FHA home loans are government-backed mortgage loans that give Americans with low credit scores or a lack of funds the opportunity to purchase a home with only a small down payment.
As opposed to a traditional loan, 3 parties are involved in an FHA home loan:
The FHA’s involvement provides security for both sides, reducing the lender’s risk and helping the borrower get approved for the loan.
From a home buyer’s perspective, the main reasons to apply for an FHA home loan are:
FHA home loans provide borrowers suffering from a poor credit rating with a path to homeownership for a down payment of 10% or less. Active and former members of the Military, National Guard, and Reserves who suffer from poor credit or a lack of funds can apply for a VA loan. For anyone else who can’t get approved for a conventional mortgage, an FHA mortgage loan is usually the best type of loan for getting into the housing market. FHA loans are especially popular with first-time homebuyers, with 82% of first-time borrowers using an FHA loan in 2017.
FHA mortgages are fixed-rate loans that the borrower must repay over a period of usually 15 or 30 years. These are the main points of difference between an FHA loan and conventional loan:
1) Low down payment: Under Federal Housing Administration rules, lenders can offer 2 tiers of FHA loans. Home buyers with a 580-619 credit score may take out an FHA loan with only a 3.5% down payment. Home buyers with a 500-579 credit score may take out an FHA loan with a 10% down payment.
2) Private Mortgage Insurance: All borrowers must pay monthly PMI until they have paid off at least 20% of the value of their home. PMI consists of an upfront payment of 1.75% of the loan amount, plus an annual premium that varies from 0.45%-0.85% depending on several factors.
3) Maximum loan amounts: The FHA sets a maximum loan amount for each part of the country, based on median home prices for the area. In 2020, the maximum loan amount stands at $679,509 in the highest cost areas (located mostly in the Los Angeles, San Francisco, New York, and Washington, D.C. metro areas). The maximum stands at $294,515 in the lowest-cost areas.
|Low credit score requirements||Monthly PMI|
|Low down payments||More paperwork|
|Higher debt-to-income ratio allowed||Not all properties qualify|
The main benefits of an FHA home loan are that it carries far lower credit and down-payment requirements than a conventional loan. There are a few catches, namely that the borrower must pay monthly PMI (to insure the lender in the event of default). The borrower must also provide documentation to prove they meet all the additional FHA requirements. For example, total monthly payments must not exceed 30% of the borrower’s gross monthly income; and borrowers must not have filed for Chapter 7 bankruptcy in the past 2 years or Chapter 13 bankruptcy in the past year.
As with a regular home loan, there are many factors to consider when deciding which lender to apply to for an FHA home loan.
What interest rate is being offered?
Whether you’re shopping around for an FHA loan, conventional home loan, or any other type of loan, always compare the interest rate and APR offered by the different lenders. FHA mortgages are fixed rate, meaning the rate stays the same over the entire term. The lower the APR, the less you’ll pay over a 15-year or 30-year term. A 0.05% or 0.10% difference between rates mightn’t sound like much, but this could translate to thousands or tens of thousands of dollars over the life of your loan.
What additional fees are there?
Like a regular mortgage, FHA home loans can carry closing costs ranging from around 2%-5% of the value of the loan. Closing costs can vary significantly between lenders, so in addition to comparing APRs, it is always worth asking for an estimate of closing costs before deciding.
What level of customer service does the lender offer?
Like with any big loan, it’s important to read up about the lender and check them out online or by phone before signing below the dotted line. When comparing lenders, check to see that they have expertise in providing FHA mortgage loans, that their online reviews are mostly positive, and that they have an open door when it comes to communication.
If FHA loans aren’t your thing, here are some government-backed or conventional loan options to consider.
Government-backed loans: Active and former members of the U.S. Military, National Guard and Reserve, as well as spouses of veterans who died in service or as a result of a service-related injury, may take out a VA loan provided they meet the other eligibility requirements. With a VA loan, a borrower can purchase a house for little or no down payment and without having to pay PMI, although there are some trade-offs, including the need to pay certain closing costs.
Conventional loans: If you’re purchasing your first house or have low to moderate income, your lender might be able to offer one of Fannie Mae’s My Community Mortgage loans for a down payment of as low as 3%. Like FHA loans, these loans require the borrower to pay PMI, but other conditions vary—meaning that in certain cases, the loan could work out cheaper than an FHA loan.