Buying a home can be tough. From finding the right agent to work with, to sorting through listings until you find your dream home, to figuring out innovative ways to keep your costs down, to outbidding all the other buyers in 2021’s red hot market, it’s easy to overlook one of the most important (and most nerve-wracking) aspects of buying a home — the financing.
Among the many mortgage options buyers have, the FHA loan is one of the most popular. But it’s not the best option for all buyers, and you may not even qualify for it. Read on for a complete rundown of what an FHA loan is, how you qualify for one, and how an FHA loan compares to a conventional home loan.
What Is an FHA loan?
An FHA loan is a mortgage that’s backed by the federal government via the Federal Housing Administration. An FHA loan is issued through an FHA-approved lender, which takes on little risk when issuing these loans because the government will cover any default.
The FHA loan program was started during the Great Depression to boost the U.S. homeownership rate. The program has been extremely successful, bringing that rate from around 10% in the Great Depression to over 65% today.
FHA loans have less stringent requirements than conventional loans when it comes to qualifying credit scores and the minimum down payment. The minimum credit score for an FHA loan can be as low as 500, whereas a conventional loan typically requires around 620.)
An FHA loan can be for up to 96.5% of the value of the home you’re buying. If you have a credit score of at least 580, that means your down payment could be as low as 3.5%.. If your credit score is any lower, you’ll have to make a down payment of 10%.
Your down payment can also come from a down-payment assistance program grant, a financial gift from friends, family, employer, or other party, or from your own savings.
There are a few other conditions for an FHA loan. You must use the home as your primary residence for at least a year, it must have been at least two years since any bankruptcy (and three years since any mortgage foreclosure), you must be current on your taxes and federal loan payments, and you’ll be required to get a strict home appraisal.
Great Flexibility — But at What cost?
An FHA loan is a lot easier to qualify for than a conventional mortgage, which is why it’s especially popular with first-time buyers. But it does come with a few downsides.
One of the biggest downsides is that you’ll be required to pay mortgage insurance, possibly for the entire life of your loan.This happens in two parts; a lump sum at closing, then a monthly premium that’s added to your mortgage payment.
The lump sum is called an upfront mortgage insurance premium (UFMIP) and equals 1.75% of your total loan amount. The UFMIP is assessed at closing and will be added to the balance of your mortgage.
The amount of your monthly mortgage insurance premium depends on how much you borrowed, how much you put down, and the length of your loan term. This premium is generally around 0.85% of your total loan, though it can be between 0.45% and 1.05%. It’s assessed annually, divided by twelve months, and then tacked onto your monthly payment.
If you make a minimum 3.5% down payment, you’ll have to pay mortgage insurance for the entire life of your loan; if you made a down payment of 10% or more, you’ll only have to pay for 11 years. For comparison, you only have to pay mortgage insurance on a conventional loan until you’ve built up 20% equity.
However, there are a couple of minor silver linings here. First, unlike mortgage insurance on a conventional loan, your credit score has no bearing on your FHA loan mortgage insurance. And second, you can claim your mortgage insurance premiums as tax deductions.
Pros and Cons of an FHA Loan
So is an FHA loan worth it? It depends. If you’re on the fence, it can help to ask an expert. But there’s no doubt an FHA loan can be a lifesaver, especially if you have an imperfect credit history, an unconventional employment or income situation, or you simply don’t have a lot of cash on hand for a down payment.
However, there are a few strings attached. Let’s look at the pros and cons of an FHA-backed mortgage, so you can weigh your options, and make the best choice for you!
- Low credit scores are not disqualifying
- Higher debt is not disqualifying
- Down payments as low as 3.5%, with very few restrictions on source of income
- No maximum income limits
- Higher mortgage insurance cost
- Possible mortgage insurance for the entire life of the loan
- Not allowed for investment properties
- Strict upper limits based on median home values in your area
- Stricter appraisal process than for conventional loans