If you are looking to buy a house and thinking about leveraging an FHA loan think again. At the surface, FHA loans sound great allowing individuals to buy a property with only 3.5% down (even multi-family investment properties, if owner-occupied).  However, when you peel back the layers you’ll find that there are hidden costs and restrictions that limit your ability to save thousands of dollars.  Here are 3 reasons why you should NOT consider an FHA loan when buying a house and go conventional instead.

FHA is a blessing for people with lower credit scores, since a 580 is the minimum score to qualify for a 3.5% down payment.  However, this article applies to people who have a FICO score higher than a 700.  If you have a FICO score above 700 you should go conventional over FHA and here’s why.

Reason 1: FHA Loans Require PMI for the LIFE of the Loan

Yes, you read that right!  While most conventional loans require PMI (Primary Mortgage Insurance) for properties bought with less than 20% down, you are able to eliminate the PMI from your monthly payment when you reach 20% in equity.

This is NOT the case with FHA.  Instead you are required to pay PMI for the life of the loan unless you refinance.  If you refinance, you have to pay additional closing costs, get the property appraised, and run the risk of obtaining a higher interest rate.

Reason 2: Save Money Annually with non-FHA Loans

With conventional loans, you can pay off your primary mortgage insurance policy at the time of closing, even if your down payment is less than 20%.  Also, if you are buying a property that’s in a flood area or another hazard area like lava or earthquakes, you do not have to get a more expensive federally backed insurance policy and can opt for private insurance instead.

In most circumstances, private insurance is significantly less expensive than federal insurance policies.

Real Life Example on a Duplex

To give you an example of how this plays out, I bought my duplex with a 3.5% down FHA loan because I thought it was the only way to buy a duplex property with a down payment under 20%.

My property sits on a coastal barrier island of New Jersey, so I am required to have flood insurance.  Since I had an FHA loan I was required to have a FEMA (federal) flood insurance policy.  My policy cost $2,732 per year.

Luckily, after reaching out to several mortgage companies I finally found a lender who would do 5% down conventional loan, if it’s owner occupied and decided to refinance.

I was able to switch my flood policy from Federal to Private and reduce it down my premium $1,531 per year by refinancing to a conventional loan.  That’s a monthly saving of $101 ($1,212 a year) from simply refinancing.

In addition to switching insurance policies, I also paid off the Primary Mortgage Insurance at the time of closing to eliminate the monthly PMI payments.  That’s an additional monthly saving of $169.63.

With the refinance to a conventional loan, I am saving the following per month:

• Eliminating the monthly PMI by $169.63
• Reducing the flood insurance payment (in Escrow) by $101
• Total Monthly Savings: $270.63
• Total Annual Savings: $3,247.56

As you can see, simply by leveraging an conventional loan I am putting money back in my pocket!  The craziest thing about this is that I have a higher interest rate now than when I had the FHA loan.  If I was aware of a 5% conventional loan opportunity when I bought the duplex originally I would have saved even more.

Reason 3: A Down Payment of 3.5% Only Equals 1.9% Equity

Mortgage companies will not inform you when you buy a home with an FHA loan and put 3.5% down, you do not have 3.5% equity.  In reality, after I close, the mortgage amount was 98.1% of the purchase price, so my total equity at the time of closing is only 1.9%.

If you do the math right, you would expect the mortgage amount to be 96.5%, if I’m putting 3.5% down.  However, because of the Up Front Mortgage Insurance Premium it was not.

The Up Front Mortgage Insurance Premium (UFMIP) can be up to 1.75% of the loan, a hidden costs that buyers are not made aware of until it’s time to close or when they get the loan estimate.

Real Life Example

Below is an image of my closing disclosure when I purchased my first duplex in the summer of 2018.  Here are the metrics around the purchase:

• Purchase Price: $250,000
• Down Payment: $8,750 (3.5% down)
• Upfront Mortgage Insurance Premium: $4,221 (Wrapped into the loan)

If you’re wondering why the mortgage loan amount isn’t $241,250 it’s due to the Upfront Mortgage Insurance Premium (UFMIP).

Theoretically, if I put 3.5% down ($8,750) my equity should be 3.5% and my loan should be $241,250.

However, due to the Upfront Mortgage Insurance Premium, my loan amount is $250,000 – $8,750 = $241,250 plus the Upfront Mortgage Insurance Premium, $241,250 + $4,221 (UMIP) = $245,471.

The frustrating part is that your down payment goes towards the UMIP instead of the equity, so instead of having equity of 3.5%, your true equity is the loan amount divided by the purchase price of the house.

$245,250/$250,000 = a whopping 1.9%… I get so frustrated thinking about this!

When does it make sense to go FHA?

In my opinion, it doesn’t make sense to leverage an FHA loan unless you absolutely cannot qualify for a conventional loan.  Mortgage companies prey on the lack of understanding consumers have for FHA loans and market the fact that FHA requires very little money down.

In fact, when I found a new loan option available to me (5% conventional on a duplex) I immediately called my mortgage company (Quicken Loans) and informed them about this type of loan.  They said it’s not possible to do this and weren’t aware of any duplex purchasing with 5% down unless it’s FHA.  Long story short, they lost my business.

If you’re in the mindset that you want to buy a property with as little money down as possible, remember that FHA requires PMI for the life of the loan and in the long run you will spend way more money than opting to go conventional off from the beginning.

Summary: Bringing it All Together

3 Reason to Avoid FHA Loans (click the link below to reread that section)

1. FHA Loans Require PMI for the LIFE of the Loan
2. Save Money Annually with non-FHA Loans
3. Your Down Payment of 3.5% Only Equals 1.9% Equity

Now you know what to look out for when choosing conventional vs FHA loans.

Remember, not every mortgage company is aware of 5% down conventional loans on duplex but they exist (if owner occupied).  If they say that’s not possible, challenge them and ask your mortgage lender of Freddie MAC loans.

Below is a useful chart directly from their website.  You can see that for a 1 to 2 – unit Primary Residence the Maximum LTV (Loan to Value) is 95% meaning 100%-95% = a 5% down payment.

Feel free to reference the following article, here -> http://www.freddiemac.com/singlefamily/factsheets/sell/ltv_tltv.htm if you’re still having trouble finding a lender to accept this type of loan.

Another form of low money down multi-family purchases is through the Vendee loan program, which offers civilians the opportunity to buy a house with zero percent down owner occupied or 5% investment.

If you have any questions or comments about conventional vs fha loans and which one makes sense for you, ask/comment below!