Is an FHA loan right for you?
Do you have too much debt to qualify for a conventional mortgage? Less than stellar credit scores or not much cash for a down payment?
You should consider buying a home with an FHA loan.
The Federal Housing Administration, a division of the Department of Housing and Urban Development, was created 80 years ago to help low- and moderate-income families borrow the money they need to buy a home.
The FHA doesn’t actually make home loans. It guarantees that lenders will be repaid if you default on the loan.
That guarantee allows banks and mortgage companies to work with borrowers who might not be able to qualify for conventional home loans and at surprisingly competitive interest rates.
The great majority of lenders make these mortgages, and about one out of every six new home loans is backed by the FHA, according to Ellie Mae, a California-based mortgage technology firm.
There are serious limits on how much you can borrow with an FHA loan for a single-family home — up to $271,050 for single-family homes in most parts of the country or as much as $625,500 in high-cost cities such as New York and San Francisco.
(Here's where to find the FHA loan limits in your area.)
But if the amount you need falls within those guidelines, here’s what you need to know about getting an FHA loan.
They have smaller and more lenient down payment requirements.
Most FHA mortgages require a 3.5% down payment — that’s $3,500 for every $100,000 you borrow — and the average down payment on an FHA home loan is about 5%, according to Ellie Mae.
That's far less than the 20% average for conventional home loans.
Your down payment can be a gift from a relative, a friend or an organization that provides financial assistance.
Many conventional mortgages require the down payment to come from a borrower’s savings or other assets, such as proceeds from the sale of another home.
You can qualify with below-average credit.
Before the financial crisis, FHA loans were for borrowers with bad credit.
And we mean bad credit. Applicants with FICO credit scores below 640 scooped up more than half of all FHA-backed mortgages, while those with credit scores below 580 received about a quarter of them.
Now borrowers with such bad credit obtain fewer than one out of every 10 FHA loans.
Indeed, the average FICO score for rejected FHA applicants is 659, a score that would have landed in the top half of FHA borrowers just a few years ago.
Most of the money currently goes to home buyers who have below-average, but not terrible, credit. The average credit score for successful applicants was 683 last fall.
But let's be clear: That's still way below the average score of 754 for non-FHA loans.
So what’s the secret to qualifying if you have a credit score in the low 700s or high 600s?
Successful applicants usually have a two-year history of steady employment and paying their bills on time.
You can get an FHA loan if you’re self-employed. Just be ready to document your income with tax returns and financial statements from your business.
The same big financial problems that derailed FHA applications in the past continue to do so. If you:
- Declared Chapter 7 bankruptcy, you usually must wait two years from the date of discharge before qualifying.
- Lost a home through foreclosure, you must wait three years. However, if you can prove that the foreclosure was caused by involuntary job loss or income reduction, and your payment history has been good since then, the waiting period can be as little as one year.
- Are delinquent on a federal debt, such as a student loan or income taxes, you can’t get an FHA loan.
- Have a credit score lower than 500, you won’t qualify under FHA guidelines. Most lenders have a higher minimum of 600.
You’re allowed to carry more debt.
To obtain a non-FHA loan, borrowers must be spending no more than 36% to 45% of their pretax income on all debts, including mortgage payments, student loans, credit card bills and auto loans. The limit depends on the borrower’s down payment and credit score.
With an FHA mortgage, you can stretch that ratio to 47% — or even a little higher in some instances.
“We’ve actually had loans approved over 50%, but they have excellent credit, good job stability, skin in the game and money in the bank after closing,” says Greg Cook, a mortgage broker who specializes in helping first-time home buyers in Temecula, California.
If your credit score is below 580, however, debt-to-income ratio can’t exceed 43%.
Just because you can be approved with a higher debt ratio doesn’t mean you will be. The typical rejected applicant has a debt-to-income ratio of 49%, while the typical approved applicant had a debt-to-income ratio of 41%, according to Ellie Mae.
The biggest drawback of FHA loans.
The big disadvantage to FHA financing is the mortgage insurance. It’s the price you pay for having the government stand behind your loan.
All borrowers, regardless of loan term or down payment, must pay the 1.75% up-front mortgage insurance premium at closing.
That means that you pay a $1,750 insurance premium on every $100,000 borrowed.
While that sum can be added to your loan amount so you don’t have to bring more cash to the table, it’s still an extra charge. And if you finance it, you’ll pay interest on it, too.
Most borrowers will also have to pay monthly insurance premiums, which were actually reduced in January 2015 for 30-year fixed-rate mortgages.
For a 30-year loan with a down payment of less than 5%, your premiums will be 0.85% (down from 1.35%) of the outstanding balance each year.
That cost is typically divided into 12 monthly payments and added to your mortgage payment. That’s $850 per year, or about $70 per month, per $100,000 of loan balance.
If you put more than 5% down on a 30-year loan, your annual premiums will be 0.80% (down from 1.30%).
It used to be that you only had to carry this insurance for at least five years on all loans longer than 15 years, or until the balance on your mortgage was down to 78% of the original purchase price, whichever took longer.
Since mid-2013, new FHA borrowers who put down less than 10% have been required to pay these premiums for the life of the loan. This rule isn’t changing.
If you keep your FHA financing for 30 years, you’ll pay significantly more in mortgage insurance premiums than you would with a conventional loan and private mortgage insurance.
That’s because on non-FHA loans, borrowers can usually drop private mortgage insurance once the loan balance is down to 80% of the purchase price and after as little as one year.
Conventional loans also allow you to count home price appreciation toward obtaining the needed equity. FHA mortgages do not.