Small Down Payment Boosts Popularity of FHA Mortgage

Dan rafter
Written by
Dan Rafter
Read Time: 5 minutes

Wishing you could buy a home but lack the money for a down payment? Or does bad credit prevent you from qualifying for a mortgage in the current tight lending environment? An FHA mortgage could be just the ticket for you.

With an FHA mortgage, you can put down as little as 3.5 percent for the down payment - one of the few mortgages still available that require that little. FHA mortgages also have no official credit limits, meaning home buyers with blemished credit can still obtain a mortgage so long as they have established a reasonable history of paying their bills.

With conventional lenders demanding higher credit scores and bigger down payments, it's no surprise that FHA mortgages have become extremely popular - the FHA reports that it currently accounts for about 25 percent of all new mortgages issued, up from about 3 percent a few years ago. First-time homebuyers and low-income borrowers, in particular, have been going the FHA route to take advantage of the current housing market's combination of sharply reduced prices and unusually low mortgage interest rates.

Mortgage insured through the federal government

The FHA, or Federal Housing Administration, doesn't actually offer mortgages. Instead, it guarantees mortgages issued by approved lenders that meet certain guidelines. Because the FHA insures the loan, lenders are willing to take a chance on borrowers with lower down payments or weaker credit than they otherwise might consider, allowing persons to buy a home who might not otherwise be able to do so.

It does this by charging fees - a flat 1.75 percent of the loan amount upfront, and a monthly premium equal to 0.5 percent of the loan each year. For this reason, and because FHA loans typically charge a slightly higher interest rate than conventional 30-year loans, the FHA has traditionally been regarded as a lender of last resort for those who couldn't qualify elsewhere.

However, with both housing prices and mortgage rates as low as they are, combined with an $8,000 tax credit for first-time buyers, many borrowers are deciding that buying a house with an FHA loan is still a bargain, compared to what they might have to pay for a conventional loan or in housing prices a few years down the road.

Only available for modestly priced homes

FHA loans do have some other downsides. While there's no limit on personal income, unlike some other government-backed programs, there is a maximum loan value that varies by region. In many parts of the country, the biggest loan the FHA will allow is about $270,000 for a single-family home, although in more upscale communities the maximum can go to nearly $730,000.

FHA loans also have strict property assessment procedures and can take longer to be approved than a conventional loan - sometimes 45 days or more. And while you can qualify for an FHA mortgage with bad credit, expect to pay a premium on your interest rate compared to other FHA borrowers with better financial histories.

On the upside, though, an FHA loan can be a great deal for a borrower who can't come up with the 20 percent down payment needed to avoid paying for private mortgage insurance. The 0.5 percent annual rate charged for insurance by the FHA is comparable to or even less than what you'd pay for PMI, and while the 1.75 percent fee upfront may seem steep, the FHA also limits what lenders can charge in closing costs, so you don't have to worry about getting socked with excessive fees there.

Closing costs and fees can also be rolled into the loan principal, so you don't have to pay them upfront. And unlike many other loans, the 3.5 percent down payment can be provided by a relative, government agency or another third party, although the seller may not do so.

Can apply $8,000 tax credit toward purchase

You can also apply the current $8,000 tax credit for first-time homebuyers to the purchase price, although it cannot count as part of the 3.5 percent down payment. However, it can be used to cover closing costs or increase your down payment above 3.5 percent, which may qualify you for a lower interest rate and at least will reduce interest payments over the lifetime of the loan by reducing the principal at the onset. Just remember, to qualify for the credit, you must close on the property by Dec. 1, 2009, unless the program is extended by Congress.

FHA mortgages also have no prepayment penalties and are always "assumable," meaning that if you decide to sell the house, you can do so by transferring the balance of the mortgage to the buyer, on the same terms. This may come in handy a few years down the road if you run into financial troubles or simply want to sell at a time when prevailing mortgage rates are higher than they are today.

Rates vary by lender

Because FHA loans are not offered by the FHA itself, but through authorized private lenders, there is no set or fixed "FHA mortgage rate." Instead, the rate varies by lender and depends on the borrower's credit profile. The same as a conventional loan, it pays to shop around various mortgage lenders or mortgage brokers to find the best rate.

Although the Department of Housing and Urban Development, the FHA's parent agency, offers some information on FHA mortgages, most detailed information is provided by individual FHA lenders. Check with participating mortgage lenders and brokers in your area for more specific information about an FHA loan for your particular needs.

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