A Federal Housing Administration (FHA) mortgage is a loan that is insured by the federal government. This backing gives lenders the ability to provide loans for home ownership that are distinguished by lower down payments, lower closing costs, and a lower credit rating threshold for qualification. Simply stated, the FHA eases the process of becoming a homeowner for Americans whose financial outlook, employment situation, or credit background might make it difficult or impossible to either secure or afford the expenses that come with a conventional loan.
The FHA can be an extremely beneficial option for many aspiring homeowners, especially first-time home buyers. But it also comes with some conditions that you should know about first, some of which could even cost you more money in the long run. If you’re considering an FHA, make sure you have a complete understanding of the pros and cons of this mortgage option. Once you do, it could be your ticket to affording your first home.
Of course, there is more to affording home ownership than simply finding a way to make that initial purchase. Before you venture into this huge investment, be sure you understand the full scope of expenses that come with home ownership. To learn more, check out our look at The Real Costs of Owning a Home.
Otherwise, read on and find out if an FHA loan could be right for your situation.
What is an FHA loan and how does it work?
An FHA loan is a specific type of mortgage which is designed to remove some of the financial barriers to home ownership that many Americans face. The FHA works through a program coordinated between the U.S. federal government and mortgage bankers and lenders.
According to Investopedia, “A Federal Housing Administration (FHA) loan is a home mortgage that is insured by the government and issued by a bank or other lender that is approved by the agency. FHA loans require a lower minimum down payment than many conventional loans, and applicants may have lower credit scores than is usually required.”
As these terms suggest, the purpose of the FHA is to provide a more attainable threshold for homeownership to those with modest income or those who are first-time homebuyers. The FHA is part of the Department of Housing and Urban Development (HUD), and has been provided to those in need of loan assistance since as far back as 1934.
What are the benefits of an FHA loan?
The benefits of an FHA loan are considerable for those who either have limited funds to make a down payment or for those who may not have a sterling credit rating. For these reasons, the FHA is especially popular among prospective first-time homebuyers. To this point, Bankrate notes that FHA’s 2020 Annual Report placed the number of first-time buyers among FHA borrowers at 83%.
The lower down payment threshold is one major reason why. According to HUD, “Your down payment can be as low as 3.5% of the purchase price.” Another major reason is the lower credit score threshold relative to the conventional loan. You could qualify for an FHA loan with a FICO credit score as low as 500.
With these combined figures, most borrowers would have a very difficult time being eligible for a conventional loan. Moreover, those who do qualify for a conventional loan with a lower than average down payment and credit score would experience certain penalties including much higher monthly mortgage payments and insurance premiums.
As an FHA borrower you would typically be responsible for mortgage insurance premiums—which will be explained in further detail in a section below. However, in general, the FHA is constructed to make homeownership more accessible to those who aren’t ideal candidates for a conventional loan.
What’s the difference between an FHA loan and a conventional loan?
The difference between an FHA loan and a conventional loan is that the FHA can lower the bar for receiving a home loan thanks to its backing from the U.S. government. According to Bankrate, “Unlike FHA loans, conventional loans are not insured by the government. Qualifying for a conventional mortgage requires a higher credit score, solid income and a down payment of at least 3 percent for certain loan programs.”
While technically, your down payment with a conventional loan can be as low as 3%, this comes at a greater long-term cost. The lower your down payment, the greater your long term costs including higher monthly mortgage and insurance payments. Because your loan is not backed by the federal government, a lower down payment will trigger responsibility for Private Mortgage Insurance (PMI). PMI can be particularly expensive depending on your credit rating, and is required of all conventional mortgage borrowers who put down less than 20%. Simply stated, those with a higher credit rating will pay a lower PMI and those with a lower credit rating will pay a higher PMI. This could be a determining factor as you decide which type of loan is right for you.
Generally, the purpose of mortage insurance is to protect the lender in the event that a buyer defaults on a loan. Indications that you may be a high risk borrower—including lower down payment and credit score—can raise your insurance rate with a conventional loan. By contrast, the FHA insurance rate is generally based on the loan amount itself. This can place a cap on how much you’ll pay for insurance with an FHA loan.
In other words, for those who anticipate having substantially less than 20% to put down on their home and who have a less than perfect credit rating, an FHA loan can offset upfront and monthly costs. This can make home ownership more accessible to those with both limited cash funds and credit scores that might spur higher PMI rates.
This accessibility is also underscored by the lower credit rating threshold extended to FHA borrowers in general. Whereas the threshold for a conventional mortgage is typically in the range of a 620 credit score, access to the FHA loan begins with those who have a minimum FICO score of 500. For those with negative reports in their credit history, or those who have yet to build strong credit, an FHA can actually provide a great point of entry to building, improving and repairing credit.
What is the downside to an FHA loan?
The downside to the FHA loan is that all FHA borrowers must pay mortgage insurance, whereas conventional borrowers who can meet the 20% down payment threshold can bypass this expense. For those who do choose the FHA loan, the mortgage insurance payment will be divided into two premiums—one which is paid on the loan amount at the time of closing; and one which is paid monthly over the life of the mortgage.
As Investopedia explains, “1.75 percent of the loan amount [is] paid when the borrower gets the loan. The premium can be rolled into the financed loan amount” whereas the Annual mortgage insurance premium is usually “0.45 percent to 1.05 percent, depending on the loan term (15 years vs. 30 years), the loan amount and the initial loan-to-value ratio, or LTV. This premium amount is divided by 12 and paid monthly.”
It’s also worth noting that, whereas you can eventually drop your PMI with a conventional loan, you are usually required to carry your mortgage insurance for the life of an FHA loan. So in addition to paying this added sum on your closing cost and as part of your monthly mortgage payment, your mortgage insurance typically can’t be dropped at any time with an FHA. The only way to drop this insurance is to refinance. As a result, many FHA borrowers do ultimately pay more for their home over the life of the mortgage.
There are a few other limitations with an FHA, according to Lending Tree, that the borrower must take stock of first. Among them, there are both borrowing and usage limitations when it comes to an FHA. With an FHA loan, you are only eligible for a loan on a property valued up to a certain amount—The Mortgage Reports places that number at just over $420,000 in 2020—whereas the limit for a conventional loan is just under $700,000.
Likewise, a home purchased using an FHA loan can not be purposed as an investment property. It must serve as a primary residence.
Does an FHA loan hurt your credit score?
Technically, an FHA loan will not hurt your credit score, but any time you are shopping around for a lender, you need to be aware of the way that credit inquiries are received and recorded. According to FHA.com, “The leading credit agencies (Equifax, Experian, TransUnion) as well as the federal government’s own official websites remind potential borrowers that as long as you are shopping around for a lender within a 45-day window, multiple credit checks are applied to your credit report as a single credit inquiry.”
In other words, plan your pursuit of a lender carefully and make sure you are diligent about getting it all done inside of this window. Regardless of whether you pursue an FHA loan or a conventional loan, its impact on your credit rating will depend on the timeliness of your search.
How can I be eligible for an FHA loan?
According to Bankrate, to qualify, borrowers must meet the following conditions for eligibility:
- Your FICO credit score must be at least 500. Borrowers with scores in the range of 500 to 579 may be eligible for an FHA loan with a minimum of 10% down whereas those with a FICO score of 580 or higher may be eligible for the loan with just 3.5% down.
- You must be able to demonstrate current and ongoing employment history with documentation to verify a minimum of two years of full-time employment.
- You must be able to demonstrate a current stream of income with a full spectrum of documentation including bank statements, pay stubs, and tax return statements.
- The property under consideration must be designated for use as a primary residence, and must both meet HUD guidelines and pass appraisals with an appraiser approved by the FHA.
- You must not have declared bankruptcy in the two years prior to the loan nor experienced foreclosure in the three years prior to the loan, though Bankrate notes that exceptions for this last condition may be made in extenuating circumstances.
In addition to these requirements, applicants must meet certain debt to income ratios in order to qualify. Among them,
- The debt created by the monthly mortgage payments resulting from the loan should not exceed 31% of the borrower’s gross monthly income; and
- The back-end debt ratio, composed of the mortgage and all existing monthly debt payments, may be no more than 43-50% of the borrower’s gross monthly income.
The ratios noted above are generally more flexible for buyers than are the thresholds for receiving a conventional loan.
If you are exploring home ownership for the first time but you’re struggling with bad credit or no credit, you do have a few other options. To learn more, find out How to Buy a House With Bad Credit.