A 20% down payment might seem like an intimidating prospect. Many first-time homebuyers find themselves unable to meet that requirement, and even if you're responsible with your money, it's not always a realistic option. Fortunately, you can still pursue your dreams of homeownership with an FHA loan.
The Federal Housing Administration provides support for people who don't qualify for traditional mortgages. It insures loans from approved lenders to assist homebuyers with less-than-perfect credit and a low-to-moderate income. However, anyone can apply for an FHA loan and enjoy the same advantages.
As an example, you can enjoy a mortgage with a down payment as low as 3.5% if you meet certain criteria. Concerning these qualifications, it's far easier to receive approval for an FHA loan than a typical mortgage. What should you keep in mind if you're interested in seeking this type of loan?
Qualifications for an FHA Loan
The requirements for an FHA loan are far more relaxed than typical ones, but you still need to receive approval. You should start by reviewing your credit report. If you don't have one on hand, you can turn to the national credit bureaus, Equifax, Experian and TransUnion, which provide a free report once every 12 months.
If you're interested in a 3.5% down payment, you'll likely need a credit score of at least 580 or higher. Borrowers with a score between 500 and 579 will qualify for a down payment of at least 10%, while those with a credit score below 500 are ineligible. However, the FHA will make exceptions in certain situations.
Borrowers with a nontraditional credit history or insufficient credit may still satisfy the FHA's requirements. Of course, they extend beyond your credit score. You also need to show a debt-to-income ratio of 50% or less if you're planning to apply for an FHA loan in the near future — and that's not all.
- You need at least two separate credit accounts, such as a credit card or car loan.
- You must not have judgments or debt from past FHA-insured mortgages or any delinquent federal debt.
- You have to account for cash gifts that assist with the down payment, with verification by the donor.
You also have to show proof of a Social Security number and provide pay stubs, W-2 forms and valid tax forms as necessary. The property itself will also factor into approval, as you can't seek an FHA loan for specific types of property. Review the following qualifications as you move forward:
- You can't get an FHA loan for an investment property or a home you intend to flip.
- You have to take the title to the property in your name or the name of a living trust at settlement.
- You can only use the loan for a principal residence, and at least one borrower must be living there within 60 days of closing.
- You need to agree to an FHA appraisal, which will assess the property not only on its value but also on minimum property standards.
Even if you satisfy these requirements, you'll have to meet the lender's needs as well. The FHA may insure the loan, but the lender makes the final decision on whether you receive the money. They may demand a higher debt-to-income ratio than 50% or a better credit score, so evaluate all your available options.
Drawbacks and Disadvantages
You'll likely find it less difficult to receive approval for an FHA loan, but it's not always the better option. Yes, you'll have a lower down payment and an attractive interest rate, but these benefits come at a cost. You'll have to include the cost of FHA mortgage insurance with your monthly payments.
FHA mortgage insurance is similar to private mortgage insurance, a form of security that lenders require when borrowers put down less than 20% on a conventional mortgage. Like private mortgage insurance, you have to pay a small monthly charge in addition to a one-time payment at the loan closing.
Unlike PMI, you have to pay your FHA mortgage insurance for at least five years. If your loan-to-value ratio is below 78% after five years, you can cancel the mortgage insurance — but not before. This extra expense is critical to consider as you continue.
Ultimately, you should give serious thought to a 20% down payment. If you can save enough money to meet that requirement, you won't have to manage FHA mortgage insurance on top of your monthly payments. An FHA loan is convenient and accessible for first-time homebuyers, but they have their drawbacks.
Beyond mortgage insurance, a federal loan may also have stricter guidelines for home inspections. A seller may also feel hesitant to accept an offer with an FHA loan, unsure if you're a risk. Though an FHA loan may seem appealing at first, it has negative aspects that are just as crucial to address.
Buying a Home With an FHA Loan
A home is a substantial investment, and it's best to take your time when comparison shopping for a mortgage. Research lenders, review your options and give thought to an FHA loan. You may find it's a perfect fit for a financial situation — or you may discover you're better off with something more traditional.
Either way, feel confident as you continue. Homeownership is within reach.
