An FHA mortgage might seem like an attractive option, especially to homebuyers with less-than-perfect credit or not much cash to put down. However, the true cost of the loan is much more than the FHA mortgage rates you see advertised by lenders. The hidden costs of an FHA loan may actually mean renting would be the better option until you can qualify for a conventional loan.
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Looks good at first
It's easy to see why an FHA mortgage might look like a good deal.
Your credit history isn't terribly important in the lending process: You can actually get full FHA financing with a credit score as low as 580. While a conventional loan doesn't have an official minimum credit score, when you consider that the average applicant rejected for a conventional mortgage has a 724 credit score (above 720 is considered "excellent" credit), it's not just consumers with very bad credit who may need another option.
Also, the FHA down payment requirement is much lower than with conventional loans. You can obtain FHA financing with as little as 3.5% down. Conventional lenders often look for 20% up front, with some exceptions.
Even the FHA mortgage rates look pretty enticing. According to Wells Fargo's rates as of this writing, the current 30-year FHA interest rate is 4.125%, which is actually lower than the 4.375% going rate for a 30-year conventional loan. It sounds pretty good so far, right?
But the mortgage insurance will cost you
In exchange for agreeing to finance buyers with low credit scores and a high loan-to-value ratio, the Federal Housing Administration charges a pretty substantial premium to insure the mortgages. This is why banks are willing to give FHA buyers lower rates. They know that if you default on your mortgage, the FHA will cover the losses.
Having gone up significantly in recent years, FHA mortgage insurance has an up-front cost of 1.75% of the loan amount, as well as a recurring annual cost (added to the monthly payments) of up to 1.35% of the outstanding loan amount.
So if you purchase a $300,000 home with the minimum down payment, you're looking at an additional $5,066 in up-front (closing) costs and over $3,900 per year added to your mortgage payments.
The higher loan balance means higher payments
Also don't forget the fact that your loan payments will be higher than with a conventional loan, simply because you're financing a lot more of the purchase.
On a $300,000 house, you are financing $240,000 if you obtain a 30-year conventional loan and put 20% down. However, on an FHA plan with just 3.5% down, your loan will be for $289,500. This makes your monthly payment about 17% higher before adding in the mortgage insurance.
How much more?
To illustrate the higher costs from an FHA loan, consider the example of that $300,000 house.
On a conventional loan, the payment for principal and interest would be about $1,198 per month based on existing interest rates.
The FHA loan would carry a principal plus insurance payment of $1,403, and the mortgage insurance premium adds another $326, making the total monthly payment $1,729, or an astounding 44% higher than a conventional loan on the same house. And, under recent changes in the FHA loan program, the mortgage insurance must be paid for the life of the loan.
You might be better off waiting
Instead of rushing into buying a home with an FHA loan, it may be a better financial move to rent for the time being and work on your qualifications for a conventional mortgage.
Set aside as much money as you can, as your goal should be to have 20% of your house-purchase budget ready to put down. Of equal importance is building up your credit by paying bills on time, reducing credit card debt, and any other "damage control" you need to do. Most lenders use the FICO score, and myFICO.com has a great discussion of what makes up your credit score and the best strategies to improve it.
The bottom line is that although FHA mortgage rates might look like a cheap and attractive way to speed up your path to homeownership, the reality is quite a different story.
