An FHA loan is one that is insured by the government and backed by the Federal Housing Authority (FHA). This insurance offers protection to Private lenders who fund FHA loans. In the event of default, FHA will help cover losses incurred by the lender. Lenders are then more willing to loosen otherwise tougher standards imposed on a regular conventional loan, thus providing more advantages for many borrowers who otherwise would not qualify for other more stringent financing. Here are some of the advantages and disadvantages of FHA financing.
Lower Interest Rates
One of the advantages of FHA loans is the interest rate is usually much lower than conventional rates, which allows considerable savings over the life of the loan. Another advantage is credit challenged borrowers are usually less penalized due to having a lower credit score, thus still able to receive a low interest rate.
Lower Down Payment
While traditional loans require a minimum of 5 percent down payment, FHA loans only require 3.5 percent down. In addition, the entire down payment can be a gift from a relative. For qualified buyers, FHA loans offer advantages to those buyers who want to take advantage of lower priced homes now, rather than having to wait to save more money for down payment.
Higher Debt-to-Income Ratios
While conventional loans tend to me more restrictive when it comes to debt-to-income ratios, another advantage with FHA loans is they allow loan approvals at higher debt ratios. This works to the advantage of a buyer who may be making excellent income, but has difficulty in documenting enough income to qualify at the time of application. FHA can also be more lenient on certain types and scenarios of qualified income.
Credit History and Seller Contributions
As mentioned earlier, FHA has less stringent requirements in regards to some negative credit history versus traditional lending. For example, you may qualify for an FHA loan in as little as two years after a bankruptcy and three years after a foreclosure, however the borrower must have clean, reestablished credit during that time. Conventional lending requires a minimum of four years following a bankruptcy or foreclosure.
Another advantage to FHA Lending is higher seller contributions are allowed. Conventional loans restrict seller contributions to 3 percent (with loan-to-values above 90%), whereas FHA guidelines allow for 6 percent to be contributed. This gives the buyer more advantages in the purchase contract negotiation. Not only can a buyer negotiate for the seller to pay all of their closing costs, but the seller could also contribute to buying down the interest rate on your loan, thus resulting in more savings.
One of the disadvantages to FHA lending is up front mortgage insurance and the monthly mortgage insurance. Currently, FHA will charge the borrower an up front mortgage insurance premium of 1.75 percent of the loan amount, which is not a requirement in traditional lending. The up front premium, however, can be added on to the loan, thus allowing the borrower to not have to pay in cash. Another disadvantage is the monthly mortgage insurance will have to be paid for the life of the loan, which can be expensive.