The FHA Loan: Buy a Home with 3.5% Down
Homeownership is becoming increasingly hard to come by for the middle class and lower-income individuals. Many families are struggling to afford the high monthly payments on conventional mortgages, let alone the hefty down payments needed to qualify for one to begin with.
Recognizing the need for more accessible loan options, the U.S. Federal Housing Administration (FHA) works with lenders to lower barriers to homeownership. Specifically, the FHA backs mortgages, creating an insurance policy that protects lenders in the event the borrower fails to make his or her loan payments.
As a result, lenders are more willing to issue loans—especially to “riskier” customers with lower credit scores, incomes, and financial resources. Let’s take a deeper look at what FHA-approved mortgages can do for borrowers, and how qualifying for one can help you buy a home.
Want your own single-family home but can’t afford 20% down? No worries. For the FHA, a mere 3.5% will do.
FHA-approved loan basics
For starters, borrowers can be approved for FHA-backed loans with a credit score as low as 500, though you’ll have to put up a minimum down payment of 10% to qualify. If your credit score is 580 or above, the minimum required down payment falls to just 3.5%—meaning you can put as little as $10,500 down for a home with a $300,000 purchase price.
Contrast this to non-FHA mortgages, which require credit scores of at least 620–640 and 5% down. And if you want to avoid private mortgage insurance (PMI) on a conventional loan, you’ll have to shell out enough money for 20% down.
In addition to these benefits, interest rates with FHA-approved mortgages are usually on par with rates for conventional loans, meaning you won’t be penalized for putting down less money or having a lower credit score. So, what’s the catch, and what should you be aware of before you reach out to lenders for an FHA loan?
Mortgage insurance
The catch is that you’ll have to pay a mortgage insurance premium (MIP) on an FHA loan if you only put 3.5% down. But this doesn’t mean you’ll be at any disadvantage to borrowers opting for conventional home loans, since an FHA loan’s MIP is essentially equivalent to a conventional mortgage’s PMI. In short, mortgage insurance is unavoidable if you’re looking for a mortgage with a lower down payment.
If there is a disadvantage unique to FHA-backed loans, it’s that your closing costs might be higher than that of a conventional mortgage. This is because a certain part of the MIP, called the upfront mortgage insurance premium (UFMIP), is paid upfront—right at closing. It’s equivalent to 1.75% of the loan amount; on a $300,000 loan, that’d amount to an additional $5,250.
If you can’t afford to pay the UFMIP at closing, you can opt to finance it instead. That means the UFMIP will be added to your total loan balance, extending the duration of your mortgage. While that means you’ll have to pay more in interest, it also means you’ll be able to own a home with less money out-of-pocket.
The good news
On a positive note, neither MIP nor PMI will stick around forever. Once you pay off enough of your mortgage, you can request that your mortgage insurance be canceled. For an FHA loan, you can remove your MIP once the balance of your loan drops below 78% of the purchase price of your home.
On a conventional mortgage, your loan balance must be lower than 75-80% of the home’s purchase price before you can get rid of PMI. Though the exact loan-to-value threshold will vary depending on your lender, it is usually never above 80%.
Once you cancel your MIP or PMI, you’ll never have to pay mortgage insurance again for the lifetime of your loan. However, you may be forced to pay mortgage insurance if you cash out, re-finance into a new loan, or purchase a second home—and your home equity falls below 20% of the purchase price.
If you pay off enough of your mortgage, you won’t have to pay mortgage insurance anymore.
Can anyone get an FHA loan?
While there are minimum credit score and down payment requirements, there’s no maximum—so even higher-income households looking to finance the purchase of more expensive homes will qualify.
In particular, the FHA will even insure jumbo mortgages—loans exceeding the conforming single-family baseline loan limit of $548,250 in 2021. While jumbo loans come with slightly higher interest rates, they’re the only option if you’re looking to buy an expensive home and need to borrow above the conforming loan limit. And when you get an FHA-backed jumbo mortgage, you once again unlock access to down payments as low as 3.5%, meaning you will only need to have $35,000 on hand to afford a $1,000,000 property.
Should you get an FHA loan?
Now that you know that you can get an FHA-insured loan, should you? On one hand, it’s a great option to consider if you’re low on cash but want to become a homeowner now. After all, owning your home comes with a trove of benefits. You’ll be able to renovate your space however you like, build wealth in the form of home equity, and unlock access to a sense of security and peace of mind that comes with knowing that you live in a place you get to truly call your own.
On the other hand, borrowing money isn’t free. Putting a lower down payment on a home means you’ll have to borrow more—exposing you to higher interest rates, monthly mortgage payments, and possible mortgage insurance costs. It may mean that you’ll have less discretionary income to spend on other things you like, and might, in a worst-case scenario. put you at risk of missing mortgage payments if you are laid off, fired, or become disabled and can no longer work.
Wrapping things up
The FHA guarantees loans in order to ensure that aspiring homeowners can realize their dreams of affording a home. FHA-backed loans come with more relaxed underwriting standards as compared to conventional loans, meaning borrowers with lower credit scores and people who want to put less money down can both get access to mortgages.
However, FHA loans come with certain quirks, including the possibility of having to pay a mortgage insurance premium—a portion of which must be paid upfront. Nonetheless, FHA loans remain a useful option for all kinds of buyers who want to make the jump into homeownership—whether they are a first-time homeowner or a family looking to upsize into a larger home in a better school district. Either way, FHA loans offer more Americans than ever before the opportunity to enjoy one of the greatest and most important purchases in life—their own home.
Will you be one of them?
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