You’ve cleaned up your credit, put some savings in the bank, paid down some debts and you’re finally nearing one of your lifelong goals of homeownership. All that hard work is about to pay off into one of the ultimate American dreams. There’s only one problem – what loan program do you choose?
In today’s rising rate environment, choosing the right loan program can make a difference in whether you qualify for a mortgage or not. We’ll break down one of the most utilized mortgage loans for first time homebuyers, so you’ll know if it is right for you.
What is FHA Loan?
An FHA loan is a loan that is backed by the Federal Housing Administration and is one of the most commonly used loans by first-time home buyers. The FHA reported that in 2020, 83% of borrowers were first-time homebuyers. With an FHA loan, you can put down as little as 3.5% with a credit score of at least 580. Even borrowers as low as 550 can purchase a home with an FHA loan if they put down 10%.
Advantages of an FHA Loan
FHA loans are designed for borrowers that have less than stellar credit profiles and higher monthly debt balances. The maximum debt-to-income (DTI) ratio for an FHA loan is 50%. In some cases, lenders will allow a total DTI as high as 56.9% with compensating factors such as a high credit score and a large amount of savings.
For borrowers with recent adverse credit events, FHA also has less strict seasoning periods. Those with Chapter 13 and 7 bankruptcies must wait only one and two years, respectively, to apply for an FHA mortgage. Those with a recent foreclosure on their credit must wait a 3-year seasoning period.
Due to these loans being backed by the Federal Housing Administration, they are less risky for lenders and thus interest rates are slightly lower than conventional loans. Typically, FHA rates can be an eighth to a quarter of a point lower than conventional rates.
For many borrowers, the lower rates and lenient guidelines make this a perfect mortgage for a first-time homebuyer.
Disadvantages of an FHA Loan
Not everything is greener on the other side with FHA loans. These loans carry Mortgage Insurance Premium (MIP) no matter how much you decide to put down. MIP covers the lender in case of mortgage default and serves as no benefit or protection for the borrower.
If you put only the minimum 3.5% down on an FHA mortgage, you’ll have MIP for the life of the loan. The only way to get rid of it would be through a refinance. Borrowers who put 10% down or more will only have MIP on the mortgage for 11 years. Many choose to refinance these mortgages as soon as rates allow.
In addition to MIP, you’ll have to pay an upfront mortgage insurance premium of 1.75% of the loan amount. For example, if the loan amount for a home purchase is $300,000 your upfront MIP payment will be $5,250. This cost will be financed into the loan.
Another disadvantage to an FHA loan is that there are limitations to the types of properties you can buy. FHA loans can only be used for primary home purchases. They cannot be used for second homes or investment properties. The exception is if a borrower is purchasing an owner-occupied multi-unit property.
An additional drawback to an FHA mortgage is the appraisal, as per its guidelines, is more strict than conventional loans. For these reasons, sellers are sometimes hesitant to accept an offer that has FHA financing.
FHA loans can be a great financing option for a first-time home buyer due to its low-down payment requirements, lower interest rates and lenient credit overlays. Whether or not you choose to buy a home with this type of loan will depend on how stable your financial footing is and your individual circumstance.