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Is an FHA loan still a good idea?

(MoneyWatch) If you're thinking about taking out an FHA home loan, you may want to reconsider.

For nearly 80 years, the Federal Housing Administration has helped home buyers purchase their first homes by offering loans that are easier to qualify for, require smaller down payments and feature interest rates lower than they might otherwise get through a conventional loan.

For millions of buyers who have decent -- but not stellar -- credit scores and haven't saved up a big down payment, the FHA has been a good deal.

That may no longer be the case.

The FHA is experiencing a cash crunch. Congress requires the agency to keep cash balance equal to at least 2 percent of all outstanding loans in its mortgage insurance funds. But due to the slew of bad loans taken on during the housing crisis, the agency isn't meeting that goal.

So prices are going up yet again for FHA borrowers. The cost of mortgage insurance has risen and, what's worse, homeowners can no longer cancel it -- a common feature of conventional loans.

"FHA was always designed to make home buying possible for first-time buyers that couldn't otherwise afford it," says Sin-Yi Lambertson, a broker at real estate agency ERA Yes! in Los Angeles. "Yet the mortgage insurance really increased so much that it's very difficult for first-time home buyers to afford."

On top of the 1.75 percent FHA borrowers pay up front, monthly mortgage insurance costs increased again in April, the third hike in two years. In 2010, borrowers paid more than half what they're paying now in mortgage insurance costs.

This all translates to tacking about 1.35 percent onto your interest rate, an additional cost not borne by borrowers with no mortgage insurance. And, thanks to a new rule that just kicked in this month, borrowers will pay that increased insurance rate over the entire life of the loan. Previously, the mortgage insurance premium on a loan was automatically canceled after borrowers had attained 22 percent equity.

So if the added insurance cost results in an extra $100 each month, you will pay that extra money for 30 years instead of about five. Which translates to borrowers' paying $30,000 or more over the life of the loan. That's not pocket change.

Even so, that doesn't mean there's no place for FHA loans.

When to consider an FHA loan

Simply put, the FHA option makes sense only when there is no alternative.

The FHA accepts applicants with lower credit scores, typically between 640 and 680, whom conventional lenders may turn down.

You can also get away with a higher debt-to-income ratio, meaning that when all your housing costs are compounded, from insurance to taxes to mortgage payments, the amount is under a certain percentage of your income. To qualify for an FHA loan, that number is about 47 percent, whereas with conventional loans, it might be about 38 to 40 percent, Lambertson says.

The FHA also offers loans with down payments as small as 3.5 percent, and that down payment can come from gifts from family and friends, not just your savings.

When an FHA loan is not the right choice

If  you do qualify for a loan, the FHA won't offer much of a deal.

During the housing crisis, many first-time buyers had trouble qualifying for loans as a result of really strict standards, and they turned to the FHA. That is changing, says Lambertson, and lenders now offer loans requiring lower down payments (south of even 10 percent) and have loosened their credit requirements, though you will likely pay a higher interest rate.

Though with a conventional loan you will still typically pay mortgage insurance if you don't put 20 percent down,  your insurance costs are lower and you can cancel the policy when you have enough equity.

In making your choice, ask your lender for an honest comparison of your individual costs.

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