Saving up the traditional 20% for a mortgage down payment is the kind of financial obstacle that can bar first-time homebuyers with minimal savings from becoming homeowners. The government-backed Federal Housing Administration (FHA) mortgage is one solution for those who want to buy a home but can’t pull together a large down payment.
FHA mortgages are home loans funded by FHA-approved lenders and insured by the government.
The government backing protects lenders from loss if borrowers default. Because of this protection, lenders can be more lenient with their qualifying criteria and can accept a significantly lower down payment.
You can get approved for an FHA mortgage with a minimum credit score of 500, and you only need to put 3.5% to 10% down to buy a home.
How much can an FHA mortgage help you?
For a $150,000 home, a 20% down payment would mean you would need to bring $30,000 (along with other closing costs) to the table. That’s no small chunk of change. By comparison, an FHA mortgage would require anywhere from 3.5% to 10% for a down payment, which comes out to $5,250 to $15,000.
In this post, we’ll cover the following topics to explain the FHA mortgage, including:
- FHA mortgage terms
- FHA qualifying criteria and restrictions
- FHA costs and mortgage premiums
- FHA mortgages vs. conventional mortgages
- How to shop for an FHA mortgage
FHA mortgage terms
There are both 15- and 30-year fixed-rate and adjustable-rate FHA mortgage options. With a fixed-rate FHA mortgage, your interest rate is consistent through the loan term. However, your monthly mortgage payment may increase based on your homeowners insurance, mortgage insurance premium, and property taxes.
Adjustable-rate FHA mortgages are home loans where the rate stays low and fixed during an introductory period of time such as five years. Once the introductory period ends, the interest rate will adjust, which means your monthly mortgage payments may increase.
A unique situation where signing up for a low, adjustable-rate FHA mortgage could make sense is if you plan to sell or refinance the home before the introductory period ends and the interest rate can change. Otherwise, a fixed-rate FHA mortgage has predictable mortgage payments and may be the way to go.
Qualifying criteria and restrictions
Although the FHA home loan is particularly appealing for first-time homebuyers, it's not only open to first-time purchasers. Repeat buyers planning to use the home as a primary residence may qualify for an FHA home loan as well.
Besides the low down payment, an undeniable benefit of the FHA mortgage is the low credit score requirement. You may qualify for 3.5% down payment with a credit score of 580 or higher. You can also qualify with a credit score lower than 580, but you’ll have to make a 10% down payment.
Debt-to-income (DTI) ratio is another key metric lenders consider in addition to your credit score to determine whether you can afford a mortgage. DTI measures the amount of debt you have compared to your income, and it’s expressed in a percentage.
Lenders look at two debt-to-income ratios when determining your eligibility — housing ratio or front-end ratio and your total debt ratio or back-end ratio.
Your front-end ratio is what percentage of your income it would take to cover your total monthly mortgage payment. Lenders like to see your front-end ratio below 31% of your gross income.
Your back-end ratio shows how much of your income is needed to pay for your total monthly debts. Lenders prefer a back-end ratio of 43% or less of your gross income.
The FHA mortgage can be used for both single-family and multi-family homes, but there are loan amount maximums that vary by state and county.
For an example, in Fulton County, Atlanta, the maximum loan for a single-family house is $342,700. You can find the loan limits for all states and counties here.
FHA mortgage costs and mortgage insurance premium
Just like a traditional mortgage, an FHA home loan has closing costs. Closing costs are the costs necessary to complete your transaction, such as appraisals and home inspections. However, you may be able to negotiate to have some of these costs covered by the seller.
The real expense of the FHA home loan lies in the mortgage insurance premiums.
At first glance, the FHA mortgage probably seems like the ultimate hack to buying a home with minimal savings. The flip side to this is you need to pay mortgage insurance premiums to cover the lender for the lower down payment.
Remember, FHA-approved lenders offer mortgages that require less money down and flexible qualifying criteria because the Federal Housing Administration will cover the loss if you default on the loan. The government doesn’t do this for free.
FHA mortgage borrowers must “put money in the pot” to cover the cost of this backing through upfront and annual mortgage insurance premiums. The upfront insurance premium for the FHA mortgage is currently 1.75% of the loan amount, and it can be rolled into your mortgage balance.
The annual insurance premium is broken into a payment that you make monthly. The annual premium for mortgage insurance can be up to 1.05% based on your loan term length, loan amount, and loan-to-value ratio (LTV).
LTV is a percentage that compares your loan amount to your home’s value. It also represents the equity (or lack of equity) you have in the property.
For example, putting 3.5% down means your LTV would be 96.5%. In other words, you have 3.5% equity in the home, and your loan is covering the remaining 96.5% of the home value.
Here’s the annual mortgage insurance premium on a 30-year FHA mortgage (for loans less than $625,000):
- LTV over 95% (you initially have less than 5% equity in the home) - 0.85%
- LTV under 95% (you initially have more than 5% equity in the home) - 0.8%
As you can see, starting off with less equity (or a smaller down payment) will cost you more in insurance premiums. You can expect to pay 0.85% in annual mortgage insurance premiums if your down payment is 3.5% on the 30-year mortgage.
Unfortunately, if your LTV was greater than 90% at time of origination, insurance premiums tag along for the entire loan term or 11 years, whichever comes first. There are exceptions if you have an FHA mortgage that was taken out before June 3, 2013.
How does the FHA home loan compare to conventional home loans?
Government-backed home loans like the FHA mortgage are part of special programs that serve borrowers that can’t qualify for a traditional mortgage.
At the other end of the spectrum is the conventional mortgage or the “Average Joe” of mortgages.
These traditional mortgages are offered by lenders and banks backed by Fannie Mae and Freddie Mac’s mortgage standards. Fannie Mae and Freddie Mac are government-sponsored agencies that buy loans from mortgage lenders and banks that conform to preset requirements.
Since conventional mortgages are loans eligible to be purchased by Fannie Mae and Freddie Mac, the qualifying criteria bar is usually set higher. For instance, you should have at least a 620 credit score to qualify for a fixed-rate conventional loan. Although, credit score minimums vary by lender, and a score above 620 will be necessary for the most competitive interest rates.
A misconception about the conventional mortgage is that borrowers must have 20% for a down payment to qualify. Mortgage lenders may accept less than 20% down for a conventional mortgage if you have a high credit score and pay their version of mortgage insurance premiums, which is called private mortgage insurance (PMI).
PMI is a private insurance policy that protects the lender if you default. Be careful not to confuse the two types of insurance policies.
If you have PMI on a conventional mortgage, you’re able to request a removal of insurance payments when you build up 20% equity in your home.
On the other hand, the mortgage insurance premiums for new FHA mortgages (post 2013) can’t be removed unless you refinance.
When to choose a conventional mortgage instead
Putting down less money with the FHA mortgage can be a shortcut to homeownership if you don’t have much cash saved or the credit history to get approved for a conventional mortgage.
But, the convenience doesn’t come without strings attached and the additional insurance costs can follow you for the entire loan term. This can get costly.
Furthermore, putting a small sum down on a home means that it will take you quite some time to build up equity. A small down payment can also increase your monthly payments. Homebuyers with a strong credit score should consider saving a bit more money and shopping for a conventional home loan first before thinking the FHA home loan is the only answer to a limited down payment.
You may be able to qualify for a conventional home loan with PMI if you have a down payment of 5% to 10%. A conventional home loan with PMI may not require the same upfront insurance payment as the FHA home loan, so you can find some savings there. Plus, you're capable of getting rid of PMI without refinancing.
How to shop for an FHA mortgage
If your present credit score and savings make you ineligible for a conventional home loan, the FHA home loan is still a viable option to consider for financing. Just make sure you understand the implications of the extra cost.
Like a conventional mortgage, you need to shop around with multiple FHA-approved lenders to find the most competitive rate. If you’re unfamiliar with FHA-approved lenders in your area, you can go to the HUD website to find a few.
Don’t rush to a decision. If you’re not sure which option (FHA or conventional mortgage) will be the most cost effective for you, ask each lender you shop with to break down the costs for a comparison.