Buying a house can be a pretty daunting process. When my husband and I decided to buy our first home in 2016, we spent months with a real estate agent not only looking for the right place, but then going back and forth with the bank to confirm we had all of the documents we needed to get our mortgage approved. I knew that buying a house and getting a home loan wouldn’t be easy, but I was a bit surprised at how long it took and what the bank needed to be confident we’d be able to cover the closing costs and make our monthly mortgage payments on time.
When you apply for a mortgage, the underwriter takes a look at all of your financial information and determines how risky it would be to lend to you. Your income, debt, and credit history will all be scrutinized as the bank tries to determine your ability to make mortgage payments. They’ll also use this info (and more) to decide if they want to lend to you, and the interest rate they will offer on the mortgage.
For young people with a modest salary, student loans to pay off, and a limited amount of cash in savings, buying a home can seem like a far off dream. That’s where an FHA mortgage may make a difference.
Here’s what an FHA mortgage is, the benefits and drawbacks, and how to figure out if it’s a good financing option for you.
What Is a FHA Mortgage?
A FHA mortgage is a loan program to buy a house that’s backed, or insured, by the government’s Federal Housing Administration (FHA). Its purpose is to help first-time homebuyers and others who may have a hard time getting approved for a conventional loan, because of roadblocks like low credit scores or high debt-to-income ratios.
The loan is still issued by a bank, it’s just that the FHA insures it—which reduces the risk for the lender, encouraging them to issue you a mortgage even if you’re not a “perfect” candidate.
The Pros of FHA Mortgages
One huge benefit of a FHA mortgage is that your down payment can be as low as 3.5% (vs the standard 20%) of the purchase price. This can make it possible for someone with a steady income, but only a small amount set aside in savings, to purchase a house with down payment assistance. (There are some caveats related to credit score—but we’ll get to that in a minute.)
It is possible to put less than 20% down on a conventional mortgage, but it can make the whole process even more difficult. Your mortgage lender may ultimately decide that the low down payment won’t be enough, or they may approve your mortgage but require you to set aside multiple months of mortgage payments to build a reserve, as another form of insurance for them. That doesn’t happen with an FHA.
With an FHA mortgage, a first-time buyer’s down payment can also come from an outside source, such as a family member, employer, or charitable organization as a gift. Though, there are some restrictions and limits that you’ll need to ask your lender about beforehand.
You also have a better chance of getting approved for a FHA mortgage vs a conventional mortgage if you have less-than-ideal credit. The minimum credit score you need to get an FHA mortgage is 500. However, it’s important to note that if your credit score is between 500-579, you’ll need to put down at least 10%. If your credit score is 580 or higher, you can choose to put as little down as 3.5%. For a conventional mortgage, you typically need a credit score of at least 620 to even be considered.
FHA mortgages tend to still have competitive interest rates because the bank has less risk when the loan is backed by the federal government. Your exact interest rate will depend on the lender and your specific financial situation, though, so it’s important to shop around as with any other loan. Another plus: FHA interest rates are fixed, meaning they won’t change over the life of the loan. Conventional mortgages can be either fixed or variable.
If you do eventually struggle to make mortgage payments, the FHA offers a few programs and resources specifically to assist people with FHA mortgages and help them avoid foreclosure.
The Cons of FHA Mortgages
While the upsides of a FHA seem pretty great, taking out this type of loan means you will incur an additional cost that someone who puts 20% down on a traditional mortgage won’t have: mortgage insurance premium, or MIP.
MIP is yet another way for the bank to insure itself. For an FHA mortgage—no matter how much you put down—a MIP of 1.75% of the total loan amount is due when you purchase your home. You can either choose to pay it in cash at closing, or finance it and pay it off throughout the life of the loan. You’ll also have an annual MIP, paid monthly, for the duration of the loan or for 11 years if you put down 10% or more. The annual MIP amount will depend on how much money you put down and the terms of your loan.
Let’s go back to conventional mortgages for a second: If you get a conventional mortgage and put less than 20% down, you will have to pay something similar, called private mortgage insurance, or PMI. The exact cost of your PMI depends on your credit score and down payment, but typically ranges from 0.3 percent to 1.5 percent of the loan amount. Some lenders will ask for this upfront; others will want an upfront payment and an annual payment, similarly to the MIP.
So while a FHA mortgage may require a smaller down payment and could potentially score you a lower interest rate than a conventional mortgage, that additionally MIP will make it likely that you’ll end up paying significantly more over the life of the loan.
Read more: Why Get Pre-Approved for a Mortgage Early
How to Get a FHA Mortgage
A FHA mortgage can be used to purchase a 1-4 family home, a condo, or a manufactured housing unit on a permanent foundation. To get an FHA loan, you have to work with a lender that works with FHA-backed mortgages. You can search the HUD (the Department of Housing and Urban Development) website for an approved lender, or ask your preferred bank if they give out FHA loans.
The bottom line: If you’d like to buy a house and are limited by the cash you need for a downpayment or a low credit score, a FHA mortgage can make it possible for you to become a homeowner. However, it’s important to always consider the amount that you’ll need to pay in interest and insurance before deciding if this, or any other type of mortgage, is a good choice for you.