You may have heard that “government loans” are available for would-be homeowners who are saddled with bad credit and/or a history of bankruptcies or foreclosures. In reality, though, it’s not quite that simple.
The federal government is not in the home-loan business. However, in the interest of promoting home ownership – especially for low-income Americans – it may be willing to guarantee a mortgage for you if you have less-than-optimum credit. In other words, the government promises the lender that it will make good on the loan if you don’t.
FHA vs. HUD
The federal government agency charged with encouraging individual home ownership is the U.S. Department of Housing and Urban Development (HUD) through one of its offices, the Federal Housing Administration (FHA). While HUD does some loan guarantees on its own, its focus is on multifamily units, not individual homes (with the exception of HUD Section 184 loan guarantees, which are available only to Native Americans buying homes or other real estate). It is solely the FHA that insures mortgages for single-family-home buyers.
Qualifying for an FHA Loan
To secure an FHA-guaranteed mortgage, you have to go to an FHA-approved lender, typically a bank. One thing that makes an FHA-guaranteed home loan particularly attractive is that you do not need a perfect credit history. Individuals who have gone through bankruptcy or foreclosure are eligible for an FHA loan, depending on how much time has passed and whether good credit has been re-established. Borrowers with a credit score of at least 580 qualify for an FHA loan, although lenders can require a higher score. Still, if you're approved with a FICO score of at least 580, you are only required to put down 3.5% of the home's purchase price in cash.
If your FICO score is below 580, however, you will need to come up with 10% of the purchase price for the down payment. Still, that’s better than the 14.8% of the purchase price that the average home buyer put down on closing last year. Research by RealtyTrac shows that in the first quarter of 2015 (the most recent data available), the average dollar amount paid on closing with a conventional mortgage was $72,590, whereas the average FHA insuree put down only $7,069.
If your FICO score is below 580, securing an FHA-guaranteed loan can be tough, cautions FHA mortgage expert Dennis Geist, who is engagement director at Treliant Risk Advisors in Washington, D.C. “Approval of borrowers with credit scores between 500 and 580 is subject to higher down payment requirements and additional underwriting scrutiny,” says Geist. “It’s important to note that ‘nontraditional credit’ can’t be used to offset negative ‘traditional’ credit.” He adds that although you may see information holding out hope for FHA-insured loans to would-be buyers with credit scores under 500, the chances of that actually happening are nil.
Do not, however, mistake FHA-insured loans for “easy credit” lending, Geist adds. "There is a misconception that FHA loans are subprime. Nothing could be further from the truth,” he says. “Although FHA loans provide flexible qualifying guidelines, including lower credit scores and higher debt-to-income ratios, the demonstrated ability to repay is a significant factor in the approval of any FHA loan.”
Another plus of an FHA-insured loan is that, unlike a conventional bank loan’s terms, an FHA loan allows you to get the cash needed for the down payment as a gift from friends, family or a charity. The FHA will even allow the seller to pay your closing costs, although if they do so, it may boost your mortgage’s interest rate, since not having enough money for even that makes you look less loan-worthy. There are FHA-insured loans available with both fixed rates and adjustable rates.
The debt-to-income ratio requirement involves several calculations based on the mortgage amount and all other debt payments. First, the amount of the mortgage payment – including mortgage insurance (see below) and all other escrow charges – must be a maximum of 31% of a borrower's gross monthly income. Second, the mortgage added to all other monthly debt payments, such as student loans or credit cards, must be no more than 43% of gross monthly income. Using these ratios, a borrower who has a gross monthly income of $3,000 can have a mortgage payment of up to $930 a month. The total of the mortgage and all other monthly commitments, however, must fall under the maximum of $1,290. For more on this, see What is the debt ratio for an FHA loan?
Before you decide to pursue an FHA-guaranteed loan, do consider some of the downsides. First, your options are more limited than with a conventional mortgage, because you can only do business with an FHA-approved lender. That limits your ability to shop around for the most favorable rates and terms. “A careful and complete comparison of loan products, fees and mortgage insurance is an important step in determining which loan product is best for you,” notes Geist.
FHA-insured loans have caps on the amount of the loan that vary by region. The absolute top amount the FHA will insure is $625,000, which in major metropolitan areas may not go very far. Further, many condo developments are not FHA-approved, so some less-expensive housing options are off the table. Also, FHA loans require the home meet a checklist of conditions and also be appraised by an FHA-approved appraiser. They can only be utilized for homes that serve as the buyer’s primary residence.
Consider also that although the cash needed up front may be low, the required FHA insurance premiums will add considerably to your monthly mortgage payments, since you are contributing to a HUD reserve fund that is used to pay off the banks when an FHA-guaranteed mortgage goes bad. And mortgage insurance payments may not always be tax deductible, depending on your income.
You will pay an up front mortgage insurance premium (UFMIP) of 1.75% of the base loan amount. Then, on a 30-year mortgage, which is the most common FHA loan term, the annual premium can run as high as .85% of the loan amount if you choose the lowest down-payment option. At the opposite end, on a 15-year loan with 10% or more down, the premium drops to .45%.
Added to your monthly payments, these premiums often tend to make the interest rate on FHA-backed mortgages – which nominally is slightly less than that on their conventional counterparts – actually higher than that of regular mortgages. And, unfortunately, the FHA requires homeowners to carry mortgage insurance for the life of the loan. With a traditional loan, homeowners can usually cancel the mortgage insurance once they have at least 20% equity in the property.
That’s why some FHA loan-guarantee recipients later seek to refinance their properties with a conventional bank loan once their credit history has improved. To do that, and say good-bye to the FHA mortgage-insurance payments, you will have to get FHA approval. “The FHA mortgage insurance continues for the full term of the loan,” says Geist, “so the primary reason to refinance an FHA-insured loan with a conventional loan would be to eliminate mortgage insurance and/or to reduce the term of the loan.”
The Assumable Advantage
On the upside, however, is the fact that FHA-insured mortgages are assumable, meaning that whoever buys your property can take it over from you, while conventional mortgages generally are not.
The buyer has to qualify, meeting the FHA's terms (as you did). Once he's approved, he assumes all the obligations of the mortgage upon the sale of the property, relieving the seller of all liability. In some cases, the seller may still be responsible for the debt if the buyer does not sign a liability release from the lender. This means that if the buyer does not make the payments, the seller's credit could be negatively affected.
“An assumable FHA loan could create a competitive advantage when it’s time to sell, especially if current interest rates are higher than the existing rate on the FHA loan,” says Geist. “Assumption costs are also lower than costs associated with a new loan.” Closing costs and any mortgage buyout costs are also typically much less than those for a new conventional loan.
So your FHA loan could potentially be an incentive if you find yourself selling in a buyers’ market with rising interest rates.
The Bottom Line
FHA-guaranteed loans are part of HUD’s mandate to encourage home ownership (HUD itself doesn’t do loan guarantees for individual homes, unless you're a Native American). If you have reasonably good credit but are short on funds for a down payment, an FHA-insured loan can help you become a homeowner. But because of limits on property purchase price, housing type and loan choices – plus the added cost of mortgage insurance – you’re probably better off with a conventional mortgage if you have enough cash on hand. It all comes down to exploring your options fully and doing the math of the upfront and lifetime cost of each loan you are considering.