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Are you in the market for your first home? Shopping for the perfect property is the fun part—finding a mortgage that works for your finances is another story. If you have very little money saved or bad credit, it may be tough to get approved for a conventional loan.
If this is the situation you find yourself in, you may qualify for an FHA loan. These mortgages are government-insured and help first-time homebuyers who have credit challenges or minimal savings get into a new home.
What Is an FHA Loan?
FHA loans have more lenient qualification requirements than a conventional loan, and can be a great option if you have minimal cash savings to put down or less-than-perfect credit. FHA loans are insured by the Federal Housing Administration and issued through administration-approved mortgage lenders, which include credit unions, banks and direct lenders.
You may qualify for an FHA loan with a down payment as low as 3.5%. There's also the option to roll a portion of the closing costs into your loan. However, FHA loans can be more costly in the long run due to the mortgage insurance premium you're required to pay to minimize the lender's risk. There are also limits on the amount you can borrow with an FHA loan, depending on where the property is located.
In addition to traditional FHA loans, there are four other FHA loan options:
- FHA 203(k) loans: These are rehabilitation loans that grant you up to $35,000 for home upgrades, improvements or repairs.
- Home Equity Conversion Mortgages (HECM): These loans are designed for homeowners age 62 and older and act as reverse mortgages.
- FHA Energy Efficient Mortgages (EEM): These loans allow homebuyers to roll the cost of energy-efficient improvements into their mortgage payments.
- FHA Section 245(a) loans: These mortgages have a graduated repayment structure in which monthly payments increase in amount over time. They cater to borrowers who expect their income to increase.
Who Qualifies for an FHA Loan?
There's no way to know if the lender will approve you for an FHA loan until you apply. However, you should be mindful of these general requirements for this loan program:
- Valid Social Security number: The lender will ask for your Social Security number to help confirm your identity when you apply.
- Verifiable income: The lender will request pay stubs and tax returns to confirm your earnings. You may also have to provide bank statements to show you can afford closing costs, the down payment and your monthly mortgage payments.
- A credit score of at least 500: If you'd like to make the minimum down payment of 3.5%, you'll need a score of 580. But if you can provide a 10% down payment, you may get approved with a score as low as 500. You can check your free Experian FICO® Score☉ to see where you stand and if your credit could qualify you for an FHA loan. If it's not quite where it needs to be, take steps to improve your credit score to give yourself the best shot at getting approved for an FHA loan with a competitive interest rate.
- Minimum down payment of 3.5%: Your credit score will dictate whether you can put down the minimum. You will need to put down at least 10% if your credit score is between 500 and 579.
- Mortgage insurance premium: Mortgage insurance equal to 1.75% of the loan amount is due at closing, and can be financed. An additional 0.45% to 1.05% of the loan amount is charged annually and added to your monthly payments. If your down payment was under 10%, you'll be required to pay mortgage insurance for the life of your loan (unless you refinance).
- Debt-to-income ratio (DTI) that does not exceed 43%: Your DTI measures how much of your monthly income is used to pay debt. So, if you earn $5,000 per month and your minimum debt payments total $2,000, your DTI ratio is 40%. Ideally, you want to keep your mortgage payment under 36% of your monthly income. It's possible to be approved for an FHA loan with a DTI that exceeds 43% with certain compensating factors such as a high income or excellent credit scores.
- No recent foreclosures: You cannot qualify for an FHA loan if you have foreclosures within the past three years.
Some lenders have overlays, which are additional requirements borrowers must meet to qualify for an FHA loan. Inquire with the lenders you're considering to learn more.
You can also contact a HUD-approved housing counseling agency in your community to assess your FHA loan eligibility or learn more about the homebuying process.
How to Decide Whether an FHA Loan Is the Right Choice
Not sure you should get an FHA loan? These loans have many benefits that make them an attractive option:
- Relaxed qualification criteria: This is particularly helpful if you have a low credit score or minimal cash reserves on hand to make a down payment and cover closing costs.
- Competitive interest rates: Conventional loans typically have lower interest rates than FHA loans. However, you can get a far lower rate on an FHA loan than you would on a so-called "nonprime" mortgage available to those who have lower credit scores. Also, interest rates are fixed on FHA loans, so your payment will remain the same over the life of the loan.
- Closing costs: You have the option to roll some of your closing costs into the loan and pay them over the loan term. This can help you keep more cash in your pocket.
There are, however, some potential downsides to consider, including:
- Mortgage insurance: It's mandatory and may be required for the life of the loan.
- Stringent appraisal standards: Not all properties qualify for FHA loans, and the home you purchase with the loan must be used as your principal or primary residence.
Ultimately, it's up to you to decide if an FHA loan works for your financial situation. Weigh the pros and cons to determine if the benefits of this type of loan outweigh the costs of carrying mortgage insurance.
Where to Get an FHA Loan
If you're ready to explore lenders who offer FHA loans, use the HUD lender directory to locate options in your area. Shop around for the best deal before deciding on a lender.
Lenders must follow a set of FHA guidelines, but are allowed to set their own interest rates. This means you may qualify for a better loan offer with some lenders than others.
Worried about the down payment? There are several first-time homebuyer programs and grants you may qualify for to help you get the funds you need to secure your home loan. You can browse online or ask local real estate agents or brokers who work with a lot of first-time homebuyers.
Prepare for an FHA Loan
An FHA loan may be a viable option if you want a flexible mortgage product that doesn't require high credit scores or a large amount of cash out of pocket. While you will be stuck with mortgage insurance payments for years to come, the benefits could be worth it.
Shop around for lenders who meet your needs and inquire about their eligibility criteria to prepare for the mortgage process. It's also best to check your credit at least three more months in advance when looking to get a mortgage to make sure there are no surprises.