This Could Be the Biggest Reason to Avoid an FHA Loan

A couple signing paperwork with a realtor in a new house.

Image source: Getty Images

Read this before you apply for one.


Key points

  • FHA loans help borrowers with poor credit secure a mortgage with a minimal down payment.
  • Despite these benefits, having to pay a mortgage insurance premium is a major drawback of these loans.

A big challenge many buyers run into when trying to purchase a home is not having enough money for a down payment. This might especially hold true today.

Home prices are up on a national level, so coming up with a down payment now means having to accumulate even more cash. Even if you’ll be able to afford the monthly mortgage payment, you may still be limited in funds to put down at closing.

If that’s the case, you may want to look at an FHA loan. FHA loans allow you to purchase a home with as little as 3.5% down. They also have lower credit score requirements than conventional mortgages, so if your credit needs work, this may seem like a suitable option for you.

Despite that, there’s one clear drawback to getting an FHA loan, and it’s something that may make you rethink the idea of applying for one.

When you take out a conventional mortgage and don’t put down 20% at closing, you’re charged private mortgage insurance (PMI). PMI is typically tacked onto your monthly payments, making your mortgage more expensive.

But PMI can be canceled eventually — specifically, when you’ve built enough equity in your home so the principal balance on your mortgage falls to 80% of your home’s value. If you end up getting stuck paying PMI, you won’t necessarily have to bear that cost throughout your entire repayment period.

If you take out an FHA loan, however, there’s a similar expense you’ll be hit with that won’t go away. It’s called a mortgage insurance premium, and it’s similar to PMI in that it’s a fee you pay in exchange for getting to take out your mortgage.

With an FHA loan, you’ll be charged an upfront mortgage insurance premium that equals 1.75% of the amount you borrow. But you’ll then be charged ongoing mortgage insurance premiums for the duration of your payoff period, making that loan more expensive. And for this reason, you may want to reconsider your plans to apply for an FHA loan.

A workaround if you don’t have down payment funds just yet

If a lack of funds for a down payment is what’s driving you to take out an FHA loan, but you don’t like the idea of having to pay ongoing mortgage insurance premiums, there’s one solution you can look at. It involves taking out an FHA loan initially, but then refinancing to a conventional loan down the line.

Once you reach the point where you have 20% equity in your home, you can generally refinance an FHA loan to a conventional one, provided your credit score is strong enough to qualify. The minimum credit score for a conventional mortgage is 620, although some mortgage lenders have stricter requirements.

But if you’re unable to qualify for a conventional mortgage, you can take out an FHA loan now to buy a home, push yourself to ramp up your savings, and make extra payments toward your mortgage to build enough equity to refinance. That solution might give you the best of both worlds: the chance to buy a home sooner rather than later without getting stuck with costly mortgage insurance premiums for decades.

A historic opportunity to potentially save thousands on your mortgage

Chances are, interest rates won’t stay put at multi-decade lows for much longer. That’s why taking action today is crucial, whether you’re wanting to refinance and cut your mortgage payment or you’re ready to pull the trigger on a new home purchase. 

The Ascent’s in-house mortgages expert recommends this company to find a low rate – and in fact he used them himself to refi (twice!). Click here to learn more and see your rate. While it doesn’t influence our opinions of products, we do receive compensation from partners whose offers appear here. We’re on your side, always. See The Ascent’s full advertiser disclosure here.

https://www.fool.com/the-ascent/mortgages/articles/this-could-be-the-biggest-reason-to-avoid-an-fha-loan/

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