Thinking of an FHA mortgage? Think again!

If you're looking to buy a home and don't have a lot of money to put down, your lender might suggest an FHA loan. While you may have been planning on putting five or ten percent down, you might be intrigued by a loan that requires you to only put three percent down. It's something that I was suckered into when I bought my home in 2007, and I'm still kicking myself for it.

Let's go through a quick scenario. Say you're going to buy a house for $200,000 and only have about $12,000 cash in the bank that you can access to cover closing costs and a down payment. If you can talk the seller into covering some of your closing costs (not unreasonable in this environment), you'll have about $10,000 left to put toward a down payment, which just happens to be five percent. But you're nervous about parting with all of your cash. Then you hear about an FHA loan, which will allow you to put only three percent down($6,000). That extra four grand in your pocket would sure come in handy when buying furniture for the new place!

But you're a fool if you think the convenience of putting down $4,000 less comes without a price. The price will actually be $3,500. That's right -- the Federal Housing Authority will charge you a fee of 1.75% of the purchase price for the convenience of putting down 2% less than you would have to with a more traditional loan. They simply roll that fee into the principal of the mortgage and call it "mortgage insurance" (not to be confused with Private Mortgage Insurance, or PMI -- you'll have to pay that, too).

Given your current financial situation, your lender will give you two options: the FHA loan, which will require 3% down plus closing costs, and an "80/15" mortgage, which is actually two mortgages; one for 80% and one for 15% of the home's value. With the FHA loan, you will put down 3% of the price before the lender shadily tacks on 1.75% to the principal balance, leaving you with 1.25% equity (3% minus 1.75). When your first payment comes due, your principal balance will be around $197,500. With the 80/15 mortgage(s), though you will put 5% down, all of that actually goes toward the principal. So when your first mortgage bills come, you'll owe a total of $190,000.

Two other related factors in the matter are PMI (associated only with the FHA loan) and different interest rates associated with the two separate mortgages (one rate for the 80% loan and a higher rate for the 15% loan).

PMI is a monthly fee that lenders charge for people with a mortgage that has a balance greater than 80% of the home's value. With the FHA loan, your mortgage will be 98.75% of the home's value, so you can bet your ass you'll be paying the $85/month PMI. On the other hand, with the 80/15 mortgage, because neither mortgage will exceed 80% of the home's worth, you don't need to pay PMI. I know it sounds silly, but it's how it works.

The only catch with the 80/15 mortgage is the different interest rates, but any downsides will be canceled out by the fact that you're not paying PMI. An FHA loan is one big mortgage with one interest rate. Let's say 5%. The 80/15 mortgages will have different rates. The 80 will be at a low rate, similar to the FHA loan, while the 15 will have a higher rate. Your interest rate might be 5% on the "80" and 7.25% on the "15." This calculates to be an effective interest rate of 5.37% with a monthly payment of $1,063.56. The FHA loan, though it has a lower effective interest rate (5%, remember?), has a monthly payment of $1,145.22 after you factor in the $85/month PMI that will be required by your lender. All of these assume a 30-year mortgage.

So why do I recommend 80/15 mortgages to first time homebuyers that are strapped for cash? For two reasons:
#1) You start off with 3.75% more equity in your home from day one. On a $200,000 house, that's $7,500!
#2) Your monthly payment will be significantly less, leaving you with extra money to spend (or better yet, to send toward extra principal each month).

If you're in the market to buy a house but can only put 3% down, run away from FHA loans. My advice is to wait and save up that extra few thousand bucks.

Good luck!