If you are in the market for a mortgage and have concerns about your financial qualifications, an FHA mortgage may be your key to a new home.
"With a relatively alow minimum down payment of 3.5% and a more liberal attitude towards debt-to-income ratios," explains Michael Dunsky, a Vice president at Boston-based Guaranteed Rate Mortgages, "an FHA mortgage is a prime loan for somebody with less money available for a down payment, more debt, and a less than stellar credit score."
While conventional loans require potential homebuyers to come up with at least a 5% down payment, FHA Mortgages allow them to slide by with a minimum down payment of just 3.5%. Unlike conventional loans, FHAloans do not charge a higher interest rate for a low credit score and have a low, minimum qualifying credit score of 500. Depeding on lender overlays, though, many lenders require a higher (though still low) score between 600 and 640.
"Underwriting guidelines are much more liberal than conventional financing," says Seattle-based residential mortgage banker Dan Keller. "For example, on a loan that I just got an approval on yesterday, the client had a 57% debt-to-income ratio whereas with conventional financing you are capped at 45%."
The term FHA Mortgage is a bit of a misnomer as the Federal Housing Administration (FHA), doesn't actually provide the loan. Instead, the loan is financed through a conventional lending institution like a mortgage company, bank, or savings and loan, and then HUD insures the mortgage, allowing the homebuyer to get a lower rate than otherwise would be possible.
The only catch, if you can call it that, of the FHA mortgage is that the homebuyer has to pay mortgage insurance, which adds to the cost. To protect the lender, private mortgage insurance is typically required on any mortgage where the down payment is below 20%.
"The mortgage insurance is split up into two pieces," says Dunsky. "First, you pay a lump sum upfront, which is 1% of the entire loan. Then, you have the monthly cost, which is presently at a factor of 0.9%." To get a rough estimate of this monthly mortgage insurance cost, take the loan amount, multiply it by 0.9%, and then divide that number by 12. You can expect that cost to go up in the upcoming year as the FHA has plans to change it to a factor of 1.15% in April.
Comparing an FHA Mortgage to a Conventional Mortgage
If you are trying to decide between a conventional mortgage and an FHA mortgage and you have less than 10% to put down for the deposit, an FHA loan may be your best choice.
"The issue that stands out with an FHA," explains Jeff Belonger, an area manager for Infinity Home Mortgage Company in New Jersey," is that with a conventional mortgage, you not only have to go through the loan approval process, but also the mortgage insurance approval process." In other words, you have to get approved by the mortgage insurance company, which is different from the mortgage lender.
"With an FHA loan, it doesn't matter," continues Belonger, "the mortgage insurance is controlled by the FHA. If you need to get mortgage insurance on a conventional loan, it goes into a tailspin because there are maybe five or six mortgage insurance companies out there. And from what I'm seeing, with 5% down it's hard to get mortgage insurance even with a credit score between 680 and 700."
So, if you are doing a conventional loan with mortgage insurance and you put 10% or less down, it's hard to get approved for that insurance unless your credit score is 700 or above. "That's why it's quick to say," continues Belonger, "that with a credit score of 699 or below with 10% down, an FHA is usually going to be your better loan." In Belonger's opinion, after playing with the numbers, an FHA loan is still usually going to be a better value-keeping in mind that it's important to keep sight of long-term financial goals when a loan officer helps you to make these types of decisions.
Like any product that is designed to assist homebuyers with bad finances, the FHA Loan can easily be abused. Just because you can scrape together a 3.5% down payment and have the minimum credit score, it doesn't mean that you should pursue an FHA loan.
"Each borrower is different," says Keller. "If I've got a homebuyer who has a 640 credit score and $1200 dollars in the bank, meaning no money in the bank and no retirement, and they're borrowing their 3.5% down payment - that has red flags written all over it."
"There's nothing worse," notes Belonger, "than when you get a client who calls and says, 'I'd like to buy a house in the next month or two but my credit's not that good.' In that situation, you really need to go through the steps of fixing your credit. You just don't jump out there. What, are you going to die if you don't buy a house tomorrow?"
"I think that this economy has created a new breed of loan officer," says Keller. "When you get those kinds of clients with a low credit score and not much money in the bank, maybe it's better to give them a little more advice versus thinking about closing a loan so that you can get paid."
For a financially responsible person who wants to get into a home but doesn't have a great credit score or the savings for a sizeable down payment, the FHA loan may be their only option for getting into a house. For many people, this the ideal financial product. Still, if you can afford to wait to save up more for a down payment, you probably should.
"I advise all of my clients, first-time homebuyers or not," says Keller, "that anytime that they can avoid paying private mortgage insurance they should. Ideally, 20% down is the best way to go."
That said, if you do have the cash on hand to pay 20% down, don't discount an FHA loan. "20% down on an FHA loan, even with mortgage insurance, might still be better than a conventional mortgage with 20% down and no mortgage insurance," explains Belonger. "If you have a credit score of 639 or less, in many cases even the FHA loan would be better for you with mortgage insurance depending on your goals."