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How Does an FHA Mortgage Work and What Are Its Pros and Cons?

How Does an FHA Mortgage Work and What Are Its Pros and Cons?
4 min. read

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Buying a home with a low credit score isn’t impossible, and a FHA mortgage can certainly help low income earners realize their homeownership dreams. However, it’s important to know exactly what applying for an FHA mortgage entails. So, let’s see how they work, as well as the pros and cons.

How Does an FHA Mortgage Work?

An FHA mortgage is a loan backed by the Federal Housing Administration, provided through an FHA-approved lender. This type of loan aims to make buying a home easier for families with low or medium incomes, as well as lower credit scores compared to those required by conventional lenders. In some regards, FHA loans are more lenient, and they even allow friends or family to provide you with the down payment as a gift.

However, FHA loans are stricter when it comes to how much you can borrow and the type of property you’re looking to buy, and they will require mortgage insurance as a condition for the loan approval. Let’s take a closer look at whether an FHA loan is the right choice for you.

FHA Mortgage Pros

Low Credit Score Requirements

The main selling point of an FHA loan is the low credit score requirements. In fact, they are the lowest among mortgage lenders, whether they’re conventional or government-backed ones. What this means is that you can qualify for an FHA loan with a credit score as low as 500. A minimum of 580 is ideal, however, as this will allow you to make a down payment as low as 3.5%, as opposed to 10% if your credit score is 500.

Lower Down Payment

The minimum down payment on FHA loans is only 3.5%. If you take into account that FHA allows this payment to be provided by friends and family in the form of gifts, then you’re one step closer to becoming a homeowner than you would with a conventional mortgage.

Shorter Wait for Eligibility after Bankruptcy or Foreclosure

FHA loans are more forgiving not just when it comes to credit scores and down payments, but also if you’ve experienced financial distress prior to your application. For example, if your credit score has improved, you can apply for an FHA loan as early as two years after a Chapter 7 bankruptcy was discharged, or one year after a Chapter 13 bankruptcy (with court approval). You can also apply for an FHA loan three years after you’ve been through a foreclosure, significantly shorter than the seven years required by conventional lenders.

Streamlined Refinancing

Another perk of FHA loans is that refinancing your mortgage can be done sooner, and it also has fewer requirements than conventional refinancing. For starters, home appraisals are not needed. If you’ve owned your home for a minimum of six months, no credit checks will be performed. You can apply for refinancing as early as 12 months after the loan is approved, and the wait time can be as short as 180 days.

FHA Mortgage Cons

Mortgage Insurance Is Required

The main drawback of FHA loans is the added cost of the mortgage insurance, which is a prerequisite for the loan approval. You will need to make an upfront payment of 1.75% of the loan amount, followed by monthly payments that average around 0.85% of the loan amount per year. And you can’t get rid of it either: with FHA loans you will be paying it for the entire duration of your loan.

Loan Amount Limitations

Like all government-backed loans, FHA mortgages are aimed at making homeownership easier for families with lower incomes. This means that there’s a limit on how much you can borrow, and the figures can vary depending on the area and the type of property you’re prospecting. On average, this limit is set at 115% of the median home price per county, so make sure to check local requirements to see if your dream home qualifies for an FHA loan.

Stricter Property Appraisals

Before approving your loan, the FHA will conduct an appraisal of the property to ensure that it meets living standards. This can only be conducted by an FHA-approved appraiser, and if they decide that the house you want to buy does not meet their criteria, they can refuse the loan. This can put a spanner in the works if you’re looking to buy a fixer-upper, for example.

Can Put Off Sellers

Last but not least, buying a home with an FHA loan can put off sellers, precisely because of the rigorous home appraisals and inspections that the FHA requires. This can make sellers hesitant, especially if you’re buying in a competitive market, and you can risk seeing your dream home whisked up by buyers using a conventional mortgage instead.

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