There’s a lot of talk about the advantages of FHA loans for home buyers, but there’s little to no talk about the disadvantages of FHA loans when in practice, there are some downsides to this loan program too.
Just like with any service or product, home buyers ought to know about both sides of the argument before deciding to commit to an FHA-insured mortgage loan.
In this article, I’m going to discuss the cons of an FHA loan, so that you’ll have all the necessary knowledge about them to make an informed decision.
Another question that I’m going to cover is whether the disadvantages are significant enough to deter you from applying to this loan.
Why FHA Loan Can be Detrimental to Home Buyers?
Before I delve into all the reasons why an FHA loan might not be the best deal for you, here’s a quick recap of its pros:
- Borrowers with little cash saved up for a down-payment can apply for this loan since there is a low down-payment requirement that’s set to 3.5%;
- Another important benefit is that FHA lenders will accept a lower credit score (580+) compared to conventional loans;
- Overall, it’s easier to qualify for an FHA loan as opposed to a conventional loan;
- Some FHA loans are assumable, which means a prospective buyer can assume your loan under the same conditions and release you from your debt.
In a nutshell, these are the most oft-repeated advantages of FHA loans and this is why first-time home buyers that don’t otherwise qualify for conventional loans decide to apply for these instead.
However, to get the full picture of this type of federal loan program, you’ll need to know more about its downsides too. So, here are the cons of FHA loans:
1. High Mortgage Premium Insurances
Among the downsides of FHA loans for home buyers, the high rate of the mortgage insurance premium is the biggest disadvantage to worry about.
With this loan program, borrowers must pay mortgage insurance since the program is designed to protect lenders from losses incurred in the event of a borrower default.
The requirement of mortgage insurance is determined by the Department of Housing and Urban development, and there are two types of mortgage insurance premiums that borrowers must pay:
- One mortgage insurance premium is set to 1.75% of the base loan amount and it’s an upfront MIP;
- The other mortgage insurance is annual, and it can vary, however, it’s usually set to 0.85% of the base loan.
Borrowers can choose to have these mortgage insurance premiums rolled into their loan, however, monthly payments and the amount that’s going to be paid over time is generally higher compared to conventional loans.
With conventional loans, however, mortgage insurance premiums can be avoided altogether if the borrower can roll out a 20% down-payment.
Therefore, the extra cost of mortgage insurance premiums designed to protect the lender is a significant disadvantage that borrowers should be made aware of.
Of course, those who wouldn’t otherwise qualify for a conventional loan, are left with having to pay the extra costs of the mortgage insurance if they want to buy a home.
2. FHA-Specific Property Appraisal is More Thorough
With conventional loans, property appraisal is straightforward — the appraiser will determine solely the value of the property without going into any other aspects of the property.
FHA-specific appraisals will also evaluate the value of the property, but with the added dimension of determining if the property also meets the minimum safety and health standards set out by the HUD guidelines.
This means that a house that’s not habitable or which presents a potential health hazard to the borrower is unlikely to pass the inspection of the appraiser, and unless the issues that were flagged by the appraiser are resolved, the FHA loan procedure is halted.
Similarly, the appraiser may take issue with the lot that the house is built on. For example, if the lot is sloped in a way that water drains towards the house and not away from the house, this too constitutes a problem that could cause safety and health issues because it can damage the foundation of the house.
Another important aspect that’s checked during the appraisal process is that all bedrooms have egress to the exterior in case of a fire outbreak. For example, a room with only a window that’s too small to allow egress is not enough to meet the safety and health standards imposed by the HUD.
Other issues that the appraiser will inspect are the state of the roof, whether the house contains lead-based paint, whether stairs and stairways have handrails, whether the heating is powerful enough, whether the foundation is in a good state of repair, etc.
All these potential issues and any issues that pose a threat to the health and safety of the occupants can drag out the closing of a loan and all these issues need to be sorted out before the loan can close.
From this standpoint, the FHA loan appraisal is much more thorough as opposed to conventional loan property appraisals.
Therefore, sellers that are selling homes in a serious state of disrepair are in the right to not accept an FHA loan offer since their property will not pass the appraisal process anyway.
Even with the more stringent safety and health requirements, most homes will meet the FHA requirements, or the discrepancies flagged by the appraisal report can be easily corrected if the seller is willing so that the deal can move forward.
Plus, recent revisions to the guidelines have streamlined the process in the sense that sellers are no longer required to fix minor issues before the loan can close.
3. Property Type Restrictions
Another restriction of FHA loans is related to the type of property that can be bought with this type of loan. Since this loan program is designed for owner-occupants, you can’t be approved for an FHA loan if you’re buying a vacation home or an investment home.
FHA loans are designed for owner occupants that will have their primary residence at the property they’re financing with an FHA loan.
There’re also restrictions for buying a condominium. Borrowers that are looking to buy a condo will be required to consult condos that are on the HUD’s approved condominium list. Many condos don’t meet HUD’s requirements, and therefore, can’t be purchased with an FHA loan.
Therefore, not only that FHA appraisals are more stringent, there are also specific property type restrictions in force, which you must follow if you want to get approved for and close an FHA loan.
4. Some Sellers Might Not Accept FHA Loan Offers
I mentioned that the FHA loan appraiser has a dual duty of appraising the value of the property but also checking if it meets the minimum HUD requirements for safety and health.
Because of this ‘extra verification’, some homeowners will generally shy away from accepting FHA loan offers, which puts buyers in a more difficult situation when looking for a property.
While some of the concerns that sellers have put forward regarding FHA loans are founded (like in the case of a property that is in a serious state of disrepair and would be a health hazard if issues that are flagged aren’t resolved), other concerns related to minor repairs (e.g. leaky faucets, countertops that need replacing) aren’t an issue.
With ‘as is’ appraisals, sellers are no longer obligated to fix minor issues if the buyer accepts the property as is, which means that such hurdles no longer determine whether the loan can close or not.
Although in the past the seller was required to fix even minor issues that were flagged by the appraiser, the HUD guidelines have been revised since and the seller can accept the property even with the minor flaws, and the FHA loan can close.
Sellers can choose not to consider buyers that are thinking of financing their home with an FHA, and they cannot be compelled to accept such offers.
Still, even if the biases of sellers are unjustified, they’re still there and it’s important to know about them because it will impact your search for a house.
In Summary…
All types of loans have their upsides and downsides, and the FHA loan is certainly no exception. The key is to make an informed decision and know what these types of loans entail.
Before choosing this type of loan program, make sure you speak to a HUD-approved housing counselor and a real estate agent who has experience with FHA home buyers. They’ll be able to guide you through the process and find a suitable property for you.
Despite the mortgage insurance premium costs that will inflate the monthly costs of home buyers, and the sometimes unjustified position of sellers, FHA loan programs by and large remain a good option for borrowers that don’t have the perfect credit or enough money saved up to qualify for a conventional loan.