any FHA loan closing costs you have to pay.

In a nutshell, FHA loans are generally more expensive than their conventional counterparts.

Advantages of FHA loans

Of course, the main advantage of FHA loans is that they're easier to qualify for than conventional loans.

The bare minimum for a conventional loan is a 620 FICO® score, and borrowers near this threshold can expect higher mortgage interest rates. Meanwhile, FHA borrowers pay a standard interest rate depending on current market conditions, not on whether they have good credit. So, if today's average mortgage rate is 4%, that's roughly what you should expect from an FHA mortgage rate.

Another nice feature of FHA loans is that closing costs can be rolled into the loan, or you can ask the seller to pay for your closing costs. So, if you choose the 3.5% down payment option, that could be all you have to pay upfront.

Drawbacks of FHA loans

In addition to the high costs, there are a few other potential drawbacks to FHA loans.

For one thing, there are no choices for term length aside from the standard 15- and 30-year loan terms. Conventional loans are available in a variety of other choices, such as 20- and 25-year options.

Also, FHA loans are limited in terms of loan size. In general, FHA loans are not intended for purchases of homes that cost much more than the median home price in their market.

FHA mortgages can be great tools for homebuyers

FHA loans can be especially good choices for:

• First-time home buyers who might not have a ton of cash available.
• Borrowers who have made some credit mistakes in the past.
• People who want to get into real estate investing but don't have the capital required for traditional investment property financing.

The bottom line is that while FHA mortgages are considerably more expensive than conventional home loans, they can still be excellent homebuying tools for many buyers.