Not all homebuyers have the money to make a traditional 20% down payment. The perception that you need one is one of the main financial obstacles that can discourage people from pursuing homeownership.
In reality, there are several options for buyers who want to get a mortgage but can only pull together a small down payment. One of the best ones, particularly for first-time homebuyers, is an FHA loan.
This article offers you a guide to getting an FHA mortgage, including details on how to qualify and the costs to consider.
What it takes to qualify for the FHA mortgage program
FHA mortgages are insured by the Federal Housing Administration (FHA), part of the U.S. Department of Housing and Urban Development. The program is a key way that people of moderate income can become homeowners. Nearly 83% of homeowners who borrowed an FHA loan in 2018 were first-time homebuyers, according to a report from HUD.
FHA mortgages are funded by FHA-approved lenders and then insured by the government. This 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 as little as a 3.5% down payment and a credit score of 580. You may also qualify with a credit score as low as 500, though you’ll need to put down 10% instead.
On a $200,000 home, that comes out to a down payment of $7,000 to $20,000 when taking out an FHA loan, depending on your credit score.
Keep in mind you’ll also be responsible for closing costs, which typically cost 2% to 5% of a home’s purchase price. Closing costs are necessary to complete your transaction, and include services such as appraisals and home inspections. However, you may be able to negotiate to have some of these costs covered by the seller.
Is an FHA loan right for you?
FHA loans are particularly suited for several different types of homebuyers.
First-time homebuyers, who often have lower credit scores and smaller available down payments, tend to gravitate to FHA loans. Additionally, boomerang buyers — people who lost a home in the past due to a bankruptcy, foreclosure or short sale — might also benefit from an FHA loan.
Negative credit events such as foreclosure can drop credit scores by more than 100 points in many cases, and there’s typically a waiting period of three years before you’re eligible to buy a home again. Once that’s up, the lower credit score requirements of the FHA loan program could help you become a homeowner again.
Types of FHA mortgages
The FHA offers both 15- and 30-year mortgages, each with fixed rates or adjustable rates.
With a fixed-rate FHA mortgage, your interest rate is consistent through the loan term. You know what your principal and interest payment will be for the life of the mortgage. However, your overall monthly payment may increase or decrease slightly based on your homeowners insurance, mortgage insurance premium and property taxes.
Adjustable-rate FHA mortgages start out with a low and fixed interest rate during an introductory period of time, usually five years. Once the introductory period ends, the interest rate will adjust annually, which means your monthly mortgage payments may increase based on market conditions.
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 changes. Otherwise, a fixed-rate FHA mortgage has predictable principal and interest payments and may be the better option.
FHA loan limits
The FHA imposes a limit on the amount of money that homebuyers are allowed to borrow each year. For 2019, the FHA loan limits for one-unit properties are $314,827 in most U.S. counties and $726,525 for high-cost areas. You can find your county’s loan limit information for one- to four-unit properties by using the FHA’s lookup tool.
Qualifying for an FHA loan
Besides the low down payment, an undeniable benefit of the FHA mortgage is the low credit score requirement. You may qualify for a 3.5% down payment with a credit score of 580 or higher. You can qualify with a minimum credit score of 500, but you’ll have to make at least a 10% down payment.
Your debt-to-income (DTI) ratio is another key metric lenders use when determining whether you can afford a mortgage. DTI measures the percentage of your gross monthly income that is used to repay debt. Lenders consider two DTI ratios when determining your eligibility — the front-end (housing debt) ratio and the back-end (total debt) ratio.
Your front-end ratio is the percentage of your income it would take to cover your total monthly mortgage payment. Lenders typically like to see a front-end ratio of no more than 31%.
Your back-end ratio illustrates the percentage of your income that covers your total monthly debts. Lenders prefer a back-end ratio of 43% or less, but may approve a higher ratio if you have compensating factors, such as a higher credit score or a larger down payment.
You’ll also need to have a steady income and proof of employment for the last two years. Additionally, the home you’re purchasing via FHA must also be your primary residence, at least for the first year.
FHA mortgage insurance
At first glance, an FHA mortgage probably seems like the ultimate hack to buying a home with minimal savings. The flip side to this is you must pay mortgage insurance premiums (MIP) in exchange for your 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 costs 1.75% of the loan amount and can be rolled into your mortgage balance.
The annual mortgage insurance premium is divided into 12 installments and paid monthly as part of your mortgage payment. The annual premium ranges from 0.45% to 1.05%, based on your loan term, loan amount and loan-to-value ratio (LTV).
How your loan-to-value ratio affects mortgage insurance
Your LTV is a metric that compares your loan amount to your home’s value. It also represents the 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 MIP on a 30-year FHA mortgage (for loans less than or equal to $625,500):
- 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 a smaller down payment will cost you more in mortgage insurance premiums. Additionally, in most cases, you’ll pay annual MIP for the life of your loan.
However, if your LTV was less than or equal to 90% at time of origination — meaning you made a down payment of at least 10% — you can cancel MIP after 11 years.
FHA loans vs. conventional loans
Government-backed home mortgages like the FHA loan are special programs serving borrowers who might not qualify for a traditional mortgage.
Conventional mortgages are offered by lenders and banks and typically follow Fannie Mae and Freddie Mac’s mortgage standards. Fannie and Freddie are government-sponsored enterprises that buy loans from mortgage lenders and banks that fit their requirements.
The qualifying criteria bar for conforming loans is usually set higher. For instance, you typically need to have at least a 620 credit score to qualify for a fixed-rate conventional loan. However, credit score minimums vary by lender, but in any case, a score above 620 will be necessary for the most competitive interest rates.
A misconception about conventional mortgages 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).
Similar to FHA mortgage insurance, 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 the removal of those insurance payments when you build up 20% equity in your home. On the other hand, the mortgage insurance premiums for most new FHA mortgages can’t be removed unless you refinance.
When to choose a conventional mortgage instead
Choosing an FHA loan 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. Still, the convenience comes at a price that can follow you for the entire loan term.
Furthermore, putting a small sum down on a home means it will take you quite some time to build up equity. A small down payment can also increase your monthly payments and interest rate.
Homebuyers with a strong credit score should consider saving a bit more money and shopping for a conventional home loan first before thinking an FHA mortgage is the only answer to a limited down payment.
If you plan to put down at least 5% toward your home purchase and have a good or excellent credit score, it might make sense to borrow a conventional mortgage instead. 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.
There are a few conventional mortgage programs that allow a 3% down payment, including Fannie Mae’s HomeReady program and Freddie Mac’s Home Possible program. These products also have cancellable mortgage insurance.
Shopping for an FHA loan
So, you’ve reviewed all the information and determined that an FHA loan is right for you. Once you’re ready to start the homebuying process, one of the most important things on your to-do list is shopping around.
Gather quotes from multiple FHA-approved lenders to find the most competitive rate. If you’re unfamiliar with the approved lenders in your area, you can use the HUD’s lender list search to locate them.
Comparison shopping for the best mortgage rate can save you thousands in interest over the life of your loan, according to research from LendingTree, which owns MagnifyMoney. Be sure you also compare the various other costs associated with borrowing a mortgage, including lender fees and title-related expenses.
Don’t rush to a decision. If you’re still not sure which mortgage type will be the most cost-effective for you, ask each lender you shop with to break down the costs for a comparison.