When first considering buying a house, the minimum down payment can be a deal-breaker for some people’s financial situation. Even for someone who can afford the mortgage payments in the long run, coming up with that big of an amount of money can be nearly impossible. Luckily, for people who don’t have enough savings or don’t meet other criteria usually required by other loans, such as higher credit scores, there is now a solution. FHA loans provide first-time homebuyers with the opportunity to purchase a house under looser financial requirements.
An FHA loan is a type of loan insured by the Federal Housing Administration, under the Department of Housing and Urban Development. Since these loans are government-backed, the lender is protected in the event that the borrower defaults on the loan. FHA loans range from $356,362 to $822,375. While FHA requirements make them more appealing to first-time homebuyers or people earning a lower income, there are some criteria a borrower needs to meet to get approved for an FHA loan, such as:
- A credit score of 500 or above: If you have a credit score above 580, you are eligible for a down-payment of only 3.5%. However, if your credit score is between 500 and 580, you will need to pay a 10% down payment.
- Mortgage Insurance Premium: In order to be approved for FHA loans, you will need to pay an upfront fee which is usually 1.75% of the total amount, and an annual mortgage insurance premium of 0.45% - 1.05%. The FHA ensures that the lender will be paid in case the borrower defaults on the loans, by collecting these MIPs.
- Debt-to-Income < 43%: Your total monthly debt including any existing student loans, car loans, minimum credit card payments, etc. together with the mortgage payments and its premiums will need to amount to a maximum of 43% of your monthly income.
- Primary residence: The house bought has to be your primary residence. This is done so that FHA loans serve as an assistance only for people who are not able to afford other loans, not for the ones looking to use it as an investment opportunity.
- Steady income and proof of employment: This requirement is in place to ensure the lender that you will be able to afford the mortgage payments.
Pros and Cons of FHA loans
FHA loans present a number of advantages and disadvantages, which you will need to weigh out before deciding if this loan is the right decision for you in the long term.
- FHA loans have lower minimum credit score requirements of at least 500 compared to other loans, such as conventional loans which require a minimum credit score of at least 620.
- You can put a down payment of 3.5% if your credit score is higher than 580, and a down payment of 10% if your credit score is between 500 and 580.
- Generally, FHA loans interest rates are lower than the conventional loans interest rates.
- FHA loans are assumable under certain conditions, meaning that if the borrower, later on, wants to sell the house, the existing FHA loan can be taken over by the new owner.
- FHA loans come with the expensive cost of mortgage insurance premiums which is separated in an upfront fee and annual mortgage insurance premiums.
- While in a conventional loan, your private mortgage insurance premiums are canceled once you reach the 20% down payment, in an FHA loan, the borrower needs to pay insurance premiums until he completely repays the loan.
- FHA loans cannot be used to purchase investment properties. According to Pete Evering with Utopia Management, one of the largest property managers in California, many who first hear about FHA loans don’t realize that they must occupy the home, themselves, for at least one year before using the property for renting. According to FHA requirements, the home must be owner-occupied during this time. However, an FHA loan can still be used to purchase multi-family residences.
In conclusion, FHA loans are a great solution for people with little savings or ones who have yet to build their creditworthiness. While this loan comes with the hefty cost of insurance premiums, it also relieves you from the stress of coming up with a large down payment. Therefore, because of their many benefits, FHA loans must be carefully considered if you are in the home buying process.
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