A beginner's guide to FHA loans
Applying for a home loan should be an exciting time in your life. But if you're a first-time homebuyer, the process can be a little overwhelming. Where do I start? What type of loan do I need? These questions are common during the application process.
If you've done your research, you've probably heard of FHA loans. These loans are a great option for first-time homebuyers, but you may also qualify for this type of mortgage even if you've purchased a home before. Let's take a closer look at FHA loans and how they differ from regular home mortgages.
What is an FHA loan?
An FHA loan is a mortgage loan insured by the Federal Housing Administration. These loans are similar to other mortgage options, with a few exceptions. While most mortgages may require at least a 5% down payment, you can get an FHA loan with as little as 3.5% down, making these loans an appealing option for first-time homebuyers or anyone wanting to put a lower down payment.
In addition, many buyers find the lending requirements less restrictive than other types of loans. While the Federal Housing Administration guarantees these loans, they’re not a mortgage lender. Only FHA-approved lenders can provide FHA loans.
How an FHA mortgage compares to a traditional home mortgage
When you consider home financing, you want to make sure you get it right. The first step is choosing the right type of loan. So how do FHA loans work, and how do they compare to traditional home mortgages?
- Lower down payment: Traditional mortgages often require at least 5% down. If you’re buying a $300,000 home, that means you have to come up with $15,000. On the other hand, FHA loans require as little as 3.5% down. For borrowers who may not have funds to put towards a large down payment, an FHA loan can be a good fit. FHA loans also permit the full down payment to come from an eligible gift donor, such as a parent or sibling.
- Less restrictive qualification requirements: Not everyone has perfect credit, but this doesn’t necessarily mean you won’t be able to buy a home. FHA loans allow for lower credit scores, and the minimum credit score requirement varies by lender.
- MIP: MIP stands for mortgage insurance premium. Mortgage insurance protects the lender in case you default on your loan. For traditional mortgages, mortgage insurance is only required if you put less than 20% down. For FHA loans, MIP is always required and needs to be paid in two parts. The first premium is paid upfront at closing, the second is included in your monthly payment and paid annually for the life of your loan or 11 years depending on the term of your loan.
- Lower loan limits: Conventional loans allow homebuyers to borrow up to conforming loan limits. FHA loan limits are lower than conventional loans, so depending on what county you’re financing in, you’ll only be able to borrow up to a certain amount.
Before you apply for an FHA loan
The first thing you need to do is evaluate your finances. Don't go house hunting just yet. Start with the basics. Look at your income, your bills and the cost of homes in the area you’re interested in. If you know how much you want to spend on a home, plug the numbers into an online mortgage calculator to estimate your monthly mortgage payment.
Once you've taken a close look at your finances and have a good idea of what you can afford, it’s time to reach out to a real estate agent and work on getting pre-qualified. Not all lenders will offer the same rates or have the same requirements, so it's a good idea to shop around and find the terms that work best for you.
FHA loan qualification requirements
We've briefly touched on credit score requirements and down payments, but there's a lot more that goes into qualifying for an FHA loan. Basic conditions vary by lender, but some factors they consider include:
- Credit history: FHA loans have some of the most lenient requirements in regards to your credit score. Additionally, there’s typically a shorter waiting period after financial problems such as bankruptcy or foreclosure. That said, a higher credit score usually means better terms. If you have a lower credit score, consider spending some time improving your credit before you apply for a loan.
- Debt-to-income ratio: Your debt-to-income ratio (DTI) is calculated by combining all of your monthly payments and dividing that amount by your total pre-tax monthly income. For joint applications, both applicants' incomes and debts may be considered. FHA generally considers an acceptable DTI to be no greater than 43%. Although lenders may be able to approve with a higher DTI, the lower you can keep this number, the more likely you are to qualify for more favorable terms.
- Employment history: Your ability to pay is a critical qualifier for obtaining a loan. Your lender will consider how long you’ve been at your current position, as well as your employment history.
It's also important to note that you can only use an FHA loan for your primary residence. If you plan to use your home for a rental property or vacation home, you'll need a different type of loan.
The pros and cons of FHA loans
Before you choose what type of loan you’ll use, it's important to weigh the pros and cons. A home is a big purchase, and there’s a lot to consider.
- Pro: Lower qualification standards. FHA loans are often easier to get than other types of loans. If you have had issues with your credit or a bankruptcy in your past, this option might be right for you.
- Con: Lower lending limits. FHA loans have much lower lending limits than traditional loans. If you want to purchase a home above these limits, you'll need to use a different type of loan, put more money down, or find a different house.
- Pro: Lower down payment. This is one of the main draws of an FHA loan. With as little as 3.5% down, homeownership can become a reality for borrowers who wouldn't otherwise qualify.
- Con: Mortgage insurance. FHA loans require MIP. The amount you pay depends on the price of your home and your loan-to-value ratio, but MIP will ultimately increase the overall cost of your loan. Unlike conventional loans, the MIP on an FHA loan won’t be eliminated when the LTV is reduced to 78%.
- Pro: Competitive interest rates. FHA loans may offer interest rates at or below conventional loan rates. This can help reduce your monthly payment.
- Con: Primary residence only. While FHA mortgages can be used for single-family and multi-family homes, they can only be used for your primary residence. This means if you're looking to buy a vacation home or second home, FHA loans won't work for you.
How to make your FHA mortgage more affordable
FHA loans may offer competitive rates and terms. However, MIP and closing costs can increase the overall cost of your loan. There are a few things you can do to make your loan more affordable and reduce your monthly payments.
- Shop around. It's a good idea to talk to more than one lender. In some cases, there can be a considerable difference in terms offered, which could save you thousands of dollars over the life of your loan.
- Consider a larger down payment. You may not want to pay more out-of-pocket than you need to, but increasing your down payment will reduce your principal and can also reduce your MIP.
- Pay down your debt. Lenders typically offer more favorable terms to borrowers they consider lower risk. The lower you can get your debt-to-income ratio, the better off you will be.
- Ask the seller to pay closing costs. Closing costs vary by lender but are a required expense when you purchase a home. It's fairly common to ask the seller to pay your share of the costs. While this may not directly reduce the amount of your loan, it could give you more money to put down.
Is an FHA mortgage right for you?
An FHA mortgage is a great option for borrowers who may not qualify for a conventional home loan. Here are five important questions to ask yourself before deciding:
- Will you be using the home as your primary residence?
- Are you looking for a loan that offers competitive rates?
- Will the price of your home be within FHA loan limits?
- Do you have a limited down payment?
- Do you have less than perfect credit?
If you answered yes to all of these questions, an FHA loan may be a good fit for you. There are many factors you should consider before you apply for any type of loan. One of the best things you can do is talk to an experienced Home Lending Advisor about the options available to you.