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Pro's and Con's of FHA Loans

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Many borrowers have heard about FHA loans and wonder whether or not they qualify, and if an FHA loan is a good idea.

The U.S. Federal Housing Authority (FHA) helps homebuyers by providing mortgage insurance on loans made by FHA-approved lenders. The FHA itself does not make loans. The term "FHA loan" refers to a loan that is provided by a traditional lender such as a bank, but which is backed by FHA mortgage insurance. FHA mortgage insurance provides the lender with protection against default, and the lender assumes less risk. If the homeowner defaults on his or her mortgage, the FHA pays a claim to the lender.

The FHA insures loans made to single-family homes, condominiums, and multiple-family dwellings. If the borrower meets FHA credit and income requirements, the borrower is eligible for up to 96.5% financing. The borrower is able to pay the upfront mortgage insurance premium with the mortgage payments. The borrower is also responsible for paying an annual premium.

FHA Loans and the high credit-risk borrower

For borrowers with a poor credit rating, an FHA loan can mean the difference between being granted a mortgage and being denied. Of course, every borrower is an individual and each borrower has his or her own unique set of circumstances including credit history, credit rating, income, recurring monthly debt, and the selling price of the house that the borrower wants to buy. Distinct from the FHA approval process, changing any one of these factors can make a difference.

Because it is a federal program designed to encourage home ownership, FHA will often insure mortgages given to borrowers who have less-than-stellar credit histories. There are a number of very good reasons why an FHA loan may be right for you.

Attractive features of FHA Loans

  • Credit score. A borrower's FICO score can be lower than that required for a conventional loan.
  • Bankruptcy. As long as the borrower has maintained good credit since his or her debts were discharged, many borrowers can qualify for an FHA loan two to three years from the date of the bankruptcy discharge.
  • Foreclosure. If the borrower's credit history is in good condition after a foreclosure, an FHA loan may be available two to three years from the date of the foreclosure.
  • Loan rate. With FHA insurance to reduce the risk, a lender may be able to offer a lower interest rate than without FHA participation.
  • Down payment. The FHA will insure loans up to 96.5% of value, which permits a down payment as low as 3.5%.

FHA Loan Drawbacks

There are reasons not to seek an FHA loan. Here are a few.

  • Lower loan amounts. The FHA sets limits on the loan amounts they are willing to insure. FHA loan limits may be less than conforming loans under Freddie Mac or Fannie Mae. You can check your state or regional limits on the FHA website. Before you go shopping for your dream house, you should set your budget and plan how much of a mortgage you can obtain.
  • A lower interest rate on the mortgage than the lender might have offered without FHA mortgage protection.
  • Credit history. In most cases, to get an FHA home loan you need to have a credit history. Your credit doesn't have to be perfect, but you need some history for the FHA to evaluate. If you have no credit history, start building your credit now. But even if you have no credit history, it never hurts to ask.
  • Mortgage insurance fee. FHA home loans come at a price. While you may have to pay private mortgage insurance (PMI) anyway, you'll pay 1.5% extra up front, plus 0.5% annually (paid monthly). Borrowers must pay this insurance premium on an FHA home loan for five years, regardless of the equity in the home or a good loan-to-value ratio.

Is an FHA loan a good choice for you? Shop around, balance the pros and cons of an FHA loan, and make the decision that's right for you.