How to Know if an FHA Loan is Right for You
Are you a home buyer with a credit score that could be improved? If so, you may not be able to qualify for a conventional mortgage loan. If you do qualify, the interest rate could be very high. Luckily, if you’re a first-time homebuyer with minimal cash savings and a credit score that’s not the best, you do have options. You may be eligible for a government-backed mortgage loan called an FHA loan. FHA loans come with significant benefits, but there are also some drawbacks you’ll need to consider. Take some time to learn about the pros and cons of FHA loans before you make a decision. This can help you decide whether an FHA loan is right for you.
What is an FHA Loan?
A Federal Housing Administration (FHA) loan is a mortgage loan that the federal government insures. Though the federal government insures these loans, you can apply for them and obtain them through a typical lender, like a credit union or bank. FHA loans are geared toward first-time homebuyers since the borrowing criteria are more lenient than conventional loans.
Many first-time homebuyers are drawn to FHA loans because they only need to put down as little as 3.5%. The interest rates and terms are usually more favorable for first-time homebuyers than conventional loans. However, in exchange for these benefits, you may need to pay mortgage insurance for the entire life of the loan.
Pros of FHA Loans
First, we will discuss the pros of an FHA loan. One of the main benefits of an FHA loan is that you can have a lower credit score and a lower down payment and still qualify for the loan. Many borrowers choose to pursue this type of loan because the credit qualifications are less stringent than a conventional loan. FHA Loans are some of the easiest loans to qualify for, especially for those with lower credit scores. Specifically, an FHA loan only requires a credit score of 500. Meanwhile, many conventional lenders require a credit score of 620 or higher.
They Allow for Compensating Factors
When you apply for conventional loans, your credit score and income will be the most decisive factors. However, when you apply for an FHA loan, you can submit proof of compensating factors in your favor. These factors show your creditworthiness and can help you be approved for the loan. Compensating factors include the following:
- Minimal housing payment increase
- Verified cash reserves
- Low debt
- Residual income
- Substantial non-taxable income
- Increase earning potential
Low Down Payment
As a borrower, if you have a credit score of 580 or higher, you can get an FHA mortgage with a down payment of just 3.5%. Obtaining a conventional loan with such a low down payment amount is challenging unless you have a high credit score. Saving for a down payment is increasingly challenging, so many people choose to pursue an FHA loan to purchase a home.
Favorable Interest Terms
The annual percentage rate (APR) on an FHA loan is usually 1.5 to 2 points higher than those for conventional fixed-rate mortgages. However, FHA rates are typically lower than rates for subprime mortgages. You will receive a fixed interest rate with an FHA loan, while most subprime loans have adjustable rates that can increase significantly after the introductory three to five-year period.
Financing Some Closing Costs
Closing costs average 3% to 5% of the home loan amount. Some closing costs can be rolled into your FHA loan. Using lender credits is one way to cover these closing costs. The borrower needs to pay slightly more interest, and the lender will give them credit that helps cover the closing costs. These credits can be helpful when you are hoping to spend as little out-of-pocket as possible. Let your loan officer know if you would like some of the closing costs to be financed so they can work out the numbers for you.
Cons of FHA Loans
There are many benefits to pursuing an FHA loan. FHA Loans can be your only option if you have a below-average credit score or limited cash on hand. However, before you begin pursuing an FHA loan, you should be aware of all the potential drawbacks of this type of government-backed loan.
Mandatory Mortgage Insurance
Borrowers with low credit scores are more likely to miss payments or default on their loans than borrowers who have higher credit scores. As a result, lenders require FHA loan borrowers to pay monthly mortgage insurance to mitigate this risk. The cost of mortgage insurance is spread across two payment types:
- A single payment of 1.75% of the total loan amount may be due at closing. As with other closing costs, this can often be included in the loan financing.
- Depending on the loan terms and the down payment amount, an additional annual premium of .45% to 1% may be required. This insurance fee will be added to your monthly mortgage payments.
Strict Appraisal Standards
Another potential drawback of an FHA loan is the rigorous appraisal standards. The US Department of Housing and Urban Development (HUD) has strict property appraisal standards. As a result, many properties you may want to purchase could be excluded from eligibility for an FHA loan. Additionally, you will need to show that the home will be your primary or principal residence. You can't use FHA loans for investment properties, although some loans can be used for multi-family properties. Also, while mobile homes and prefabricated houses could easily qualify, condominiums need approval.