Is an FHA Home Loan Right for You?

By Dan Rafter on 11 January 2016 0 comments

You're ready to buy a home, and you know that you can afford the monthly payments that come with a mortgage loan. But there's one challenge: You don't have enough money for a large down payment.

Don't despair: An FHA loan can help. These mortgages insured by the U.S. Department of Housing and Urban Development's Federal Housing Administration require more affordable down payments, which could make getting the home of your dreams an easier financial task. And borrowers can qualify for FHA loans even with lower credit scores. FHA loans, though, do come with some additional fees, which might impact the overall cost of the mortgage. (See also: Here's Why Your Parents Could Buy a Home While You Still Rent)

Still interested? Read on to learn whether an FHA loan is for you.

When FHA Loans Make Sense

You can technically qualify for an FHA loan even if your FICO credit score is as low as 500. However, that doesn't mean that you won't struggle to find a lender to work with you. The FHA doesn't actually originate loans — it only insures them — so, you'll still have to work with a private lender to get an FHA mortgage. And many of these lenders (despite the willingness of the FHA to insure borrowers with such low scores) won't provide mortgage money to borrowers whose scores are too close to 500.

Still, FHA loans are a good option for borrowers with credit scores that are below, say, 700. Today's lenders consider FICO scores of 740 or higher to be ideal. They'll reserve their lowest interest rates for borrowers with strong credit. And if your score is below 640, you'll find that only a smaller number of lenders will be willing to work with you. These lenders might recommend that you apply for an FHA loan if your score is too low.

FHA loans aren't just a good option for borrowers with weak credit, though. They're also a good choice for borrowers who don't have a lot of money for a down payment. If your FICO credit score is at least 580, you can qualify for an FHA loan that requires a down payment of just 3.5% of your home's purchase price.

For a home costing $180,000, that 3.5% down payment comes out to a manageable $6,300.

If your FICO credit score is at least 500, you can technically qualify for an FHA loan that requires a down payment of 10% of your home's final purchase price, which is still better than the 20% down payment that some conventional lenders will require.

The Downsides of an FHA Loan

There is a downside to FHA loans: They come with higher fees than conventional loans.

Extra Up Front Costs

If you take out an FHA loan, you'll have to pay two types of mortgage-insurance premiums. The first is an upfront premium of 1.75% of your total mortgage loan. If you take out a loan for $175,000, that comes out to $3,062.75 (you'll have to pay this premium when you take out the mortgage). You can either do this in one lump sum as a closing cost, or you can include it in your loan amount — turning, say, that $175,000 loan into $178,062.75 — and pay it off with each of your monthly payments.

Mortgage Insurance

An FHA loan also comes with an annual mortgage insurance premium that you'll have to pay each year. This annual fee depends on the length of your loan and the size of your down payment.

If you are taking out a 15-year loan and you put down less than 10% of your home's purchase price, your annual mortgage insurance premium will be 0.7% of your outstanding loan balance. If you put down 10% or more on a 15-year loan, your annual premium will be 0.45% of your loan balance.

If you take out a 30-year loan with a down payment of less than 5%, your annual mortgage insurance premium will be 0.85% of your loan's balance. If you put down more than 5% on a 30-year mortgage, that premium will be 0.8% of your balance.

So, if you put down 3.5% initially on a 30-year FHA loan and your loan's outstanding balance is $180,000, you'd pay $1,530 that year in mortgage insurance premiums. Again, you would pay that amount off in small amounts with each monthly mortgage payment.

Unlike conventional loans, you'll never be able to cancel the mortgage insurance premium. With conventional mortgages, you can cancel your mortgage insurance payments once your loan's balance is 80% or less than your home's market value.

So when you're deciding whether an FHA loan is right for you, you'll have to weigh whether the extra yearly fees are worth the convenience of those low down payments and looser credit requirements. For many borrowers who otherwise can't afford the dream of homeownership, the answer may be yes. But if saving a larger down payment for a traditional mortgage is feasible, it's likely to result in lower overall costs.

Did you buy a home with an FHA loan? What was the process like for you?

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