The Downsides of FHA Loans

Jim TrummJan 19, 2018

The Federal Housing Administration (FHA) was created in 1934 during the height of the Great Depression as part of the federal government's attempt to jumpstart the American economy by making it easier for less affluent people to buy homes. The FHA achieves this goal not by loaning money itself, but by insuring mortgages issued by private lenders. This extra insurance makes banks and finance companies more willing to loan money to homebuyers who have imperfect credit scores and can't afford a large down payment. Today, the FHA is the world's largest insurer of residential mortgages.

So given the program's popularity and success, why wouldn't everyone want an FHA loan?

FHA Loans Require a Large Upfront Insurance Payment

People who take out FHA loans must pay an upfront mortgage insurance premium (UFMIP) at closing. This premium is calculated at 1.75% of the loan amount and may be financed by the mortgage itself, but doing so will raise the amount of your monthly payments and increase your costs of insurance over the life of the loan. On a $200,000 loan, for example, the UFMIP will be $3,500. This kind of mortgage insurance is not required on conventional loans. So even if an FHA loan is offered at a slightly lower interest rate than a similar conventional mortgage, you may wind up paying more in combined mortgage and insurance payments.

FHA Loans Require Payment of Monthly Mortgage Insurance Premiums

In addition to the upfront mortgage insurance premium, FHA loan customers must also pay a monthly mortgage insurance premium for anywhere between 11 years and the life of the loan. Private mortgage lenders may also require such insurance, but they generally provide that it can be canceled when the homeowner's equity reaches 20%.

FHA Loans May Not be Suitable for Do-it-Yourselfers Who Want to Restore Distressed Properties

The wave of foreclosures that rocked the nation in 2007 and 2008 left tens of thousands of homes abandoned and in disrepair. Sometimes owners who were foreclosed on stripped their houses of cabinets, plumbing and electrical fixtures, pipes, and wiring, and window frames. These distressed properties can be a great opportunity for ambitious would-be homeowners.

The FHA does offer a loan program called a 203(k) that allows people to borrow money both for purchase and renovation. The catch, though, is that all the work has to be done by licensed contractors. This means that even skilled do-it-yourselfers and people who employ talented but unlicensed workers won't be able to use the FHA program. This may add significantly to the cost of renovating a derelict house. Further, all the work must be completed within six months, so people who were hoping to stretch out the renovation project to allow for more manageable cash flow are out of luck.

FHA Loans Can Scare Sellers

Every mortgage entails a lot of paperwork. It's a fact of real estate life. But FHA loans require even more paperwork. With every form that's filled in, there's the chance that something will be incorrect, noncompliant, or unsatisfactory. That means there are more potential obstacles to timely mortgage approval.

Sellers crave certainty. Faced with two otherwise identical prospective buyers--one who's getting a conventional mortgage and the other who's getting an FHA loan--many sellers will prefer to go with the buyer whose mortgage application stands a stronger chance of being promptly approved. This consideration may be particularly acute in markets where prospective buyers outnumber sellers.

FHA Loans May Tempt Buyers Into Unsustainable Debt Loads

Some economists have argued that FHA mortgages are "predatory loans," since they are marketed to people who are at the lower ends of the income and credit rating spectra. They claim that the government's backing of loans to such people introduces a distortion in the market and encourages people to shoulder more debt than they can handle. This argument may seem patronizing to some less-affluent people, since it implicitly suggests that such people aren't smart enough to handle money. But indeed, if you are at the very lower edges of the FHA-accepted FICO scores and the FHA-mandated minimum down payment, you might want to consider saving up more money or buying a less-expensive property. The more you put down, the less you'll pay in interest over the life of the loan.