Are FHA Loans Good? Pros and Cons to Consider

FHA loans are a popular option for homebuyers who may not qualify for conventional mortgages. Backed by the Federal Housing Administration, these loans offer lower down payment requirements and more flexible credit standards, making homeownership accessible to a wider range of borrowers. However, they also come with costs and restrictions that should be carefully considered.

Borrower Qualifications

FHA loans have more lenient requirements than conventional mortgages, but applicants must still meet specific criteria. One key factor is credit score. While conventional loans typically require a minimum score of 620, FHA loans allow approval with a score as low as 500. Borrowers with scores between 500 and 579 must make a 10% down payment, while those with 580 or higher can qualify with just 3.5% down.

Debt-to-income (DTI) ratio is another important factor. The FHA generally allows a DTI of up to 43%, though borrowers with strong financial compensations—such as significant savings or a history of on-time rent payments—may qualify with a higher ratio. Lenders also require at least two years of steady employment, though gaps may be acceptable if followed by stable work.

The property must meet FHA standards, as these loans are only for primary residences. Investment properties and vacation homes do not qualify. Additionally, the home must pass an FHA appraisal to ensure it meets safety and livability standards. Structural damage, faulty electrical systems, or missing handrails can delay or prevent loan approval.

Down Payment Requirements

FHA loans are attractive to buyers who struggle to save for a large down payment. The minimum required is 3.5% of the home’s purchase price for borrowers with a credit score of 580 or higher. For a $250,000 home, this means a down payment of $8,750—far less than the 10-20% often required for conventional loans.

Gift funds from family members, employers, or charitable organizations can cover some or all of the down payment, provided they are not loans that require repayment. Lenders require a gift letter and documentation proving the source of the funds.

Many state and local programs offer down payment assistance in the form of grants or forgivable loans, particularly for first-time buyers or those with lower incomes. Borrowers should research available programs in their area, as eligibility and benefits vary.

Mortgage Insurance

FHA loans require mortgage insurance to protect lenders in case of default. Unlike private mortgage insurance (PMI) on conventional loans, which can be removed once a borrower reaches 20% equity, FHA mortgage insurance is mandatory and comes in two forms: an upfront premium and an annual premium.

Upfront Mortgage Insurance Premium (UFMIP)

All FHA loans require an upfront mortgage insurance premium (UFMIP) of 1.75% of the loan amount. This fee is typically rolled into the mortgage rather than paid at closing. For a $250,000 loan, the UFMIP would be $4,375, increasing the total loan balance to $254,375 if financed.

Since this fee is added to the loan balance, it increases the amount borrowed and the total interest paid over time. In most cases, the fee is non-refundable, though partial refunds may be available if the loan is refinanced into another FHA loan within three years.

Annual Mortgage Insurance Premium (MIP)

In addition to the upfront premium, FHA loans require an annual mortgage insurance premium (MIP), paid in monthly installments. The cost depends on the loan amount, term, and loan-to-value (LTV) ratio. For most borrowers with a loan term over 15 years and an LTV above 90%, the MIP rate is 0.55% of the loan balance per year. On a $250,000 loan, this amounts to about $1,375 annually or roughly $114 per month.

Unlike PMI on conventional loans, which can be removed once 20% equity is reached, FHA MIP remains in place for most borrowers unless they refinance into a non-FHA loan.

Duration of MIP

The length of time a borrower must pay MIP depends on the down payment and loan term. If the down payment is less than 10%, MIP is required for the life of the loan. Borrowers who put down 10% or more only need to pay MIP for 11 years.

For those planning to stay in their home long-term, saving for a larger down payment or opting for a conventional loan with cancellable PMI may be a more cost-effective choice.

Loan Terms

FHA loans offer repayment periods of 15 or 30 years. A 30-year term provides lower monthly payments by spreading the loan balance over a longer period. A 15-year term requires higher monthly payments but reduces total interest costs and builds equity faster.

Interest rates on FHA loans are typically lower than those on conventional loans, particularly for borrowers with lower credit scores. However, rates vary based on market conditions, lender policies, and individual financial profiles. FHA loans are usually fixed-rate, meaning payments remain stable over time. Adjustable-rate FHA loans exist but are less common and come with the risk of rising interest costs.

Loan Limits

FHA loans have maximum borrowing limits that vary by location and property type. These limits are set annually by the Department of Housing and Urban Development (HUD) and are based on median home prices in each county.

For 2024, the FHA loan limit for a single-family home ranges from $498,257 in low-cost areas to $1,149,825 in high-cost regions. Limits are higher for multi-unit properties, making FHA loans an option for buyers interested in owner-occupied duplexes or triplexes. Borrowers should check their county’s specific limits to ensure their desired home qualifies.

Closing Costs

FHA loans come with closing costs, including lender fees, appraisal costs, title insurance, and prepaid expenses such as property taxes and homeowners insurance. While these costs are similar to those for conventional loans, FHA loans allow more flexibility in covering them.

Sellers can contribute up to 6% of the home’s purchase price toward closing costs, reducing the upfront expense for buyers. Some lenders also allow borrowers to roll certain closing costs into the loan, though this increases the total borrowed amount and long-term interest costs.

Additionally, state and local programs may offer assistance with closing costs, particularly for first-time buyers. Exploring these options can help borrowers reduce out-of-pocket expenses.