An FHA mortgage may be a good choice if you have poor credit history, but make sure that you consider all your options.
An FHA loan is a government-backed mortgage that is insured by the Federal Housing Administration (FHA). The FHA insures loans for FHA-approved lenders to reduce their risk of loss in the event that a borrower defaults on the mortgage. FHA mortgages were created to stimulate the US housing market by making mortgages more accessible.
FHA loans generally have more flexible terms and lenient credit requirements compared to conventional mortgages and this is why they are popular among first-time home buyers. However, interest rates and fees for FHA mortgages- such as mortgage insurance premiums- are generally higher compared to traditional loans. FHA mortgages are available with both fixed rates or adjustable rates.
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How do FHA loans work?
The FHA agrees to pay the FHA-approved lender if the borrower defaults on the mortgage. As a result, the FHA charges borrowers a fee in the form of an insurance premium and an ongoing maintenance fee. If the borrower defaults on the mortgage, the FHA uses the insurance premium to compensate the lender.
What are the pros and cons of an FHA mortgage?
Pros
- Lower down payments. Some FHA mortgages require a down payment as low as 3.5% which can make the property market more accessible, particularly for first-time home buyers or borrowers with poor credit. However, keep in mind that this may be offset by a higher interest rate charged throughout the life of the loan.
- Reasonable credit requirements. Borrowers may qualify for a mortgage even if they don’t have a long credit history. Borrowers who have bad credit, have undergone bankruptcy, or have been foreclosed upon may still qualify for an FHA mortgage.
- Assumable. FHA loans are often assumable which means that if you decide to sell your property then you can “assume” your existing loan.
Cons
- Higher costs. An FHA mortgage often has higher fees compared to a traditional loan. For instance, an FHA loan requires two different types of mortgage insurance premiums (MIP) to be taken out, including the upfront MIP and the annual MIP.
- Lower loan amounts. Many FHA loans have lower loan amounts which means you may not be able to borrow as much as you need to secure a property.
- Limited options. There aren’t many FHA loans available on the market which means your options are limited.
What is the FHA Mortgage Insurance Premium (MIP)?
A Mortgage Insurance Premium (MIP) protects lenders in the event that you default on the loan. FHA requirements include mortgage insurance for borrowers making a down payment of 20% or less. There are two main types of MIP:
- Upfront MIP. The upfront MIP requires borrowers to pay 1.75% of the mortgage. For example, if you take out a mortgage of $400,000, then you would need to pay $7,000 insurance upfront.
- Annual MIP. The ongoing MIP is charged monthly and is based on your loan-to-value (LTV) ratio, loan size, and loan term.
Will I qualify for an FHA mortgage?
To qualify for an FHA mortgage, you will typically need to meet the following criteria:
- Steady employment history. You will need to supply evidence of your employment history including recent statements which demonstrate your income and employment status. Generally, lenders like to see at least 2 years of steady employment history in the same field prior to mortgage application.
- Minimum down payment. To apply for an FHA loan, you’ll need to make a minimum down payment of 3.5%.
- Primary residence. FHA mortgages are only available for properties that are your primary residence.
- Appraisal. To qualify for an FHA loan, you must have the property appraised by an FHA-approved appraiser.
What are the credit score and income requirements for an FHA mortgage?
Although lenders will review each application on a case-by-case basis, the FHA requires a minimum credit score of 500 for its mortgages. If you’re making the minimum down payment of 3.5%, you’ll typically need a minimum credit score of 580. If you don’t have any credit history, you may still be able to qualify for a FHA loan. Instead of reviewing your credit history, the lender will observe other records such as utility or rental payments.
When it comes to income limitations, there is no minimum or maximum. However, the borrowers’ front-end ratio (mortgage payment plus HOA fees, property taxes, mortgage insurance, homeowners insurance) typically needs to be less than 31 percent of their gross income.
Compare FHA against other loans
case
Adrienne weighs her FHA mortgage against a conventional loan:
Adrienne Fuller
Publisher
My husband and I took out an FHA loan in May 2015 in San Diego County. Because we put only 5% down, we pay almost $264 a month in private mortgage insurance — which feels like a fee down the drain.
At one point, I called Freedom Mortgage to ask whether we could get PMI removed if I paid the cash to get up to 20% equity. “After five years,” they answered. I did not realize this: In California at least, the FHA premium stays on up to five years and 20% equity.
I did the math on refinancing to a conventional loan and coughing up the remaining 15% to reach a 20% down payment. Because I was two years into my loan already, I had three years left of PMI to pay:
| Months remaining | Monthly Payment | Total cost | 36 | $264 | $9,504 |
|---|
If I refinanced to a conventional mortgage, I’d have to pay closing costs of about $2,500, plus I might qualify for a higher interest rate, because it’s a different type of loan. If my new loan was even a half percent higher than my current loan, I might end up paying $40,000 in extra interest over the life of the loan. It sounds like a bad tradeoff to save $9,500 in insurance.
We opted to keep the loan the way it is. And when the five years are up, we’ll make sure the PMI is removed.
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