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If you're a first-time homebuyer whose credit could use some improvement, you might not be able to qualify for a conventional mortgage loan—or if you do, the interest rate could be unaffordably high.
An FHA loan may be right for you if you're ready to buy a home for the first time, but you have minimal cash savings and credit that's less than stellar. This government-backed mortgage loan comes with major benefits, but there are also some important drawbacks to consider.
What Is an FHA Loan?
An FHA loan is a mortgage insured by the government through the Federal Housing Administration, though you apply for and obtain the loan through a regular lender, like a bank or credit union. These loans are geared toward first-time homebuyers since the borrowing criteria are more lenient than with a conventional loan.
One of the main draws of FHA loans is you can put down as little as 3.5%, and the interest rates and terms are favorable for new borrowers. However, in exchange for these perks, you'll have to pay mortgage insurance for the life of the loan.
How FHA Loans Work
FHA loans are issued by lenders, but they're insured by the government. This means if a borrower fails to repay a lender who issues an FHA-qualified mortgage, the FHA covers the lender's financial loss.
In exchange for this protection, the FHA requires loans offered under its program to meet certain borrowing criteria. But because these loans are government-backed and intended for first-time homebuyers, borrowing requirements are more lenient than those of conventional loans.
The downside of the more generous standards is that most FHA loans require you to pay mortgage insurance for the life of the loan. (The only way to get out of it is to put down at least 10%, and then the mortgage insurance drops off after 11 years.) Conventional loans, on the other hand, only require mortgage insurance until you reach 20% equity in the home.
When Is an FHA Loan a Good Idea?
FHA loans make sense if you don't have much saved for a down payment, or if your credit score isn't in good enough shape to qualify you for a conventional loan. It could also be the right choice if you're worried your interest rate will be too high with a conventional loan, or if you'd like to finance some of your closing fees.
Here's why an FHA loan may be attractive if you meet any of these criteria:
- Low down payment requirements. If your FICO® Score* is 580 or higher, you can get an FHA mortgage with a down payment of just 3.5%. While some conventional loans now permit down payments as low as 3%, they're not easy to obtain if your credit isn't in great shape.
- Low minimum credit score requirement. The FHA threshold for a 3.5% down payment, a FICO® Score of 580, is at the low end of the range for subprime borrowers. But if you can make a down payment of 10%, you can qualify for an FHA loan with a FICO® Score as low as 500.
- Favorable interest terms. The annual percentage rate (APR) on an FHA loan is typically 1.5 to 2 points higher than those for conventional fixed-rate mortgages available to borrowers with good to excellent credit. But FHA rates are usually lower than introductory rates on subprime mortgages. Plus, FHA loans have fixed interest rates, while most subprime loans have adjustable rates that can increase significantly after an introductory period of three to five years.
- Option to finance closing fees. Lenders charge numerous fees for processing your mortgage, and with traditional mortgages, they must be paid in full when you close on the home. These fees add up to thousands of dollars, and not everyone can afford to pay them out of pocket. The FHA allows some of these fees to be rolled into the loan financing, so you can pay them off over time instead of having to come up with a large chunk of change at closing. Keep in mind that closing fees vary from lender to lender, and they also roughly correspond to your credit scores, with lower scores requiring a higher amount of closing costs.
What Are the Downsides of an FHA Loan?
While an FHA loan can be a lifesaver if you want to buy a home and have limited cash on hand or a not-so-great credit score, these loans do have some drawbacks you should be aware of before you apply.
- Very strict appraisal standards. The U.S. Department of Housing and Urban Development (HUD) has stringent property appraisal standards that exclude many properties from FHA loan eligibility. The home also has to be your primary or principal residence, so you can't use it as an investment property (though FHA loans can be used for some multi-unit properties up to four units). Mobile homes and other prefabricated dwellings can qualify, but many condominiums cannot.
- Mandatory mortgage insurance. Borrowers with lower credit scores are statistically more likely to miss payments or default on their loans than people with higher credit scores, so lenders require FHA borrowers to pay mortgage insurance to mitigate the risk. Per FHA guidelines, the cost of this insurance is spread across two payment types:
- A single bulk payment of 1.75% of the loan amount is due at closing. Like other closing costs, this can be included in the loan financing.
- An additional annual premium of 0.45% to 1%, depending on the loan's term, down payment and amount, is added to your monthly payments.
While it's convenient to be able to roll the bulk mortgage insurance payment and other closing costs into your FHA loan, it raises your monthly payment, and you could be adding tens of thousands of dollars to the amount you'll pay over the life of the loan. It may be worth it for the opportunity to buy a home of your own, but it's important to be aware of the potential cost.
How Do I Get an FHA Loan?
If an FHA loan sounds like the right fit for you, here's how to obtain one:
- First, make sure you meet the minimum qualifications. Check your credit score so you know if you meet the FHA's eligibility standards. You'll also need proof of steady employment history and a valid Social Security number. You can use FHA's free housing counselor search tool or smartphone app to find local sources of advice on whether you qualify for an FHA mortgage, and for guidance on securing the necessary down payment. A qualified counselor can be a big help with navigating the paperwork you'll need to obtain an FHA loan.
- Ready to apply? Check out the FHA website to find qualified lenders in your area. You can also look into online lenders such as QuickenLoans. As with any other loan type, lenders set their own interest rates, credit score requirements and fees, within the scope of FHA guidelines. That means you can—and should—shop around to get the best possible deal. Just a fraction of a percentage point difference in interest can save you thousands of dollars over the life of a 30-year loan.
- If you qualify for a 3.5% down payment FHA loan, consider paying a higher down payment than the minimum required if possible. Or consider paying some or all of the closing costs on the date of sale rather than financing them. (Consult a counselor to see which scenario is more beneficial to you.) Taking these steps can save you a lot of cash over the long haul.
Other Options for Getting a Mortgage
If an FHA loan doesn't sound like the right mortgage for you, there are numerous other options for first-time homebuyers. Here are a few:
- If your credit is higher than what's required for an FHA loan, you could check and see if you qualify for a conventional loan, especially since many lenders now offer ones with low down payments.
- If you are a current or former military service member or spouse, you might be eligible for a VA loan. These government-backed mortgages allow for zero down payment and have no mortgage insurance requirement.
- Those who are low income earners and want to buy a home in a rural area could qualify for a USDA loan. These government-backed loans come in two types, but both allow for low or no down payment, and the interest rate is low.
Compare the Pros and Cons
Once you've obtained your free credit score and determined whether you might qualify for an FHA loan, take a close look at the insurance costs and consider whether the benefits outweigh it. Depending on your unique situation, you might either be better off with a different type of mortgage, or an FHA loan could be the key to your dream home.