Why We Should All Stop Worrying and Learn to Love FHA

In case you missed the news, January 2017 is a big month for FHA loans. Starting January 1st, loan limits on FHA loans in the Portland/Vancouver metro area are increasing, from $368,000 to $408,250. That’s a whopping $40,250, 11%, increase.

I know and good number of my friends and colleagues in the real estate community heard this news and then shrugged their shoulders, thinking something along the lines of: “Who cares? Nobody does FHA loans anymore anyway.” If you are in this group, this post is for you.

Anti-FHA bias

When investigating financing options, every borrower should (of course) consider the pros and cons of all available loans. FHA loans do have some legitimate cons to discuss. However, based solely on the merits of the loan, FHA financing is still the best overall option for many homebuyers.

If only the merits of the loan were the full story. Alas, the #1 negative mark against FHA loans is a pervasive anti-FHA bias in the marketplace. This sentiment among sellers (often as guided by their agents), leads me to encourage many clients, for whom an FHA loan would otherwise be the ideal fit, to consider applying for some other loan.

Given that today’s buyers must plan for the likelihood that their offer may be one of many, I want to help my clients find every possible angle to stand out to sellers in a good way. An FHA loan has become a way to stand out in a bad way. It’s become, too often, the quick path to a rejected offer.

But is this fair?  Does FHA deserve the bum rap it seems to have developed? I’m climbing up on a wee bit of a soapbox to proclaim that, no, the majority of the time, the majority of reasons that sellers shy away from FHA financing are bunk. Here me out and I think (I hope) you’ll come to agree with me: Sellers and their agents should at least keep an open mind when presented an offer from a buyer using FHA financing.

Some myth-busting

So what are the reasons FHA is viewed as a less appealing financing option? I’ve heard a bunch over the years:

FHA buyers are less qualified.

So false. This is just about 180 degrees from true. Ask any loan officer which files keep them up night with worry.  We all have them, but seldom (to never) are they FHA. I can’t even think of the last FHA file that had me sweating. FHA is a really forgiving program. Seldom do I have issues in underwriting; and when I do, there is a lot of leeway to make things work. Client buys a new car? FHA has lots of elasticity in debt-to-income ratios. Credit scores drop unexpectedly? FHA can be okay with credit scores in the 580s (and doesn’t even up-charge for MI). Unexpected inspection issues? Switch to a FHA 203(k) renovation loan, negotiate an as-is price, get a bid and the repairs can be financed and done after closing.

Ironically, the bias against FHA in a competitive situation has generated more of those losing-sleep-at-night files. I’ve been forced to crowbar many a client who would be an easy-peasy lemon-squeezy FHA buyer into a conventional loan. Things can get a bit touch-and go when lenders try to mash a square peg into a round hole. I mean, I’ve got some chisels, a hacksaw and a hammer… but you get the picture.

FHA appraisals take longer.

Untrue. The turn time on FHA appraisals is the same as that for a conventional loan. Lenders use the same appraisal management companies for FHA and conventional loans. (And I’m happy to report that turn times are much improved so far this year.)

FHA appraisal come in low more often.

Nope. There is no higher likelihood of a low value on an FHA appraisal. Appraisers use the exact same methodology and comps, when performing an appraisal for an FHA loan as they do for a conventional loan. And appraisers, it is worth adding, pay absolutely no attention to the amount a buyer is putting down when appraising a property.

Of course, if an appraisal does come in low, sellers (and their agents) always have a legitimate concern about any low down payment buyer and their capacity to come up with additional cash–but that’s as true for an FHA buyer with 3.5% down as it is for a conventional buyer with 3% or 5% down. That’s a high loan-to-value ratio issue, not an FHA issue.

FHA appraisals are always full of lender required repairs.

There’s some truth here, but generally nothing to fear. HUD does have minimum housing standards, so appraisers are required to look for problems with the health, safety and habitability of any home financed using an FHA loan. But in practice, the majority of homes we finance using FHA loans receive as-is appraisals. I took a quick survey of the homes I financed with FHA loans over the past couple of years and when I exclude repair items that would come up on any type of loan (think CO detectors and wood stove certifications), 75% of my FHA appraisals had no lender-required repairs. On the occasions when required repairs come up they are generally simple and cheap (like earthquake strapping a water heater).

That said, do check for flaky paint on houses built prior to 1978. Remedying failing, potentially lead-based paint is one item that can cause headaches (especially during our rainier parts of the year). If the house is in decent shape and there’s no bad paint, you can be as confident of an as-is appraisal as you would be on a conventional loan.

Life of loan MI is not as bad as it sounds, when it comes with lower rates, lower MI costs and lower fees.

Yup, FHA rates are lower (usually by around .25%, but sometimes even more) than conventional loans. Don’t get me wrong. A buyer with a 720 or higher credit score and 5% or more down is likely still better served by a conventional loan–especially if she plans on keeping her property for a long time and can eventually kiss her mortgage insurance goodbye. But if she has less-than-perfect credit, she can wind up paying far less on an FHA loan.

Surprisingly (to me anyway) this can be true even over a long time-horizon. A few months ago, when Fannie revised the HomeReady guidelines I was curious enough to run some computations. Turns out, a buyer with a 680 credit score will pay no more over the life of an FHA loan than he would over the life of a HomeReady loan. That’s despite the perks and discounts built into HomeReady and assuming MI is proactively canceled in a reasonable period of time. And for a buyer with less than a 680 credit score FHA, forget about it–FHA is tremendously cheaper in both the short and long term.

Legitimate issues for buyers to consider

As I mentioned before, there are some legitimate considerations prospective buyers should discuss with their lender before setting their sights on an FHA loan. FHA mortgage insurance is charged in two parts: 1.75% of the loan amount is charged up-front (financed into the loan) and 0.8% or 0.85% of the loan amount is charged per year (divvied up into the monthly payment).

For buyers with credit scores over 700-720, the premiums FHA charges are higher than private mortgage insurance premiums. For those with credit scores below 700, FHA premiums are generally lower. But even then, there is a kicker:  Since 2013, the monthly mortgage insurance premiums charged on FHA loans run for the full life of the loan for most borrowers. (For the rare FHA buyer putting at least 10% down, the MI runs for 11 years.)

By contrast the private mortgage insurance associated with most conventional loans will automatically drop off when the loan is scheduled to be paid down to 78% of the purchase price. (Weird number, I know.) That’s about 7-10 years of MI payments most buyers. And further, borrowers are allowed to petition for even earlier MI cancellation: 2 years of on-time loan payments and an appraisal showing at least 25% equity are the minimum requirements to initiate a conversation about canceling MI early.

The impact of life-of-loan MI premiums associated with FHA loans are an obvious and important topic that every borrower should discuss with his or her loan officer. A buyer with a higher credit score (especially one planning to keep the loan for a long, long time) will probably want a conventional loan. Buyers with fair to middlin’ credit scores will probably pay less with an FHA loan (even over a long window of time).

Now: The good stuff

Why am I rambling on and on about this loan? I’m so glad you asked! Let me tell you some of the great stuff FHA has to offer home buyers:

Loan down payments with no first time buyer restrictions, no area restrictions and no income limits. With their HomeReady and Home Possible programs, Fannie Mae and Freddie Mac are trying to compete head-to-head for “FHA-type” buyers. These programs have some cool features and allow a little as 3%, but they are a bit niche. To qualify, borrowers must be first time buyers and/or buy in designated areas and/or earn income below a certain threshold. FHA imposes no such limitations and offers 3.5% down financing (come one, come all).

Flexible credit score requirements (and no “add-ons” to rates, costs or mortgage insurance). Buyers with perfectly lendable, but less-than-perfect credit can often qualify for either an FHA or a conventional loan. However, without a significant down payment Fannie Mae, Freddie Mac and private mortgage insurance companies up-charge for credit scores below 740 (in amounts that can run into the thousands of dollars). FHA costs are lower than conventional rates to start (usually by .25% in note rate) and are one-size fits all–if you qualify, you pay nothing extra. And most borrowers with a credit score of at least 620 should qualify. (And scores as low as 580 can be acceptable situationally.)

Non-traditional credit (again with no up-charge). Another place where FHA shines is for folks who have opted out of using credit cards and paid cash for school and their cars. FHA and conventional loan rules allow lenders to work with borrowers on developing a “non-traditional” credit history using rent, insurance and utility payments. But for purposes of pricing a conventional loan, anybody without a credit score is charged fees based on a score of 620. For a borrower putting 3% down, the extra fee Fannie Mae charges is 3.5% of the loan amount (3.5%!). That’s on top of the 3% down payment and the other normal closing costs. FHA is, again, one-size fits all and charges no such extra fee for those flying under the credit radar.

Renovation financing option. For buyers looking to finance a fixer, FHA has two (count ‘em) renovation loan programs. Up to about $30k of non-structural improvements can be done using the “streamline 203(k)”. If the work to be done includes the foundation or structural work or is more than $30k, the “full 203(k)” is just the ticket. Write an as-is offer and get a bid from a contractor for the proposed work. We’ll secure an appraisal based on the fixed-up value of the property, close as-is and (after closing) pay contractors for the improvements out of escrowed funds. And remember that renovation financing is not just for fixers. These programs allow discretionary improvements to homes that are in otherwise good shape. Buyers can finance updating kitchens and baths, building ADUs, even purchase appliances.

3.5% down on duplexes, triplexes and four-plexes. If you aspire to live in a multi-unit property, you must save up 15%-20% down to qualify for a conventional loan. (That’s a lot of cheddar.) With an FHA loan? You just need the usual 3.5% down. And you even get a leg up on qualifying from rental income from the other unit(s). (Having lived in a couple of duplexes myself, this is a topic near to my heart.) And what if the duplex you want to buy is a little scruffy? Finance it with a 203(k) and spruce it up a bit. The only caveat is that FHA imposes a “rent test” on 3- and 4-unit properties: 85% of the market rents must equal or exceed the new payment (PITI).

Alimony netted from income. Divorce is, of course, a sad occasion for all parties involved. The cherry on top of the unpleasantries for some comes when they discover what a huge impact alimony payments can make on their prospects for purchasing a new home. Using the traditional means of calculating a debt-to-income ratio, $1000 of alimony per month (at current rates) reduces a person’s buying power by about $200,000. FHA guidelines, however, permits lenders to deduct alimony from a borrower’s income and then calculate debt-to-income ratios.  Doing so reduces the impact on loan qualifying by about half. Using this method, $1000 of alimony has about a $100,000 impact on the maximum loan amount. Still significant–but significantly less.

I feel better now

Phew! Give me a moment to climb down from my soapbox and take off my crankypants. There, I feel better now…

Joking aside, I am passionate about matching every client with the best possible loan for his or her situation and plans. I’m quick to guide a client away from a FHA when there is a better option. But too often, I find myself steering clients away from their financially ideal loan for reasons based on the myths and misinformation surrounding the FHA loan program.

I hope that a few of my friends and colleagues in the real estate community stumble upon this post and read through it. Perhaps it will go a little way toward tempering the anti-FHA sentiment in our market.

Penny for your thoughts?

For making it to  the bottom of this, my longest post to date, you deserve a prize. Share your thoughts below in the comments section below (even if you disagree with me) and I’ll hook you up with a coffee card. Let me know if you prefer Starbucks or Coava. (For the uninitiated: Coava…You want Coava.)

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