When you decide to buy a home, there are two main categories of mortgage loans to choose from.
You can choose a conventional loan. These are issued by mortgage lenders. They are either bought by one of the major mortgage agencies (Fannie Mae or Freddie Mac) or held by the bank for investment purposes.
Or, you can choose to pursue an FHA home loan. This type of loan is guaranteed by the Federal Housing Administration (FHA).
There are other types of specialty loans such as VA mortgages and USDA loans. However, conventional and FHA mortgages are the two types that anyone can apply for, whether they served in the military or where the property is physically located.
FHA loans make it easier for borrowers to access homeownership. But there is one major downside – they are expensive. Here’s an introduction to FHA loans, how much they cost, and why you might want to use one to buy your first (or next) home regardless.
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What is an FHA loan?
An FHA loan, or FHA mortgage, is designed to help borrowers with a lower credit score or less money than would normally be required for a down payment.
FHA loans are still fixed rate mortgages and have loan terms of 15 or 30 years. These types of loans are meant only for primary residence purchases. In other words, you cannot use an FHA loan to purchase investment property or a vacation home.
Who Can Apply For An FHA Loan?
FHA loans are considerably easier to obtain than conventional mortgages. Here are some factors that lenders look at when deciding if you qualify for an FHA loan.
Here is a brief rundown of the qualifications at the time of publication of this article:
You will need a minimum FICO® score of 500 to be eligible for an FHA loan.
If you have a FICO® credit score of 580 or higher, the minimum down payment required for an FHA mortgage is only 3.5% of the purchase price. If your credit score is below 580, you will still qualify, but you will need a 10% down payment.
Lenders typically take your FICO® scores from the three credit bureaus (Equifax, Experian, and TransUnion) and use the average 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.
You will also need to document your employment history within the past two years to be eligible for an FHA loan.
You don’t necessarily need to have been in the same job for the entire two-year period, but you can’t have significant employment gaps. And if you were in school for a while, that’s okay too.
To get an FHA loan, you will need sufficient income. The general rules are that your new loan payment should not exceed 31% of your gross monthly income and that the total of all your debts (including the new mortgage payment) should not exceed 43%.
These are known as the initial and final debt-to-income ratios (DTI), respectively. Lenders can stretch them, allowing an overall debt-to-income ratio of up to 50% in some cases. For this step, make sure that you can document your income and that your employment history can be easily checked.
What can you expect for your monthly mortgage payment? Use our mortgage calculator to estimate payments for different mortgage amounts.
Finally, the property itself must be appraised to an acceptable value by an FHA appraiser and must meet the minimum FHA property standards for safety, security, and structural integrity.
FHA loan fees
FHA loans are guaranteed by the Federal Housing Administration, and this guarantee is not free. It comes in the form of FHA mortgage insurance.
This insurance is required of every borrower who obtains an FHA loan, regardless of the strength or weakness of their qualifications.
Mortgage loan insurance is a standard component of most home loans where the borrower puts less than 20% down. Most mortgage insurance simply requires an ongoing mortgage insurance premium and can be canceled after you’ve paid off most of your mortgage. But FHA loans have two different mortgage insurance expenses – and FHA insurance cannot be canceled.
Current insurance premium
The current FHA mortgage insurance premium ranges from 0.45% to 1.05%. This is paid in 12 monthly installments each year and depends on the amount put by the borrower, the amount of the loan and some other factors.
For example, if you get an FHA loan of $ 200,000, you can expect an annual mortgage insurance premium ranging from $ 900 to $ 2,100.
Initial insurance costs
Additionally, FHA loans require an initial mortgage insurance premium equal to 1.75% of the original loan amount.
Continuing our example of an FHA loan of $ 200,000, this adds an additional $ 3,500 to the cost of your home.
Duration of coverage
There is another major (negative) difference between FHA mortgage insurance and private mortgage insurance (PMI).
The PMI can be canceled once the loan-to-value ratio, or LTV, reaches 80% or less. With FHA mortgage loan insurance, you’re usually stuck with the premium for the life of the loan (especially if you put less than 10% down), unless you decide to eventually refinance it into a loan. conventional mortgage. The cost of FHA mortgage insurance is in addition to the FHA loan closing costs you have to pay.
In a nutshell, FHA loans are generally more expensive than their conventional counterparts.
Benefits of FHA Loans
Of course, the main advantage of FHA loans is that they are easier to obtain than conventional loans.
The bare minimum for a conventional loan is a FICO® score of 620, and borrowers near this threshold can expect higher mortgage interest rates. Meanwhile, FHA borrowers pay a standard interest rate based on current market conditions, not their good credit. So if today’s average mortgage rate is 4%, that’s about what you should expect from an FHA mortgage rate.
Another great feature of FHA loans is that closing costs can be built into the loan, or you can ask the seller to pay your closing costs. So if you choose the 3.5% deposit option, that might be all you need to pay up front.
Disadvantages of FHA Loans
In addition to the high costs, FHA loans have a few other potential drawbacks.
For one thing, there is no choice for the length of the term apart from the standard 15 and 30 year loan terms. Conventional loans are available in a variety of other choices, such as 20 and 25 year options.
Additionally, FHA loans are limited in terms of loan size. In general, FHA loans are not intended for purchases of homes that cost significantly more than the median price of homes in their market.
FHA loans can be particularly good for:
- First-time home buyers who might not have a ton of cash on hand.
- Borrowers who have made credit mistakes in the past.
- People who want to enter property investment but do not have the capital required for the traditional financing of an investment property.
The bottom line is that while FHA mortgages are considerably more expensive than conventional home loans, they can still be great buying tools for many buyers.