First time homebuyers, more than any class of homeowners, tend to be cash poor. That’s not a judgement statement — we all start somewhere. However, compared to other loans, FHA is much more forgiving of your liquidity-related woes. Because of FHA’s low down payments and small reserve requirements, along with options to roll your up-front mortgage insurance into the loan, many buyers find they can get into an FHA loan and onto the road to homeownership much more quickly than they can with traditional products.
The Benefits of FHA
FHA mortgages are solid products with a long history of successfully funding first time homebuyers, who often have little cash or equity available and minimal credit histories. Before the FHA got into the mortgage business, securing a mortgage was tricky, typically requiring a 50 percent down payment for the luxury of a five year term that ended in a balloon payment. Because of the efforts of the FHA, the world of mortgage lending changed significantly, allowing more people to buy homes. FHA is still the first name in first time homebuyer friendly loans for these reasons:
Relaxed Credit Requirements. Unlike most mortgages, FHA realizes that you may have made some credit mistakes in the past. They won’t forgive these completely, but if your credit score is above 580 and those late pays were long ago (or you can pay the bill that’s in collections off before closing), you won’t be left in the cold.
They can be more flexible in their lending because FHA allows underwriters to overlook the results of extenuating circumstances like serious accidents that affected income temporarily, but long enough to generate some late pays. If you already know you’ve got some bumps on your credit report, make sure you choose an FHA lender who does manual underwriting for your best shot at a loan approval.
Low Down Payments. Unless you’re a military veteran or are looking to purchase a home in a rural area, FHA has the lowest down payments anywhere. A standard FHA loan only requires that you bring in a 3.5 percent down, unlike Fannie Mae’s strict five percent down payment requirement for conventional loans.
That down payment can come in the form of gift money, provided that the source of your new-found cash is a blood relative or someone that you have a family-like relationship with. As long as your benefactor doesn’t expect the money back, all they have to do is sign a few papers and you’ve got a no-hassle down payment.
Small Reserve Funds. Lenders want to know that you have enough money in your bank account to pay your bills should you find yourself with an unexpected expense or surprise unemployment. This is why FHA asks your lender to check for reserve funds. These funds represent the amount of money you would need to pay your household bills for one month. Currently, FHA only requires you have one month’s worth of reserves if you’re buying a single family home, making it easier to qualify for a loan with little cash on hand.
Increased Allowance for Closing Cost Financing. Closing costs can be expensive, but in many cases sellers will help foot the bill. Standard loan programs limit seller contributions to three percent of the loan amount, but FHA will allow them contribute up to six percent. Because FHA closely regulates the fees associated with their loans, six percent is usually enough to cover most of your closing costs.
Larger Income to Debt Ratios. When applying for a mortgage loan, your lender will examine your income and your debt to determine how much home that you can afford, according to their guidelines. Depending on the program, this figure can be capped at 36 percent. That means that your bank won’t make a loan to you if your monthly debt payments plus your future home payment is more than 36 percent of your monthly income.
FHA is much more flexible, allowing a 43 percent debt to income most of the time. A 50 percent debt to income ratio can be possible if you have extenuating circumstances or are otherwise an extremely strong borrower with significant cash reserves. Again, this will require a manual underwriting, so ask your lender if you know you’ll need special handling.
Assumability. FHA loans are still assumable, meaning that when you go to sell your home, a potential buyer could simply take over your loan. This sounds like lunacy, but buyers with big down payments in the future may jump at the chance to have a mortgage with a four percent interest rate. As rates rise, mortgage assumptions are going to become a big deal, so consider that a down the road bonus to your FHA loan if you plan to sell as your family grows.
Even though the benefits of an FHA mortgage are tremendous, there are some restrictions and requirements that may keep you from getting the most from this loan type. Traditional FHA loans, for example, are difficult to close on homes that aren’t in outstanding shape, so if you’re looking for a fixer upper you may want to choose a different product. Here are a few other points to ponder before you sign on the dotted line:
Mortgage Insurance. Hands-down, the biggest drawback to an FHA loan today is the mortgage insurance structure. Because FHA loans are considered inherently more dangerous, mortgage insurers want both an upfront and a monthly premium for any portion of your mortgage that exceeds 80 percent of your new home’s value. That fact alone isn’t a problem, it’s simply the way that banks hedge against the risk you’ll end up in foreclosure. The problem with today’s FHA loans (this does not necessarily apply to your older FHA loan) is that unless you bring more than a 10 percent down payment, the mortgage insurance on your 30 year note will last as long as the note does.
Homeowners with low down payments on loans originated before June 3, 2013 could always hold on to the dream of shedding their mortgage insurance when they managed to pay their loan down to the 78 percent of value mark. Paying all that mortgage insurance was still no fun, but if you couldn’t get into a home any other way, at least you knew that extra fee wasn’t forever. Today’s cash poor borrowers will be forced to refinance their low rate mortgages or pay mortgage insurance for the life of their loan – depending on future rates and credit requirements, this may be a difficult call for today’s first time buyers.
Minimum Property Standards. You can’t get an FHA loan on just any home, as I mentioned above. There are standards that must be met in order for your future home to qualify. Although these standards generally reflect a condition that most people might consider minimum for a home to be occupiable, the Devil is in the details. FHA appraisers are given guidelines, but it’s at their discretion whether or not something that’s harmless, like a barely leaking faucet or a non-working range hood, must be repaired before closing.
Don’t let that scare you, most of the time it’s ok, but an overzealous FHA appraiser can ruin an otherwise great deal for everybody. So, if the home you’ve got in mind is a fixer upper or needs some costly repairs right away (even if you’ve already budgeted for them), you should consider another type of loan. Sometimes sellers will make repairs if you ask for them from the beginning of the deal, or at the point where they’re discovered in the home inspection, but you can’t count on that — especially if you’re already asking for seller paid closing costs.
Loan Limits. Last, but not least, let’s talk about loan limits. FHA has them and they’re much lower than other loan programs in most areas. For 2015, FHA loans stop funding at $271,050 for most areas of the country, or $625,500 for areas considered to be unusually pricey, like San Francisco, New York City, Washington, D.C., and parts of LA. This means that FHA makes the most sense in lower cost areas, since your buying power isn’t going to be limited by the loan type.
The Bottom Line: FHA Mortgage Are Pretty Great for First Time Buyers
For most borrowers, the benefits of the FHA loan program are still untouchable by any other mortgages out there. The lower down payment, higher seller contribution allowances and small reserve requirements make it easier for an increasingly cash-poor pool of home buyers get into the market. Buyers will simply have to plan for their future refinance, improving their credit as much as possible before they reach the 80 percent loan to value point.
No matter how you slice it, homeownership still fosters a sense of social stability and hedges against ever-inflating rent costs. If it makes sense to own today instead of renting, it’ll probably still make sense in five years — and that’s the key. Despite the few drawbacks, your new home offers intangible benefits that you’ll can’t really quantify or put a price tag on.