If you are considering purchasing a property, you have likely examined the mortgage loan options available to determine which one is best.
There are many types of loans you can choose from, including conventional loans (which are not backed by the government) and government-backed loans, such as FHA, USDA, and VA loans.
Although each has its pros and cons, there is a hidden risk in getting an FHA loan, especially if you are buying a home rather than refinancing an existing loan.
In competitive markets where many bidders are competing for the same property, the financing you choose is important.
Sellers want assurances that you can actually close your loan, and that can make or break your offer.
Home sellers care about the type of mortgage you use.
Over the past decade, the home buying process has been extremely competitive. It has been a seller’s market since I was a kid.
In fact, even when the housing market bottomed out in 2012 and 2013, it was still difficult to find a property.
While short sales and foreclosures were common at the time, inventory was still relatively scarce, and many savvy buyers quickly entered the fray to take advantage of good deals.
Things have gotten worse over the years, partly because of the lack of construction since the subprime mortgage crisis, and also because mortgage rates have fallen to record lows.
This combination of limited inventory and low mortgage rates has pushed homebuying demand to new levels.
The fact that millions of people have reached the right home-buying age (34) hasn’t helped either.
In short, you will often face other bidders when making an offer on a home. One of the things sellers look at when evaluating offers is financing.
How will you be able to afford the property? Will you pay cash? Probably not, but you should know that paying cash is the most important and will make your offer stand out from the rest.
A second option might be to put 20% down on a home purchase because it shows that you have a lot of money and assets in the bank.
It also provides room for maneuver if the appraisal is low, allowing you to readjust the loan amount as necessary.
At the bottom of the ranking are FHA loans, which allow borrowers to come in with a down payment of just 3.5% and a FICO score as low as 580.
While this is great for borrowers who need flexible underwriting guidelines, sellers may not be so keen on it. After all, they need the loan to finance the sale of the property!
FHA loans have a negative stigma.
Which brings me to New report from Consumer Federation of America (CFA), which “highlights the stigma associated with FHA loans,” especially in competitive housing markets.
The chart above shows how FHA loans were very popular when banks were risk-averse in the post-crisis period, but declined once conditions improved, perhaps because these buyers were outbid by those using conventional financing.
In addition, they found that FHA lending is less common in wealthier or predominantly white communities.
This means that minority individuals may be relocated to less desirable neighborhoods, where seller’s agents are more knowledgeable and willing to work with borrowers who need FHA loans to qualify.
The result is the unintended effect of “perpetuating social, economic and racial segregation” in the housing market.
There are a number of key issues driving this negative perception of FHA loans, according to the CFA.
The first is that the Federal Housing Administration includes a mandatory inspection as part of the appraisal process to determine minimum property requirements.
Although it is not necessarily an extensive inspection, it does require that the property being financed with an FHA loan be “safe, sound and protected.”
So things like access to clean drinking water, working appliances, no hazards like lead paint or overhead power lines.
Some of these items may become a nuisance to the seller, who must now either fix the problem, resolve it, or come to an agreement with the buyer. The CFA states that sellers are not “financially responsible for making all repairs.”
However, it can be an unnecessary obstacle and jeopardize the deal, especially if the buyer is already short on funds.
This brings us to the second issue, which is that real estate agents have a “perceived stigma regarding FHA mortgages and their buyers.”
Some see this program as a loan program for less qualified applicants, or a government program (which it is) full of bureaucracy and inefficiency.
In turn, it becomes a self-fulfilling prophecy, as these applicants may be shunned and then only bid on homes in less desirable areas.
These areas then see a high concentration of FHA loans, and these loans become even more stigmatized because agents in the “good areas” don’t handle them.
If they want to make their way into a desirable neighborhood or home, they may find that they need to “bid higher” in order for their offer to be accepted.
What is the solution to make FHA loans less discriminatory?
The CFA Society has come up with four policy recommendations to level the playing field for FHA loans, which they claim have helped millions buy a home.
They believe more states and cities should pass “source of revenue” or “source of funding” laws to combat corruption.
Discrimination laws, which make it illegal to refuse to rent/sell/lease based on income used.
The law was originally intended to protect renters who use things like subsidized Section 8 vouchers, and it could apply to homebuyers who use government-insured mortgages.
For example, prohibiting anti-FHA language in an MLS listing or real estate advertisement.
The next step is to “simplify FHA inspection standards” to reduce potential hurdles for homebuyers.
Another action could be for real estate agent trade groups to dispel myths about FHA loans and educate them on how to better work with FHA buyers.
Finally, they argue that Congress and the Department of Housing and Urban Development should increase funding for fair housing centers to investigate FHA home buying trends.
If necessary, bring cases against real estate agents, lenders, brokers, etc. who commit violations and contribute to the perpetration of “finance discrimination.”
While I do not disagree with their findings or solutions, the end result is that sellers will gravitate towards more creditworthy buyers.
Real estate agents will likely reinforce this idea as well when considering multiple offers. As mentioned, the cash buyer will always be king. Then there is the buyer who puts down 20%, assuming they have at least good credit.
Unfortunately, the lowest tier tends to be FHA buyers, who can get approved with a FICO score of 580 and a 3.5% down payment.
Conversely, a conventional loan buyer using a loan backed by Fannie Mae or Freddie Mac needs a FICO score of 620. There are fewer hurdles to jump through in terms of mandatory screening as part of the evaluation.
So, in practice, while FHA buyers should not be discriminated against, they will still be ranked lower when the seller evaluates offers, all else being equal.
Some of the suggested solutions may be helpful, but if sellers and their agents view the loan the way an escrow writer would, and see a lower credit score coupled with a small amount of money up front, they may be less inclined to accept the offer.
This isn’t necessarily a bad or discriminatory approach. It’s about weighing the options and identifying the buyer who has the best chance of approval, which will lead to the sale of the home.
Make yourself a better borrower before applying for a mortgage.
While there are undoubtedly issues that need to be addressed and resolved in the lending arena, there are some practical things you can do yourself.
Often, FHA loans are used because a borrower does not qualify for conventional financing.
Sometimes this is due to a low credit score, as the chart above shows even high-income earners often end up getting FHA loans.
So one thing potential home buyers can do is work on their credit before applying for a home loan to make sure their three scores are 620+.
At the same time, they can better educate themselves about their options so they know if they qualify for a compliant loan before talking to a lender.
Or they can ask their loan officer or mortgage broker directly if they qualify for a loan backed by Fannie Mae or Freddie Mac. And if not, why not?
If you get your affairs in order early, you will have more lending options at your disposal and will be less affected by any stigma associated with a particular type of financing.
You may also get a lower mortgage rate and get an acceptable offer from the home seller in the process!
Read more: Pros and Cons of Conventional vs. Federal Loans
Prior to creating this site, I worked as an account manager for a wholesale mortgage lender in Los Angeles. My experience working in the early 2000s inspired me to start writing about mortgages 18 years ago to help potential (and current) home buyers better navigate the home loan process. Follow me on Twitter for the latest news.
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