What is the Downside of an FHA Loan I Should be Aware?

When talking about home mortgages, investors can’t help but discuss FHA loans. The loan products account for a large number of first-time homebuyer mortgages, so investors want to know the details. However, FHA loans have downsides. In particular, investors often ask me: what is the downside of an FHA loan?

The FHA will not approve a loan for an investment property, a major downside for investors. For homebuyers, besides insurance requirements, FHA loans serve as great, low-down mortgage options. And for home sellers, you just need to make sure your property passes the FHA appraiser’s inspection.

In the following article, I’ll dive into more details about FHA loans and their downsides for key players in a real estate transaction. Specifically, I’ll cover each of the following topics:

  • What is an FHA Loan
  • FHA Loan Downside for Investors
  • FHA Loan Downside for Homebuyers
  • FHA Loan Downside for Sellers
  • Final Thoughts

What is an FHA Loan

To understand the downsides of FHA loans, it helps to first understand how these loan products work. The Federal Housing Administration, or FHA, does not actually lend money to borrowers.  Rather, as a federal agency, it insures the mortgage loans issued by FHA-approved lenders.

By insuring these loans, the FHA lowers the risks associated with default for lenders. In other words, if a borrower stops repaying his or her loan, the FHA will pay the lender a portion of the outstanding loan balance. This reduced risk allows these lenders to provide home loans to low- to moderate-income borrowers, as the FHA aims to expand homeownership among these demographics.

More precisely, this reduced risk for lenders corresponds with the following outstanding characteristics of FHA loans:

  • Lower credit requirements: Compared to conventional mortgages, FHA-backed loans have far lower credit requirements. This significantly broadens the pool of eligible first-time homebuyers.
  • Low down payment: Whereas most conventional mortgages require a 20% down payment, borrowers can secure FHA-backed loans with as little as 3.5% down. This further expands home-buying opportunities.

FHA Loan Downside for Investors

At first glance, these above characteristics make FHA loans extremely attractive to new real estate investors. Throw 3.5% down for a fix & flip property then use the rest of your cash to rehab it.  Perfect, right? Unfortunately, investment properties do not qualify for FHA loans—the largest downside of FHA loans for investors. Instead, the financed property must serve as the borrower’s primary residence.

As stated, the FHA seeks to expand homeownership, not home investing, with these insured mortgages. Bottom line, the FHA crafted these advantageous loan terms to support homebuyers, not investors. But as I’ll outline below, this doesn’t mean that opportunities don’t exist for investors to work with FHA loans.

FHA Loan Downside for Homebuyers

For homebuyers, barely any downside exists to using an FHA loan. As I said above, FHA loans provide you an opportunity to qualify for a home loan with lower credit scores and only a 3.5% down payment. Conventional mortgages cannot match these loan terms.

Additionally, FHA loans allow sellers to pay closing costs, another huge benefit for homebuyers. While every closing differs slightly, closing costs average roughly 3% of a loan amount. That means that, if you’re borrowing $200,000, you can expect roughly $6,000 in closing costs—a lot of cash for many people. To prevent these costs from posing a major obstacle to first-time homebuyers, the FHA lets buyers request that sellers cover these costs, potentially saving buyers thousands of dollars.

Homebuyers really only face one major downside to FHA loans—their mortgage insurance premium (MIP). To offset the risks of default, the FHA mandates that borrowers purchase an insurance policy that covers the outstanding loan balance. This MIP includes two payments:

  • An upfront payment: This upfront payment costs 1.75% of the total loan amount.  It is due at closing, but many lenders will simply add it onto the loan principal.  This lets you pay off this amount over the life of the loan.
  • Additional annual payment: Every year, your lender requires additional mortgage insurance payments. Typically, lenders divide this annual payment by 12 and add it onto your loan payment every month.

Both of these payments have the second-order effect of increasing your monthly mortgage payment. This downside can be a small price to pay if not qualifying for a mortgage represents the alternative. But, in planning for a home purchase, homebuyers need to account for these increased payments in their monthly budgets.

FHA Loan Downside for Sellers

Next, I’ll discuss FHA loans within the context of investors as sellers. In other words, if you’ve rehabbed a fix & flip property, do downsides exist to accepting an offer from a buyer using FHA financing?

The FHA-mandated inspection constitutes the major downside for investors in this situation. As the FHA wants to increase quality homeownership, it mandates certain minimum standards of habitability and functionality in a home.

This doesn’t mean that you need completely new appliances. But, as part of the appraisal process, the FHA’s appraiser will also conduct a surface-level inspection. While not as in-depth as a proper home inspection, the appraiser will confirm that the general condition and functionality of the property meet FHA standards (e.g. appliances work, roof has at least five years of life remaining, grade doesn’t slope into the house, etc.).

So, what does this mean for me as a seller?

First, if you accept the offer, and the FHA appraiser identifies a problem during the inspection, you’ll need to fix it prior to closing. While some issues may be relatively minor, like adding covers to outlets, others can cost you thousands of dollars. For example, if an appraiser finds a wooden portion of your home in direct contact with the ground, you may need to pour a concrete slab for protection. All of these additional costs directly cut into your fix-and-flip deal’s profitability.

Of note, if you completed a quality rehab, you shouldn’t face many issues during the FHA appraiser’s inspection. Simply put, you’ll have renovated the home to a standard that exceeds FHA requirements. In these situations, picky appraisers may find minor issues, but these likely won’t require a ton of time or money to fix (unfortunately, I’ve dealt with appraisers like this—people who feel like they need to find something wrong to justify their jobs).

Second, as outlined above, most FHA borrowers will ask for sellers to cover their closing costs. If your deal has tight margins, this additional cash could mean the difference between a profit and a loss. As a result, I argue that investors should just price these costs into a deal’s budget up-front. For instance, if you want to net $100,000 in sales proceeds, price the property at $103,000. That way, you pay an extra $3,000 or so in cash at closing, but you get it right back with the sales proceeds.

Final Thoughts

Despite some of the potential drawbacks of selling to FHA buyers, I would still accept an FHA loan offer. Part of the beauty of fix & flip work involves the opportunities we create. We take distressed houses, fix them up into nice, habitable homes, and sell them to hard-working families. This awesome outcome more than outweighs the minor inconveniences FHA loans entail.

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