As a homebuyer, there are several loan options to help you secure the purchasing of a home—the most common of which are conventional loans. Each loan type available comes with its own terms and conditions.
As a first-time homebuyer, securing a conventional loan can sometimes prove to be difficult or come with a costly interest rate, which is why an FHA loan might be the better and more affordable option. An FHA loan is ideal for first-time homebuyers who might be short on cash or have less-than-perfect credit.
What Is an FHA Loan?
FHA loans are government-insured loans through the Federal Housing Administration (FHA). Though the government backs these loans, they are not issued by the government. You apply and obtain an FHA loan through a traditional mortgage lender, such as a credit union or bank.
This type of loan is geared towards first-time homebuyers that might have a challenging time securing a conventional loan due to a lack of cash for a down payment or a credit score that isn’t quite high enough. An FHA loan could also be the better option for a first-time homebuyer if they’re able to get a better interest rate when compared to a conventional loan.
A significant benefit to first-time homebuyers when securing an FHA loan includes the low down payment, which can be as low as 3.5%. Additionally, loan terms and interest rates tend to be favorable for those who are buying a home for the first time, might not have a lot of cash savings, or have some debt that impacts their debt-to-income ratio.
It’s even possible for some to secure an FHA mortgage with a bankruptcy on their record. If you have a Chapter 13 bankruptcy discharged more than 12 months ago and you’ve made a minimum of 12 bankruptcy payments on-time with a letter from the bankruptcy court granting you permission to enter into another mortgage agreement, you can apply for an FHA loan. You can also apply for an FHA loan if you have a Chapter 7 bankruptcy with a discharge date of at least two years prior.
How FHA Loans Function
Though an FHA loan is issued by traditional lenders, they’re backed by the Federal government. As a result, if a borrower defaults on an FHA loan, the government covers the lender’s loss.
For this protection afforded to borrowers and lenders, the FHA requires borrowers to meet specific criteria to qualify for the loan. Still, borrowing criteria tends to be a bit more lenient than it is to secure conventional loans.
Mortgage Insurance and FHA Loans
One downside to an FHA loan is the fact that borrowers tend to have to carry mortgage insurance for the life of the loan. The only option to avoid this is to put a minimum of 10% down payment, and the mortgage insurance will conclude in 11 years. For conventional loans, mortgage insurance is only required until the borrower reaches 20% equity in the home.
With FHA loan mortgage insurance, borrowers pay a large amount upfront at closing. From there, monthly payments are made. The upfront premium is 1.75% of the total loan amount, which the borrower can roll into the total cost of the loan.
FHA Loan Requirements
Broadly speaking, FHA loans require a minimum down payment of 3.5%, a debt-to-income ratio of no more than 50%, and a 580 or higher credit score. These loans also require mortgage insurance and an FHA appraisal. A lower credit score is possible for those making a minimum 10% down payment—the range is 500 to 579 for these borrowers.
Additional requirements to qualify for an FHA loan are being a resident of the U.S. and demonstrating a steady employment history. Some lenders might have stricter guidelines than others, so it’s best to shop around to get the best terms and interest rate.
The Department of Housing and Urban Development’s (HUD) goal is for FHA loans to support lower-income individuals with the ability to purchase a home. However, there isn’t an income-based requirement for an FHA loan.
A Few Final Words on FHA Loans
Though FHA loans are ideal for first-time homebuyers, you don’t need to be one to qualify for an FHA loan. As long as you meet the requirements and purchase a primary residence, not a vacation, investment, or second home, you might qualify for and benefit from an FHA loan. Your credit score, down payment, and other factors will influence your loan approval terms and interest rate.