While just 9.61 percent of mortgage loans in 2020 were Federal Housing Administration loans, which are insured by the FHA to protect lenders, 83.1 percent of FHA borrowers were first-time home buyers, according to the agency’s annual report.
“FHA loans are attractive for first-time buyers because they’re easier to qualify for,” says Joe Shalaby, CEO of E Mortgage Capital in Santa Ana, Calif.
“You can qualify with a lower credit score and make a down payment of just 3.5 percent with a 580 FICO score. Conventional loans require a credit score of 740 to qualify for a low down payment loan.”
Borrowers with credit challenges like collections, charge-offs and other credit blemishes that could disqualify them for a conventional loan are still eligible for FHA loans, says Gary May, a senior loan officer with Embrace Home Loans in Frederick, Md.
In addition, the debt-to-income ratio requirement is looser, May says. The debt-to-income ratio refers to the minimum payment on all recurring debt such as your mortgage payment, car loan, credit cards and student loans, compared with your monthly gross income.
“The debt-to-income allowance is less restrictive than with conventional mortgages, which is typically 43 percent,” May says. “The debt-to-income ratio allowance for FHA can go as high as 55 percent in some cases, but this is not the norm.”
Other benefits of an FHA loan compared with conventional financing include the increased ability to have co-borrowers on the loan.
“FHA allows several buyers per transaction, including non-occupying co-borrowers,” Shalaby says. “We sometimes see three or four co-borrowers on a loan, especially with first-time buyers.”
FHA loans are particularly advantageous for borrowers with a lower credit score who make a down payment of less than 20 percent, May says. Borrowers who make a down payment of less than 20 percent must pay mortgage insurance for conventional loans. All FHA loans require borrowers to pay mortgage insurance.
“Your credit score will determine how expensive the monthly mortgage insurance premium will be with a conventional mortgage, so first-time buyers often choose FHA loans when their credit score is below 700,” May says.
FHA borrowers must pay an upfront mortgage insurance premium of 1.75 percent of the loan, plus a fixed monthly mortgage insurance of 0.85 percent of the loan.
For borrowers with a credit score of 700 or higher, the mortgage insurance premium on a conventional loan, which varies according to several factors, might be 0.68 percent, May says. In that case, a conventional loan would be the better option.
But borrowers with a credit score between 620 and 680 could have a private mortgage insurance premium as high as 1.69 percent, which would make the FHA loan the better option.
Disadvantages of FHA loans
The main disadvantage of FHA loans is that the mortgage insurance premiums must be paid for the life of the loan for borrowers who make a down payment of 3.5 percent. FHA borrowers can only eliminate their mortgage insurance payment by refinancing into another type of loan.
“Conventional loans require less mortgage insurance,” Shalaby says. “In addition, borrowers have the option of lender-paid mortgage insurance, which wraps the insurance into the loan with a slightly higher rate.”
Unlike FHA loans, private mortgage insurance automatically ends on conventional loans when the borrowers reach 20 percent in home equity by paying down their loan. Borrowers can also request an appraisal and earlier end to their private mortgage insurance if their home value has increased.
One more disadvantage of an FHA loan is that FHA appraisals are stricter than those required for conventional loans, May says. Buyers purchasing a fixer-upper may have a harder time qualifying for an FHA loan unless they opt for a renovation loan.
Every mortgage loan choice should be made on an individualized basis that takes into consideration the borrowers’ entire financial plan. First-time buyers can ask their lender for a loan comparison of an FHA loan and a conventional to see which fits their needs best.
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