When you decide to buy a home, there are two broad categories of mortgages you can choose from. You can choose a conventional loan, which is originated by a mortgage lender and is either bought by one of the major mortgage agencies (Fannie Mae or Freddie Mac) or is held by the bank for its own investment purposes. Or, you can choose to pursue an FHA home loan, which is a government-guaranteed type of mortgage.
There are other, specialized types of loans such as VA mortgages and USDA loans, but conventional and FHA mortgages are the two types everyone can apply for, regardless of whether they served in the military or where the property is physically located.
FHA loans allow borrowers (particularly first-timers) easier access to homeownership, but there's one major downside -- they are expensive. Here's a primer on FHA loans, how much they cost, and why you might want to use one to buy your first (or next) home regardless.
What is an FHA loan?
An FHA loan, or FHA mortgage, is a unique type of home loan designed to help borrowers buy homes with lower credit scores or less cash than would ordinarily be needed for a down payment. Because they are guaranteed by the Federal Housing Administration, or FHA, lenders can accept borrowers whose qualifications wouldn't justify a conventional loan.
FHA loans are designed only for primary residence purchases. In other words, you can't use an FHA loan to buy an investment property or a vacation home. FHA loans are always fixed-rate mortgages, and have loan terms of either 15 or 30 years.
Who can qualify for an FHA loan?
As I alluded to in the previous section, FHA loans are considerably easier to qualify for than conventional mortgages.
On the credit side of the equation, you'll need a minimum FICO Score of 500 to qualify for an FHA loan. However, if your credit score is below 580, you'll need a 10% down payment. If you have a FICO credit score of 580 or higher, the minimum down payment required for an FHA mortgage is just 3.5% of the purchase price. These thresholds can change over time -- when I obtained an FHA loan in 2012, for example, the minimum score for the 3.5% down payment was a 620. However, these are current as of early 2020.
Lenders generally pull your FICO scores from all three credit bureaus (Equifax, Experian, and TransUnion) and use the middle score for loan approval purposes. In other words, if your three FICO scores are 588, 602, and 611, your FICO score for loan qualification is 602.
In addition to meeting the credit score and down payment requirements, you'll also need to document an employment history for the last two years. You don't necessarily need to have worked in the same job for the entire two-year period, but you can't have any significant employment gaps. And if you were in school for some of the time, that's okay, too.
You also need sufficient income to qualify. The general rules are that your new loan payment shouldn't be more than 31% of your gross monthly income and that the total of all your debts (including the new mortgage payment) shouldn't exceed 43%. These are known as your front-end and back-end debt-to-income (DTI) ratios, respectively. Lenders may stretch these, allowing an overall debt-to-income ratio of as high as 50% in some cases. And be sure that you can document your income and that your employment history can be readily verified.
Finally, the property itself needs to appraise for an acceptable value by an FHA appraiser, and must meet the FHA's minimum property standards for safety, security, and structural integrity.
Here's a quick rundown of the qualifications:
|FICO credit score||500 or higher (10% down payment)580 or higher (3.5% down payment)|
|Employment history||Two years of continuous employment in the same industry|
|Debt-to-income (front end)||31% (some lenders may be flexible)|
|Debt-to-income (back end)||43% (up to 50% can be allowed)|
|Appraisal||FHA appraiser needs to sign off on the property's value and condition|
Advantages of FHA loans
Of course, the main advantage of FHA loans is that they're easier to qualify for than conventional loans. This is especially true in regard to credit standards. The bare minimum for a conventional loan is a 620 FICO score, and borrowers near this threshold can expect higher interest rates. Meanwhile, FHA borrowers pay a standard interest rate depending on current market conditions, not on whether they have good credit. So, if today's average mortgage rate is 4%, that's roughly what you should expect from an FHA mortgage rate.
Another nice feature of FHA loans is that closing costs can be rolled into the loan, or you can ask the seller to pay for your closing costs. So, if you choose the 3.5% down payment option, that could be all you have to pay upfront.
FHA loan costs are the biggest drawback
Earlier, I mentioned that FHA loans are guaranteed by the Federal Housing Administration, hence the name.
It's important to keep in mind that this guarantee isn't free. It comes in the form of FHA mortgage insurance, which is required of every borrower who obtains an FHA loan regardless of how strong or weak their qualifications might be.
Mortgage insurance is a standard component of most home loans where the borrower puts less than 20% down. However, unlike most types of home loans, which simply require an ongoing mortgage insurance premium, FHA loans have two different mortgage insurance expenses.
The ongoing FHA mortgage insurance premium ranges from 0.45% to 1.05%. This is paid in 12 monthly installments each year and depends on how much the borrower puts down, the amount of the loan, and certain other factors. Just to put this into perspective, if you obtain an FHA loan for $200,000, you can expect an annual mortgage insurance premium ranging from $900 to $2,100.
In addition, FHA loans require an upfront mortgage insurance premium equal to 1.75% of the initial loan amount. Continuing our example of a $200,000 FHA loan, this adds another $3,500 to the cost of your home.
Another major (negative) difference between FHA mortgage insurance and private mortgage insurance (PMI) is that PMI can be canceled once the loan-to-value, or LTV, ratio reaches 80% or less. With FHA mortgage insurance, you're generally stuck with the premium for the entire term of the loan (especially if you put less than 10% down), unless you decide to eventually refinance it into a conventional mortgage.
The cost of FHA mortgage insurance is in addition to any FHA loan closing costs you have to pay. In a nutshell, FHA loans are generally more expensive than their conventional counterparts.
Other drawbacks of FHA loans
In addition to the high costs, there are a few other potential drawbacks to FHA loans as opposed to conventional mortgages.
For one thing, there are no choices for term length aside from the standard 15- and 30-year loan terms. These are the most common mortgage lengths, but conventional loans are available in a variety of other choices, such as 20- and 25-year options.
Also, FHA loans are limited in terms of loan size. In most parts of the U.S., the 2020 FHA loan limit is $331,760. This FHA mortgage limit is as high as $765,600 in certain high-cost areas, but the point is that FHA loans are not intended for purchases of homes that cost much more than the median home price in their market.
House hacking: a big advantage of FHA loans for real estate investors
One other advantage worth mentioning is that FHA loans can be a great way to buy your first investment property. This may sound odd -- especially since one of the main requirements of an FHA loan is that you're planning to use the property as your primary residence.
However, it's also important to mention that FHA loans can be made on properties with as many as four living units. As long as you're living in one of them, the property meets the FHA's definition of a primary residence.
Even better, while obtaining an FHA loan requires you to live in the property, this isn't a permanent rule. The guidelines state that you need to live in the property for a minimum of one year. So, after that time period has passed, you are free to move out and use the property exclusively as a rental property. And you could then find another property to repeat the process.
The ability to buy an investment property with such a low down payment (and low credit score) is unique to FHA loans. You can use a conventional mortgage to buy a 2- to 4-unit property, but you won't be able to do it with a down payment that's much less than 20%.
FHA mortgages can be great tools for homebuyers
FHA loans can be especially good choices for:
- First-time buyers who might not have a ton of cash available.
- Borrowers who have made some credit mistakes in the past.
- People who want to get into real estate investing but don't have the capital required for traditional investment property financing.
The bottom line is that while FHA mortgages are considerably more expensive than conventional home loans, they can still be excellent homebuying tools for many buyers.
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