What Are Advantages and Disadvantages of FHA Mortgages

A Federal Housing Administration (FHA) home loan is not for everybody.

If you have a FICO score of 740 or above, and intend to make a 20 percent down payment on a home, you qualify for the best mortgage rates offered.

FHA loans cost more but are often the only way for first-time buyers—or those with marginal credit—to get a home of their own.

Here's how to determine if an FHA loan is right for you:

What is an FHA mortgage?

An FHA mortgage is insured by the FHA, part of the U.S. Department of Housing and Urban Development (HUD).

The federal government insures loans for FHA-approved lenders to reduce their financial risk caused by borrowers defaulting on payments.

In the depths of the Great Depression, Congress passed the National Housing Act of 1934 that created the FHA.

That year, the housing industry was moribund.

Mortgage defaults and foreclosures soared. Home construction stalled, causing two million in that industry to be out of work. The number of homes sold tumbled. Prices collapsed.

Mortgage terms were onerous: 50 percent down, with a three- to a five-year term which ended with a balloon payment.

Not surprisingly, the U.S. was a nation of renters—only four in 10 owned the roofs over their heads.

As part of the New Deal, the FHA had a mandate to improve the situation. It stimulated the housing market by making loans affordable; opening them up to a wide range of people.

Since 1934 the FHA and HUD have insured more than 34 million home loans making them the largest insurers of mortgages in the world.

Today, even after the housing bubble burst, home ownership in the United States stands at 65 percent.

What are the advantages of an FHA home loan?

It's relatively easy to qualify for FHA mortgages which are backed for a borrower's primary residence only. 

Borrowers must have a solid history of employment or have worked for the same employer for at least two years.

They must be legal U.S. residents over 18 and have valid social security numbers.

Borrowers with FICO scores over 580 can get an FHA-backed home loan for as little as 3.5 percent down. That deposit can be given to the borrower by a family member.

FHA home loans can be granted to borrowers with FICO scores as low as 500 although these home loans require at least a 10 percent down payment with a maximum loan to value (LTV) of 90 percent.

The loan to value is determined by taking the mortgage amount and dividing it by the appraised value of the property.

If you've ever declared bankruptcy, it typically should be at least two years behind you, while foreclosures should be at least three years in the past.

In both of these cases, you need to have reestablished good credit.

Another big advantage of an FHA loan is that if you sell your property, the buyer can assume the mortgage.

What are the disadvantages of an FHA mortgage?

An FHA loan requires that a property meets minimum standards of habitation at the appraisal by an FHA-approved appraiser.

If the property doesn't meet those standards, either the current owner has to pay for improvements or the borrower has to handle the repairs from funds placed in escrow (before the mortgage is granted). The FHA got hit hard by the mortgage meltdown.

Concerns about financial solvency have caused the FHA to raise insurance premiums. Because its lending standards are lower than others, the FHA requires two kinds of premiums.

The first is the upfront mortgage insurance premium (MIP).

Borrowers have to pay this no matter what their credit score is or the loan's LTV. This MIP is 1.75 percent of the mortgage, so for a $300,000 mortgage, the premium would be $5,250.

This fee can be paid at closing or folded into the home loan.

The second is the called the annual MIP, although it's added to your monthly mortgage payments.

This MIP is determined by the borrower's LTV, loan size and duration. Because the numbers vary, this handy chart provides FHA insurance premium details.

A borrower's front-end ratio (mortgage payment, home owners association fees, property taxes, mortgage insurance, property insurance) usually needs to be less than 31 percent of gross income, although due to extenuating circumstances borrowers might be approved with ratios as high as 46.99 percent.

Ability to Repay Rules, mandated by the Consumer Financial Protection Bureau, require that, for an approved loan, a borrower's back-end debt-to-income ratio (mortgage plus all monthly debt service) needs to be less than 43 percent of gross income.

Like so many government-backed programs, there are strict rules and disclosures, but for many Americans an FHA mortgage is the best way to buy a home.

Which Type of FHA Mortgage Is Right for You?

When you’re approved for a mortgage loan one of the first questions asked will be if you want a fixed rate loan for either 15 or 30 years.

Depending on your financial situation and income flexibility, you should determine which is the right loan for you.

Look at the rates and your income and decide if the loan repayments are something that you can truly afford without any problems.

Experts recommend spending between 25 to 35% of your pretax income on your mortgage -- this includes property taxes and home insurance payments.

Interest rates can vary between both loans, so it’s important to determine which rate would suffice.

First-time Homebuyers

If you’re a first-time homebuyer, you may want to consider a 30-year mortgage to allow for smaller mortgage payments and overall flexibility of the loan.

If you’re in the market and looking for additional property, you can look at the variables in choosing a 15-year mortgage.

The bottom line is that you should consider the time of the loan, which could save you thousands of dollars in the end.

An FHA, or Federal Housing Administration loan can also help, as down payments can be as low as 3.5% of the purchase price, and most of your closing costs and fees can be included in the loan.

15 years

If you’re looking to pay off the mortgage in half the time of the 30-year loan, consider this option. The 15-year loan forces the consumer to discipline themselves into making those payments on time.

One big plus is that you can save money over the life of your loan and receive a lower interest rate.

Also, consider the fact that you will pay off the loan quicker and save on half the amount of interest.

If you plan to only live in the house for a few years, this loan may be better for you.

You can still lock in a lower rate with this loan which may offset the increase in the monthly payment. The downfall of the loan is that you will have a higher mortgage payment.

If you miss even one payment due to a financial emergency, you risk your house being put on the foreclosure block.

The lender is not flexible with this type of loan so you will not be able to switch to the 30-year mortgage should you change your mind. Really consider if this option is a viable one for you.

30 years

This option is great for someone who is a first-time homebuyer and is also the more popular choice due to its affordability.

Depending on the interest rate and size of the loan, you can expect to pay hundreds of dollars less than with a 15-year loan.  The flexibility of the payments on this loan varies.

Even though it may seem like you can afford to pay off a 15-year loan, you may want to consider the 30-year option due to the fact that there is flexibility.

You can pay off your 30 year mortgage in half the time by paying more each month, which can go toward the principal amount.

If by chance there is a time within the life of the loan that you run into money problems, you can go back to the original payment agreement without any stipulations.

Let’s consider the idea that if you borrow $100,000 for 30 years at 8% interest, you will ultimately end up paying the lender about $265,000. This includes the $165,000 in interest.

Whatever option you decide, make sure you do your homework before you commit to paying off a mortgage. Visit our mortgage rates page to find the best mortgage rates available.