If the conventional path for purchasing a home—20% down and a 700+ credit score to secure the best mortgage—isn’t in the cards, an FHA loan might be the next-best solution.
At a time when home prices are still rising, FHA loans have lower, more accessible requirements than standard loans. However, with these lower standards come some extra costs that may offset the easier entry level, so it pays to examine their pros and cons.
The ABCs of FHA Loans
The Federal Housing Administration, or FHA, doesn’t actually lend money to home buyers. Instead, it offers insurance to FHA-associated lenders guaranteeing them that if their borrower defaults, they’ll still get their money.
It’s designed to encourage first-time home buyers (and you must be a first-time home buyer to qualify) with lower minimum loan requirements such as a credit score of 580 and a down payment of 3.5% down. (Lower credit scores can still qualify for a mortgage, but borrowers have to put more down.)
More good news: You can still qualify for an FHA loan if you’ve gone through a Chapter 13 bankruptcy. However, you’ll have to wait at least two years after the discharge date of your Chapter 13 before you can apply (one year if you have extenuating circumstance).
Importantly, the FHA sets limits that vary from state to state, and county to county, as to how much can be borrowed, so check HUD’s website for specifics to your area.
Other Minimum Requirements
In addition to a lower credit score and smaller down payment, FHA loans require the following:
- Steady employment history for the past two years
- A valid Social Security Number
- Lawful residence in the US
- Of legal age to sign a mortgage contract for your state
- The purchased property must be your primary residence
- Properties must first be inspected by FHA-approved property appraisers
- Your “front-end ratio”—mortgage payment, property taxes, mortgage and homeowners insurance, and HOA fees if applicable—must be less than 31% of your gross income.*
- Your “back-end ratio”—“front-end” plus all other monthly debt—must be less than 43% of your gross income.*
* Exceptions can be made to allow for higher percentages, but your lender would have to provide written justification explaining why they think the loan is worth the greater risk prior to approval.
The Fine Print
Of course, just as there’s no such thing as a free lunch, FHA loans do have some drawbacks.
First, you have to pay FHA mortgage insurance not once, but twice.
There is an upfront cost of 1.75% of the total loan that needs to be paid, and then a monthly fee (generally between .45% and .85% of the loan) that will depend on how much you put down, your loan-to-value (LTV) ratio, and the length of your loan.
Second, and unlike conventional loans, you must pay FHA’s mortgage insurance anywhere from 11 years to the life of the loan (how long will depend on the size of your down payment).
While these fees may seem overly grasping, it’s how the FHA can continue to operate. The monies are used to pay lenders if the homeowner defaults.
Another consideration, if you’re only putting 3.5% down and the market drops, you could be underwater on your loan. Of course, you’ll still own the house, and when the market eventually recovers you’ll have years of equity built up, but it can still take a psychological toll.
By the Numbers
Consider starter-homes of $100,000 and $350,000. With an FHA loan, in addition to the usual closing costs, you’d also pay:
$1750 upfront PMI
$65/month in PMI (for at least 11 years)
$6125 upfront PMI
$227.50/month in PMI (for at least 11 years)
A lot of money, obviously, but still less than the $20,000 or $70,000 you’d need for a conventional 20% down payment—amounts that are generally out of reach for many first-time homebuyers.
On the other hand, if you had good credit—or could raise your score in a year or so—could manage at least 10% down, and find a home mortgage rate close to what you’d pay with an FHA loan, you’d find yourself with greater starting equity, possibly lower monthly payments, and be done with PMI after paying off just 10 more percent of the loan.
Ultimately, FHA loans can be a great avenue to home ownership, but they do require some careful considerations of the plusses and minuses.
Want to learn more about whether an FHA loan is your best option for homeownership? Answer a few questions here, and a home lending expert will contact you.