Financing a house with a damaged credit history or a down payment of less than 20% can be challenging. Still, while difficult, it is possible to obtain a mortgage with less than ideal circumstances thanks to governmental guaranteed financing programs like FHA mortgages, which can transform the dream of homeownership into a reality.
The FHA loan guarantor is the Federal Housing Authority and it is the largest mortgage issuer in the world. It helps fund single and multi family properties as well as healthcare facilities. When applying for an FHA loan, your credit history counts, as it would with all lenders, but the FHA’s guidelines are more lenient in some ways and less in others. It’s important to note, though, that while the FHA guarantees a loan, the funds for FHA loans come from mortgage lenders.
To decide whether an FHA loan is right for you, it’s important to understand what an FHA loan actually is, how much it differs from conventional loans and what the alternatives might be.
What is an FHA home loan?
An FHA loan is a home loan designed especially for individuals who have a less than stellar credit history. Many lenders require an average FICO score of 684, but having a score below this doesn’t negate your chances of owning a home. With an FHA home loan, the minimum FICO score you need is 500, but it will require 10% down. However, if you boost your credit score to 580, then the required minimum down payment drops to 3.5%. There are other requirements for an FHA home loan as well, but overall, it’s designed to help those with fair and sometimes poor credit buy a home.
FHA loans vs. conventional loans
|Loan Type||Min. FICO Score||Min. Down Payment||Insurance requirement||Debt-to-Income Ratio|
|Conventional||640||usually 10%-20%||MIP requirement varies||45% — maximum 50% in rare exceptions|
*Sometimes a lower FICO score for conventional loans might be used, but this depends on the lender’s underwriting policies and the borrower’s available liquid assets.
Types of FHA loans
When most people think about home loans, three options come to mind: fixed-rate mortgages, ARM loans and refinance loans. However, FHA loan options go beyond this.
Fixed-rate FHA loans
Fixed-rate FHA loans are a great option if you are looking to buy a home but lack the funds for a 20% down payment. The APR remains fixed for the loan, leading to predictable monthly mortgage payments.
ARM loans are an option for individuals who anticipate income growth. They generally have a fixed APR for a specific period and then the rate fluctuates to go higher or lower depending on the market. ARM loans often give you get a lower initial mortgage payment, but over time, rates and payments can increase.
Secure refinance loans
Secure refinance loans offer a solution to problems caused by the oft-problematic ARM loans by helping you overcome the threat of a potential foreclosure from an underwater loan.
Reverse mortgages are designed for homeowners aged 62 and older who could use a bump in income. They convert your home’s equity into income or a line of credit, but consumer counseling is a requirement. The mortgage is not repaid until the house is sold and if the sale doesn’t yield enough to repay the full loan, the FHA insurance covers what’s left.
Energy efficient mortgage
An energy efficient mortgage allows you to take out a second mortgage or refinance up to 96.5% of your initial mortgage. It helps you to make up to $8,000 in energy efficient improvements on your home and lower your monthly utility bills.
Graduated payment mortgages
Graduated payment mortgages, sometimes called balloon mortgages, aren’t for everyone. They are designed for people who expect a significant increase in their annual income over the next five to 10 years. Payments start small but increase significantly over time. It comes in 5-year and 10-year mortgages. The 5-year mortgage increases by 2.5%, 5% or 7.5% each year during the first five years. The 10-year mortgages increase by 2% to 3% each year for the first 10 years. After the increase period, payments for these loans remain constant for the balance of the term.
Growing equity mortgages
Growing equity mortgages also start with a smaller initial payment during the first year. Rates gradually increase by between 1% and 5% each year thereafter, depending on the plan you choose. If you expect a significant increase in your monthly income, these loans might be a good option. However, if your income growth is uncertain, it might be better to avoid these.
Condominium loans might be an option for those with low to moderate incomes. These loans offer a way for tenants to avoid displacement if the property is converted into condominiums.
FHA loan requirements
Ideally, you need a FICO score of at least 580 and a 3.5% down payment to qualify for an FHA home loan. However, some lenders may give special consideration to those with a 500 FICO score if you have at least 10% to put down.
All FHA loans require a mortgage insurance premium. It is a kind of insurance policy for the lender in case you default on the loan later. The debt-to-income ratio should be no higher than 43%. If you’re uncertain of what your debt-to-income ratio is, you can calculate it with an online tool.
Finally, the home you’re considering needs to be your intended primary residence and you’ll need to provide proof of steady income and employment to meet the requirements.
FHA loan eligibility
Planning ahead to meet eligibility guidelines is vital, and part of the planning phase includes spending at least 12 months beforehand making on-time payments to your current financial obligations. Also, consider saving for a larger down payment to improve your chances of getting financed later.
Although it’s possible to get approved with a FICO score of 500, it’s not always the best option. Many lenders require a higher score of 580 or above. Improving your credit history before you apply can work in your favor. A required mortgage premium insurance will be added to the loan amount and may increase your monthly payments, so you’ll need to be ready for it.
“I would say if you have very little saved for a down payment or have poor credit, then an FHA loan may be the best solution for you,” said Eric Jeanette of Dream Home Financing. “If you can come up with a twenty percent down payment, then an FHA loan is probably not the best option due to the costly mortgage insurance payments.”
The mortgage insurance payments are required on FHA loans and provide the lender with a kind of peace of mind in case you default on the loan. However, they are costly and come in two waves: up-front and annual, which means you’ll pay insurance twice, at least during the first year.
The up-front insurance fee is due at closing and is equal to 1.75% of your loan principal. After that, you’ll pay an annual premium at a variable rate based on the remaining loan. With that said, we’ve found two top FHA lenders to get you started.
Best FHA lenders
Quicken Loans is one online lender for FHA loans. It might be a good choice for someone looking for a fast, easy certification process. It has an online application that’s a breeze to use and current FHA rates start at 3.625% for a 30-year fixed loan.
Navy Federal Credit Union is another option. Rates start at 4.125% for a 15-year mortgage and 4.000% for a 30-year mortgage for members. However, membership is limited to veterans, active military members, their families and the Department of Defense.
FHA loan alternatives
There are a few alternatives to FHA home loans to consider: VA, USDA and conventional mortgages.
VA loans are guaranteed by the Veteran’s Association, but the loans are originated by approved lenders, which means your funds will be paid directly from a lender and not the VA. These loans are designed for veterans, active military members and their families. To qualify, you’ll need satisfactory credit, a solid income and a valid certificate of eligibility.
USDA loans are issued for rural home purchases and 90% guaranteed by the United States Department of Agriculture. Approved lending institutions originate the loans. The home needs to be for your primary residence and the property must meet all program requirements.
Conventional home loans offer another option, but they depend greatly on your income, credit history and other things. So, if you have a higher FICO score, or can afford to take the time to work on your credit history, then you may be able to save on interest and possibly mortgage insurance premiums with conventional loans.
Pros and cons of FHA loans
FHA loans make sense for many borrowers, but they aren’t for everyone. If you can afford to wait and work on your credit history and build a larger down payment, then you may be able to get a better rate and more affordable mortgage payment — and possibly without the costly mortgage insurance premium. However, this varies by lender and situation.
“The FHA versus conventional comparison almost always boils down to a function of down payment and credit score. The higher the down payment and the higher the credit score, the less likely it makes sense to choose an FHA loan,” said Matt Hackett, operations manager for Equity Now, a direct mortgage lender. “The analysis requires a lender which is equally knowledgeable in both loan products. We make these comparisons on a daily basis and it all comes down to the effective interest rate, including mortgage insurance and the effective cost of the said rate, including the up-front mortgage insurance premium. Once one has established the rate and cost options to compare, it is a simple mathematical solution.”
If you decide to move forward with an FHA loan, there is still a way to save a bundle at the end, and that involves having a solid plan for refinancing when the time is right.
“If you go the FHA route, be sure to refinance after 210 days when you will be eligible to refinance,” said Benjamin Ross, a realtor at Mission Real Estate Group. “Just know you will not be able to pull cash out. Doing this will significantly lower your monthly payment because you will no longer be paying a monthly mortgage insurance payment.”
The bottom line
If you have an imperfect credit history but a 580 FICO score or above, then an FHA home loan might be a good option. However, you’ll still have to pay a costly mortgage premium insurance. If you can afford to wait, sometimes it’s better to do so.
Build your credit by reducing debt and save the 20% down payment for the home you want. Yes, it takes extra time, but with a solid plan in place, you’ll lessen the costs of owning a home.
The dream of homeownership is achievable, but it requires planning and consistent effort to bring to fruition. When you plan, you reduce the associated risks and pave a path for success.