We hear a lot these days about the contrary nature of the Millennials, but they largely agree with their elders that home ownership is an important aspect of The American Dream.
Like earlier generations, many of them are no doubt discovering a longstanding quandary facing first-time homebuyers: When you have relatively little history of using credit and repaying loans, it can be difficult to get a mortgage. How do you get a leg up?
Enter Uncle Sam: The Federal Housing Administration (FHA), a branch of the U.S. Department of Housing and Urban Development (HUD), offers a program designed to help first-time homebuyers (of any age). FHA loans can be used to buy 1-to-4-unit homes, including mobile homes, and can even be used under certain circumstances to refinance existing mortgages. As with any form of credit, FHA mortgages come with risks as well as rewards. Read on to find out if one could be for you, and how to determine whether you qualify for one.
How FHA Loans Work
The FHA provides a form of insurance to lenders who issue special mortgages designed to help first-time buyers get into homes of their own. 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 strict guidelines and requires participating lenders to look closely at borrowers' finances to gauge their ability to repay the loans. That extra scrutiny can add paperwork to the mortgage-application process.
For qualifying borrowers with poor or limited credit histories, FHA mortgages can be much more attractive than the subprime mortgages that are typically the only other borrowing option.
FHA Mortgage Benefits
Here's are some of the reasons why FHA mortgages are so attractive:
- Low down-payment requirements. Conventional (non-FHA) mortgages require a minimum down payment of 5% of the property value, but if your FICO® credit score is 580 or better, you can get an FHA mortgage with a down payment of just 3.5%.
- 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 that Experian considers subprime borrowers. But if you can make a down payment of 10%, FHA guidelines allow for loans to borrowers with FICO® scores as low as 500.
- Favorable interest terms. The annual percentage rate (APR) on a typical 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 the FHA rates are typically lower than the introductory rates on subprime mortgages. In addition, FHA loans have fixed interest rates, while most subprime loans have adjustable rates that can increase significantly after an introductory period of 3 to 5 years.
- Option to finance closing fees. Lenders charge a number of fees for processing your mortgage, and with traditional mortgages, they must be paid in full as part of closing on the home. 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 write a check at the closing.Note that closing fees vary from lender to lender, and they also roughly correspond to your credit scores. Borrowers with FICO® Scores* from 500-579 can pay as much as 6% in closing fees, while those with scores above 750 might pay as little as 1%.
Understand the Downsides
It can be a real boon to secure a house with comparatively poor credit and a relatively low amount of cash on hand, but FHA loans have their downsides as well, and you should understand them if you're considering an FHA loan.
- Very strict appraisal standards. HUD has more stringent property-appraisal standards than many lenders, and these exclude many properties from FHA-loan eligibility. 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 buy a form of insurance that covers missed payments. Per FHA guidelines, the cost of this insurance is spread across two payment types:
- A single bulk payment of 1.75% of loan amount is due at closing. Like other closing costs, this can be included in the loan financing.
- An additional cost of 0.85% of loan total is charged annually for the life of the loan (on loans lasting 20 years or more with down payments less than 5%). This annual charge is spread over your monthly payments.
If you choose to roll the bulk mortgage-insurance payment and other closing costs into your FHA loan, you could be adding tens of thousands of dollars to the amount you'll pay over the cost of the loan. That may be worth it for the opportunity to get a place of your own, but you should be aware of it.
If you decide to seek an FHA mortgage, here are some guidelines for making the process as smooth as possible.
- Consult the FHA website to find qualified lenders in your area. 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 should shop around to get the best possible deals. Just a fraction of a percentage point difference in APR can save you thousands of dollars over the life of a 30-year loan.
- 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.
- 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, without 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.
FHA mortgages have helped more than 40 million Americans become homeowners. If you're ready to join their ranks, may you have a great experience shopping for your home.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
This article was originally published on September 18, 2017, and has been updated.
*Credit score calculated based on FICO® Score 8 model. Your lender or insurer may use a different FICO® Score than FICO® Score 8, or another type of credit score altogether. Learn more.