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Why First-Time Homebuyers are Avoiding FHA Loans

·5 min read

For many years, homebuyers seized upon the option to purchase their first house with a loan backed up by the Federal Housing Administration (FHA).

This allowed them to put down as little as 3.5% of the total cost upfront, which meant owning a home was an achievable prospect even if your credit wasn’t perfect. An FHA loan traditionally offered a great way to eliminate money stress.

However, fewer first-time homebuyers are opting for this kind of loan today, eschewing it instead for a conventional mortgage. Here are some reasons why.

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1. The history of FHA loans

To understand what FHA loans are and where they came from, you have to go back to the 1930s, when the federal government created the program. At the time, the country was in the throes of the Great Depression. Millions of people were out of work, including 2 million construction workers.

In an effort to combat unemployment, create jobs in the construction sector, and help more Americans become homeowners, the federal government introduced legislation to financially back mortgages, making them a safer bet for lenders.

This was a game-changer. Previous to this development, homebuyers had to make a down payment of 50% of the home’s total value, and the repayment schedule included a balloon payment for the rest of the mortgage after no longer than five years.

For many years, FHA loans were extremely popular. In fact, nearly 50% of first-time homebuyers chose these mortgages about a decade ago. However, now only 24% of first-time homebuyers use this option, according to the National Association of Realtors.

So, why are FHA loans on the decline now?

2. The role of private mortgage insurance (PMI)

If you put down less than 20% of a home’s total value down for your mortgage, you typically need to purchase private mortgage insurance, more commonly known as PMI. Lenders make this requirement to protect themselves in the event you default on the loan, which could leave them on the hook for a serious amount of cash.

For some buyers, getting a mortgage with PMI is a great option, as it opens the door to homeownership for those who cannot afford a large down payment. However, paying the cost of PMI can add up over time.

If you take out PMI on a conventional loan, you have the option of terminating the insurance once you have made enough payments to reduce the mortgage's principal balance to 80% of the original value of the home you have purchased, according to the Consumer Financial Protection Bureau.

If you secure a loan backed by the FHA and make a down payment of 10% or more, you can terminate PMI after 11 years.

However, if you get an FHA-backed mortgage and put down less than 10% — which is common, as you can secure this type of loan with as little as 3.5% down — you have to keep PMI throughout the life of your mortgage.

This is a big negative for borrowers, which is one reason fewer first-time homebuyers are turning to FHA loans.

3. Competition in the lending space

Another reason fewer folks are turning to FHA mortgages for their first real estate purchase is the increased competition in the lending space. It used to be that FHA loans were almost always the best option for homebuyers who wanted to make a small down payment on their mortgage.

However, that has changed. Now, you can enjoy similar terms with loans secured through Fannie Mae and Freddie Mac. In a nutshell, these two organizations — often described as government-sponsored entities (GSE) — service the vast majority of loans in the U.S.

In 2014, the GSEs began approving mortgages that only required 3% of the home’s total value as a down payment. That means FHA-backed loans now face stiffer competition for borrowers.

Pro tip: To see what we mean about competitive lenders, check out our list of the best mortgage lenders.

4. The COVID-19 factor

The COVID-19 pandemic that ravaged the world has impacted just about everything, including the real estate market.

Somewhat surprisingly, many people actually grew financially healthier during the pandemic.

As these people began to work from home, they suddenly were unburdened from their daily commute and its associated costs.

In addition, many of these folks spent evenings cooking in their own kitchens rather than going out to restaurants for meals, and almost nobody continued to take expensive trips as COVID spread and the world shut down.

As a result, people started saving more money. With fatter bank accounts, more homebuyers could make larger down payments. That means that fewer buyers needed to turn to an FHA loan to secure their first piece of real estate.

Bottom line

FHA loans have been on the decrease for the better part of a decade, meaning more borrowers are turning to conventional loans when they purchase their first home.

The reasons for this are varied. Competition in the lending space has changed options, and some people have found ways to generate more cash so they have more on hand for a down payment. However, it’s still best to consult with a mortgage professional to determine which loan is right for you.

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This article Why First-Time Homebuyers are Avoiding FHA Loans originally appeared on FinanceBuzz.