When to Consider an FHA-Backed Mortgage

When to Consider an FHA-Backed Mortgage
Photo: MIA Studio (Shutterstock)

If you’re of moderate income and are thinking of buying your first home, it’s worth looking into an FHA-backed mortgage loan. These loans only require a 3.5% down payment, and often offer lower interest rates compared to conventional loans. On the other hand, there are restrictions and trade-offs to consider, too—so here’s some information to help you figure out whether an FHA loan works for you.

What is an FHA loan?

Federal Housing Administration (FHA) backed mortgages are designed to meet the needs of first-time home buyers who might have difficulty qualifying for conventional loans. The down payment requirements are as low as 3.5% of the total mortgage (about half of what you’d have to put together for a conventional loan), and you can qualify with a credit score as low as 580 (though scores between 500 and 579 require a 10% down payment). Note that repeat buyers can get an FHA loan, too, as long as they’ll be using the home as a primary residence.

The FHA doesn’t actually offer these loans directly, but they do guarantee them, which mitigates the risk to private lenders and allows them to offer much more favorable repayment rates than you’d find outside the program. There’s a wide assortment of FHA loans to choose from, with options for variable or fixed interest rates and differing term lengths (you can see an overview of each type of loan, here.)

Restrictions

The downside to FHA loans is that they also carry more restrictions than a conventional private loan. Some of these restrictions include:

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The 2021 FHA loan limit is $356,362 in low-cost areas and $822,375 in expensive markets, which is less than you can get through a conventional loan. You can’t flip a home with a FHA-backed mortgage, as the borrower must take possession of the home within 60 days after the mortgage closes, and live in the home for the majority of the year.Conventional loan borrowers are required to pay for mandatory private mortgage insurance (PMI) only if the down payment is less than 20% of the loan, but FHA loans require mortgage insurance for all of their loans, regardless of the down payment, per Nerdwallet. This fee varies from 0.45% to 1.05% annually, plus you have to pay an upfront fee as well, which is 1.75% of the total loan amount (you can calculate how much you might owe, here).

How to qualify and apply

Per Bankrate, there are some other hoops you have to jump through before you qualify for an FHA loan. You must have:

Verifiable employment history for the last two years.A property appraisal conducted by an FHA-approved appraiser and meets HUD property guidelines.A front-end debt ratio (monthly mortgage payments) that doesn’t exceed 31 percent of your gross monthly income.A back-end debt ratio (mortgage, plus all monthly debt payments) that doesn’t exceed 43 percent of your gross monthly income. Lenders may allow a ratio up to 50 percent in some cases.No recent recent bankruptcies. If you do, you must wait 12 months to two years to apply, or three years after a foreclosure. Lenders may make exceptions on waiting periods for borrowers with extenuating circumstances.

To apply, you’ll need to contact a private lender (Nerdwallet has a round-up of their best-rated lenders, here).

Bottom line

An FHA loan is a good option if you can’t afford a large down payment or don’t have a great credit score. If you do have some money saved up, however, you’ll want to shop around, if only to see how the rates compare, and decide whether the mandatory mortgage insurance and other restrictions offset the downsides of a mortgage secured through a private lender.

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