Borrowers without a large down payment often benefit from the FHA loan. You can purchase a home with as little as 3.5% down. What’s not to love? The FHA loan is great for many buyers. But, it does have its downsides. Here we help you see those disadvantages so you can make an informed decision.
What’s Different About the FHA Purchase?
The FHA purchase works the same way as any other loan program. You bid on the home, satisfy your loan conditions, and close on the loan. The lender disburses funds at the closing and the buyer takes possession of the home. It sounds identical on the surface. The largest difference is the government guarantee. With government involvement, many people assume it’s more complicated. Sellers want anything but complicated.
In the beginning, the FHA loan was the “first-time homebuyer’s loan.” This often meant lower credit scores and down payments. For first-time homebuyers, this was acceptable. They often purchased starter homes, so it wasn’t a big deal.
Fast forward to today and everyone uses FHA loans. It’s a great alternative for people with poor credit because of the housing crisis. They have the most lenient guidelines regarding credit and negative economic events. For example, you can secure an FHA loan just 2 years after a Chapter 7 bankruptcy.
Below we discuss in detail, why sellers don’t like FHA loans.
Reasons a Seller Doesn’t Want an FHA Loan
The FHA loan carries a stigma with it. These concepts influence how many sellers choose a buyer. Here are many of the things they think:
- The Inspection is too Hard
Because the government guarantees the FHA loan, they have a say in the process. This puts many other hands in the pot. It’s not just the underwriter approving the inspection. The FHA has specific rules lenders must follow. If the inspection report shows negative issues, the loan may not go through. This puts the seller in a bind as they lose their buyer and must start from scratch.
- Riskier Borrowers – Sale might fall through
Sellers often assume FHA financing will fall through. They know the FHA allows lower credit scores. They also don’t need a large down payment. If a seller doesn’t require a large amount of escrow, they may lose the contract.
The truth is, though, any loan can fall through. In fact, standard borrowers have a better chance at closing on an FHA loan than any other loan. The flexible guidelines make it easier to get to the closing table. The reasons FHA loans fall through are the same any other loan fails. They include:
- Not enough funds for the down payment or closing costs
- Lower credit score than when you completed the application
- Taking out new loans or racking up credit card debt
- Not having seasoned funds (money in your bank account for at least a few months)
These things can happen with any loan, not just the FHA loan.
- Myths regarding closing costs (sellers don’t pay)
Many years ago, sellers paid many of the buyer’s closing costs with FHA loans. This isn’t the case today, but many still think it is. Buyers can pay most of their closing costs with the FHA loan. It comes down to the contract and what you negotiate. The seller can pay the closing costs if it’s written in the contract but aren’t required to do so. Buyers without cash for the closing costs benefit from this. The seller increases the sales price and provides a credit at the closing. This way the buyer doesn’t pay anything but the down payment. You wrap the closing costs into the loan and the seller gets the price he wants for the home.
- Condos are Tougher to Buy
The FHA has strict requirements for condominiums. The FHA must approve they development before any unit owner can use FHA financing. Unapproved developments can obtain approval; it just takes time. Sellers don’t want to wait, especially if they are under contract to purchase a home. If your condominium is on the HUD approved list, it’s easier to get the loan closed faster.
Disadvantages Buyers Experience
As a buyer, you have some disadvantages as well. Most of them are made better with the advantages. But, you should know what they are.
- Upfront Mortgage Insurance
The FHA loan requires upfront mortgage insurance. Right now, this means 1.75% of your loan amount. On a $100,000 loan, you pay $1,750 at the closing. This isn’t a part of your down payment. It’s also in addition to the closing costs the lender and 3rd parties charge. It can make closing on an FHA loan expensive. The good news is, you can roll it into your loan. Remember, though, this means you pay more for the fee as you add interest onto the amount over the life of the loan.
- Annual Mortgage Insurance
Every borrower pays annual mortgage insurance, no matter the down payment. Conventional loans, on the other hand, only charge PMI to borrowers that put less than 20% down. FHA loans also charge MIP for the life of the loan. Even when you owe less than 80% of the home’s value, you still pay it. This can make the FHA loan more expensive in the loan run.
- Tougher Inspection Requirements
The FHA’s tough inspection requirements do make some purchases harder. But, the requirements protect the buyer’s interest. Let’s say the foundation is cracked on a home you contracted. The FHA won’t allow the purchase to go through. While it might be your dream home and you may be upset, you benefit financially in the end.
- Tougher Appraisal Requirements
The FHA appraisal can be tougher than other programs as well. The FHA has specific things the appraiser must check. If the home doesn’t pass the FHA appraisal, you can’t close on the loan. The alternative, though, is to ask the seller to fix the issues. Sometimes sellers are willing to do this, especially if there weren’t any other bids on the home. It depends on the situation. Either way, though, it could slow down the purchase process.
- Good Credit Doesn’t Help
Conventional loans reward borrowers with good credit. Borrowers with lower credit scores often have higher rates than those with good credit. FHA loans, though, have the same rates across the board. Your high credit score won’t reap you any benefits. You’ll be on even playing ground with someone with a lower score or higher debt ratio. The tradeoff, though, is the lower down payment requirements.
- Lower Maximum Loan Amount
FHA loans have loan maximums. These amounts differ by area. Unlike conventional loans, which allow up to $424,100, you’ll find lower amounts in some areas. This can limit how much house you can buy. You can find the current loan maximums on HUD’s website.
Are you truly at a disadvantage to purchase a home with an FHA loan? Not really because there are pros and cons. Weigh your options and see what’s available for you. If you have only 3.5% for a down payment and mediocre credit, it’s your best option. If you improve your credit down the road, you can refinance out of the FHA loan. Just know going in that you may have a few more issues. They aren’t anything that should prevent you from buying a home though.