The prospect of buying a new home can be daunting, especially if you’ve had a less than stellar financial history or don’t have a lot in the bank. The good news is there are programs out there designed to help borrowers like you. The most popular and easiest to qualify for is an FHA loan.
What is an FHA loan?
An FHA loan is a government-backed loan funded by the Federal Housing Administration. These loans still go through traditional lenders who are approved to work with the federal government, but they are guaranteed by the FHA should you default. This extra assurance allows lenders to offer loans to borrowers who wouldn’t otherwise qualify.
The FHA began in 1934 in response to the Great Depression as a way to help Americans afford and stay in their homes. Today, the agency is still providing this service and has backed the loans for nearly 8 million American homes.
Am I eligible for an FHA loan?
To be eligible for an FHA loan you have to meet a minimum credit score and be able to put up some money for the down payment. The amount you are required to put down is contingent on your credit score.
For scores of 580 or higher, you can obtain a loan for as low as a 3.5% down payment. For scores of between 500 and 579, you have to put down at least 10%. Typically, with conventional loans it’s expected that you put down between 10% to 20%, but most lenders require you to have a credit score of at least 620 or 640 to qualify.
Are there different types of FHA loans?
The FHA offers many different kinds of loans, but they are all intended to be used for a primary residence, so they cannot be used to buy an investment property or second home. The FHA offers standard loans for single family homes, condos, duplexes or MFR’s (multi-family residences), or some manufactured homes. It also has loans for constructing your own home, or upgrading your current home to be more energy efficient.
PROS AND CONS OF AN FHA LOAN
- Low down payments, 3.5% to 10%, so it’s good for borrowers without a lot of savings
- Lower minimum credit score requirements with loans offered with a scores as low as 500
- Easy to qualify
- Many lenders are approved to help with FHA loans, so finding a lender near you is easy
- Low DTI (debt to income) ratio requirements
- Can only be used to buy a primary residence
- You still have to come up with a down payment
- Mortgage insurance is required on all loans
Why do I need to keep Mortgage insurance?
Even though the FHA provides lenders insurance on these loans, it’s often not enough and therefore borrowers are required to purchase MI (mortgage insurance). For a conventional loan, MI is required on all loans where the borrower puts down less than 20%, but it is relatively easy to remove it once the LTV (loan to value) ratio hits 80/20. For example, if you buy a home for $200K and put down 15% ($30,000), your loan amount will be $170K. The bank will require you to purchase MI until you pay $10,000 more toward the principal balance. Once you have paid your loan down to $160K, your MI will drop off since you’ve now put a total of 20% toward the purchase price. This is not the case for an FHA loan, and is probably the number one drawback of getting this type of loan.
The FHA has its own MI and the borrower has to pay an upfront premium of 1.75% of the loan value regardless of the size of your down payment. Additionally, you’ll be required to carry MI on your loan at a rate of .45% to 1.05% of the loan amount and it’s added into your monthly payments. If you put up a 10% down payment, you are required to keep the MI on your loan for 11 years. If you put down only 3.5%, you must keep the MI for the life of your loan. This can be a major drawback for borrowers since the MI increases your monthly payment and won’t drop off even if you achieve an 80/20 LTV.
How to qualify for an FHA loan
To qualify for an FHA loan, you’ll first have to find an FHA-approved lender. Remember, the loans are still financed through private lenders, and are only insured or guaranteed by the federal government. Like a conventional loan, you’ll have to provide bank statements, pay stubs, the last two years of your federal income taxes, and undergo a credit check.
Credit Score: Conventional loans usually require a credit score of at least 620 or 640, but FHA loans will accept borrowers with a minimum score of 500.
DTI (debt to income) ratio: Conventional loans often require a DTI of under 36%, but FHA loans can approve borrowers with as high as a 50% DTI. For example, if you have a gross monthly income of $4,000 and a monthly debt total (included the new mortgage) of $1,900, your DTI would be 47.5% ($1,900/$4,000 = .475 or 47.5%.) In this scenario you likely wouldn’t qualify for a conventional loan, but you would qualify for an FHA loan.
Down payment: Conventional loans typically require a down payment of 10% to 20%, though some can go lower. With an FHA loan, the most you will pay for a down payment will be 10%, but if you have a credit score of 580, you only have to pay 3.5%. While a 3.5% down payment will save you money upfront, it will cost you money over the life of your loan since you’ll have to carry MI the entire time. For example, if your loan amount is $200K you would only have to put up $7,000 up front, and you will be adding an additional $900 to $2,100 a year in MI for the life of the loan.
Is an FHA loan right for me?
If you have a low credit score (under 620) and are unable to raise it in a reasonable amount of time, an FHA loan might be your only option if you wish to purchase a home. Likewise, if you have very little in savings and are unable to make a significant down payment, an FHA loan might be a good option. It will certainly save you money upfront and can get many borrowers into a home building equity who otherwise would not be able to. This is the mission of the FHA. However, if you do have decent credit and are able to pony up money for a downpayment or borrow funds, you should opt for a conventional loan so you won’t be stuck paying MI for any longer than you have to.