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When you're in the market for a mortgage, you may assume you need a conventional loan since it's the traditional option almost all lenders offer. But if your credit isn't in tip-top shape or you have minimal cash savings to buy a home, you might not get approved.
Enter FHA loans, a type of mortgage geared to homebuyers who may have difficulty qualifying for a conventional loan. This government-insured loan has more relaxed borrowing criteria that makes it easier to qualify for than a conventional loan.
How FHA Loans Work
FHA loans are mortgages that are insured by the U.S. government (the Federal Housing Administration, more specifically), but you obtain one by applying through an FHA-approved mortgage lender. This could be a bank, credit union or online lender like Quicken Loans.
FHA loans are considered slightly more risky to the lender since borrowing criteria is less strict, so the government backs the loan to reduce the lender's risk, and you have to pay insurance for the life of the loan. If you qualify for an FHA loan (more on that below), you can apply through any FHA-approved mortgage lender. The amount you can borrow with an FHA loan depends on where you live, since housing costs vary greatly across the country.
How an FHA Loan Is Different From a Conventional Loan
While FHA loans and conventional loans are both mortgages that allow you to borrow money to purchase a home, there are a few key differences:
- Down payment requirements: While you can get some conventional loans with as little as 3% down, most require 5% down, and borrowers often put down more than that. With an FHA loan, you can get a mortgage by putting down only 3.5%.
- Insurance requirements: A conventional mortgage only requires you to pay mortgage insurance if you put down less than 20%. And if you do put down less, the mortgage can be cancelled once you have 20% equity in the house. An FHA loan, on the other hand, requires you to pay mortgage insurance for the life of the loan (unless you put down 10%, and then you can stop paying it after 11 years).
- Borrowing criteria: Conventional loans have more stringent credit score requirements; FHA loans allow for borrowers to have lower credit scores.
- Interest rates: An FHA APR is usually 1.5 to 2 points higher than conventional fixed-rate mortgages for borrowers with good to excellent credit. But FHA interest rates are lower than introductory rates on conventional subprime mortgages, especially adjustable-rate mortgages that have a big rate increase after several years.
- Closing costs: With a conventional loan, you have to pay for all closing costs in full at closing. An FHA loan lets you finance some closing costs and spread them out over time as part of your mortgage payment.
Types of FHA Loans
Not many homebuyers realize this, but there are actually several different types of FHA loans. In addition to traditional FHA loans, you also have these options:
- FHA 203(k) loans: These are rehabilitation loans that are intended to help you finance the repair and rehabilitation of a single-family home. There is a standard 203(k) loan, in addition to a limited 203(k) loan, which lets you add up to $35,000 to your mortgage to improve, upgrade or repair a home.
- Home Equity Conversion Mortgage (HECM): This FHA program is for seniors aged 62 and older, and it serves as a reverse mortgage. It allows qualified homeowners to withdraw some of the equity they've put into their home.
- FHA Energy Efficient Mortgage (EEM): This program allows homebuyers to finance energy-efficient improvements to a home as part of their FHA loan.
- FHA Section 245(a): The National Housing Act's Section 245(a) is intended to help homeowners whose income is expected to increase, so the FHA created the Graduated Payment Mortgage in response. This mortgage's payments increase gradually over a period of several years, and there are five different plan types available.
FHA Loan Requirements
FHA loans have several important requirements that you should be aware of before you apply.
- Minimum down payment: You can make a down payment as low as 3.5%, though with worse credit scores, you may have to put 10% down (details below).
- Debt-to-income ratio: All mortgage lenders look at your debt to income ratio (DTI), which compares how much you pay each month for debt with how much income you bring in each month. The higher your DTI, the riskier you appear to lenders since it indicates that a large percentage of your income goes toward debt payments. To get an FHA loan, you typically can't have a DTI ratio over 43%.
- Mortgage insurance: An FHA loan requires you to pay mortgage insurance, and the cost is spread across two payment types:
- One single bulk payment of 1.75% of the loan amount, which is due at closing but can be rolled into your loan financing.
- An additional .45% to 1.05% of loan total, which is charged annually for the life of the loan (on loans of 20 years or more with down payments less than 5%). This fee is spread out over your monthly payments.
- No recent foreclosures: If you've had your home foreclosed, you must wait three years until you're able to qualify for an FHA loan. However, if you encounter financial hardships after buying a home with an FHA loan, the FHA has several programs designed to help keep you in your house.
- Other criteria: You also typically must have a Social Security number and proof of sufficient income or assets that indicate you can afford the mortgage and your other debt obligations.
What Credit Score Is Required for an FHA Loan?
FHA loans are ideal for those who have less-than-perfect credit and may not be able to qualify for a conventional mortgage loan. The size of your required down payment for an FHA loan depends on the state of your credit score:
- If your credit score is between 500 and 579, you must put 10% down.
- If your credit score is 580 or above, you can put as little as 3.5% down (but you can put down more if you want to).
What to Consider Before Applying for an FHA Loan
Be aware that you can't use an FHA loan for every type of property. You can't use one to buy fixer-uppers or certain foreclosures, and there are strict requirements for condos. Additionally, the property has to be your primary residence, so it can't be used on an investment property. The home you buy with an FHA loan must also meet strict government appraisal standards.
Also, keep in mind that some sellers might avoid buyers who use FHA loans. That's because some sellers assume that FHA borrowers have financial issues and that the transaction may not pan out, or that the buyer won't be interested in paying for any repairs. To make yourself competitive with non-FHA borrowers, you could make a full-price offer, or offer to buy the house as-is (though, of course, that carries its own risks).
It's also important to recognize that while scoring a low down payment is a huge perk for someone with minimal savings, it also has a drawback: You'll pay more interest over the life of the loan since you're starting off with so little equity in the home. On the other hand, the less you have to borrow, the more of your payment that will go toward the principal and allow you to build equity in the home faster—so you might want to put down more than the minimum down payment if you can.
How to Qualify for an FHA Loan
Does an FHA loan sound like the right fit for you? Here's how to get ready to qualify:
- Check your credit score. If it isn't high enough to qualify for an FHA loan yet, make strides to improve your credit score.
- Make sure you have an established credit history. It's ideal to have at least two open accounts—preferably, one revolving account (such as a credit card or line of credit) and one installment account (such as an auto loan). If you don't, lenders may not believe you have enough repayment history to show that you're capable of paying back a loan on time. If you don't have a credit card yet, consider getting one and using it responsibly for a few months to help establish some positive credit history.
- Have a verifiable income. You'll need to show a lender documents like paystubs, tax returns and possibly bank statements to prove that you have enough money to comfortably pay your mortgage. Make sure you'll be able to have this documentation.
- Calculate your DTI. To do this, tally up your total recurring monthly debt (such as credit card payments, mortgage, auto loan and so on) and divide it by your gross monthly income (the total amount you make each month before taxes, withholdings and expenses). Multiply that number by 100 to get your DTI ratio as a percent. Keep in mind that you might not get approved for an FHA loan if your DTI is higher than 43%. Also, your mortgage payment ideally shouldn't be more than 35% of your income. If any of these are issues, work to lower your debt balances (or increase your income) before applying for an FHA loan.
- Save for a down payment. While you can nab a down payment as low as 3.5% with an FHA loan, it's smart to save up to at least 6% so you have enough funds to cover your closing costs. While FHA loans do give you the option of financing some of your closing costs, know that rolling them into your monthly payment will make your mortgage payment higher.
- Choose the right type of FHA loan. You might just need a basic FHA loan, but if you're buying a home that needs significant repairs or energy-efficient upgrades, consider the other types of FHA loans made specifically for these purposes.
- Shop around before choosing a lender. While lenders have to adhere to certain FHA guidelines, they're able to set their own interest rates. This means it pays to shop around and compare rates and fees at several different lenders to make sure you're getting the best deal.
See if Your Credit Score Qualifies
While a lifetime of mortgage insurance payments isn't so fun, the perks of an FHA loan may far outweigh that drawback. For homebuyers with minimal savings or credit that needs improvement, an FHA loan may be within reach when a conventional loan is not. Make sure to check your free Experian credit score to see if you might be eligible for an FHA loan. If not, it's an indicator that it's the right time to start building or repairing your credit.