We quit searching high and low for a much-obsessed-over house buying guide. Because, unfortunately, one…
How do you know when you are ready to buy a house? Is it when you are already out of school? Can you only purchase real estate when you’ve saved a lot of money? Or is it best only when you’re starting a family?
The choice to get our own home is really up to us. The factors that will affect our decision will mostly be in our control. But, on the other hand, some of the circumstances affecting our readiness to do so will probably need more effort.
The good news is, we have government programs that can help us get closer to this goal.
Today, there are mortgages backed by the federal government that you can apply for even with lower credit scores. It sounds unbelievable, but it’s absolutely true!
You don’t need a credit score in the 700s or 800s to qualify for a mortgage. If you haven’t heard of the FHA loan program before, this article is for you. Read on.
What are FHA loans?
Let’s start with the basics.
If you don’t have the cash needed to pay for a real estate transaction, you can use a mortgage to finance the purchase.
A mortgage is a secured loan where the house acts as the collateral, so if you default on your payments, the bank or lender gets your home to recoup the loss. You can pay for a home loan over several years or decades. Some mortgages require a down payment, yet some do not, but all mortgages are charged to the borrower with interest. So if you are buying a house through a mortgage, this means you are buying it at a higher price.
There are also closing costs. Apart from a possible down payment, you’ll need to pay for origination fees, broker’s fees (if you hire a mortgage broker), appraisal fees, and sometimes, insurance.
There are many types of mortgages. But, in particular, this article will focus on the popular first-time homebuyers’ mortgage: the FHA loan program.
The Federal Housing Administration (FHA) Loan
Mortgages have been around for quite a long time, but almost a century ago, only those with good to exceptional credit had the privilege to apply for home loans. Compared to how it is nowadays, the system was also very biased against racial minorities.
The Federal Housing Administration (FHA) is an agency under the Department of Housing and Urban Development (HUD) formed in 1934. It focuses on ensuring mortgages. Because the FHA has the lender’s back in this transaction, this lessens the risk that the lender takes in when a loan is approved. So if a borrower defaults on an FHA mortgage, the lender is protected from loss by the government agency. With this confidence, the lender is more willing than usual to accept a borrower with a lower credit score.
Before FHA loans, there was only one standard type of mortgage loan. There may already be a lot of government-backed loans in the market now, but FHA loans were the first.
Annual Mortgage Insurance Premium
There is one main difference between FHA loans and traditional Fannie Mae or Freddie Mac mortgages.
As we’ve mentioned, it is more common to pay for mortgage insurance when you borrow for this type of loan. FHA mortgage insurance is a kind of protection that helps the lender, not the borrower, due to the risk involved.
Traditional mortgages or conventional loans charge you for private mortgage insurance when you make less than 20 percent down payment. However, once you’ve paid enough on your loan to reach 20% home equity, the lender stops including this charge in your monthly amortization.
On the other hand, there is no way to avoid paying for mortgage insurance for FHA loans, regardless of loan-to-value. FHA mortgage insurance is also split into two different kinds. An upfront mortgage insurance premium is charged at closing, and you also have to pay for a monthly mortgage insurance premium after the loan is closed.
Depending on your down payment amount, you either have to pay for the monthly insurance for eleven years or the whole life of the loan. Of course, the longer you pay for FHA mortgage insurance, the more expensive your loan, so you don’t want to pay for it for the entire thirty years. But, on the other hand, if you’re going to pay for insurance for only eleven years, loan-to-value must not exceed 90 percent.
With this bit of quirk, it’s easy to see why more people might prefer a conventional loan over an FHA loan. After all, who wants to pay mortgage insurance? However, today, the minimum credit score required for a traditional loan is 620, so more people will qualify for an FHA loan.
If you need to make a home purchase and cannot apply for any other type of mortgage, we suggest getting an FHA loan. Once you are approved and start paying your monthly amortization, your credit score will eventually improve, provided you are also keeping healthy financial habits. Thus, maintaining a mortgage helps your credit score. When you reach a credit score of at least 620, you can then look into getting a refinance for your FHA loan to convert it into a conventional loan.
If you can do those steps before you reach eleven years of paying for your house, your loan will have become much cheaper due to the refinance.
We need to iterate, however, that refinancing a mortgage entails paying another round of closing costs. Therefore, even if you would be saving money from removing mortgage insurance, it will be better to assess if such a move will be favorable to your situation.
How hard is it to get an FHA loan?
It is popularly known that the FHA loan is meant for potential borrowers buying their first homes. Still, contrary to this belief, most Americans are eligible for this mortgage, regardless of how many times you’ve bought a house.
It is easier to get approved for an FHA loan than a conventional mortgage, though this is still relative to your position. A mortgage application is still a complex process, and every lender has the right to demand unique requirements. However, you should prepare some general things if you want to qualify for an FHA loan.
FHA Loan Requirements
1 – Minimum Credit Score
Only 1% of the American population has a credit score lower than 500. Since the minimum credit score required for an FHA is only 500, this means that almost everyone satisfies this first qualification.
2 – Down Payment
FHA loans are one of those loans that oblige you to make a down payment, but the minimum amount varies according to your credit score.
Borrowers with credit scores starting at 500 to 579 must pay a minimum of 10% of money down. Otherwise, with a 580 credit score or above, you have the prerogative to deposit 3.5 percent. You want to keep in mind, though, that if you pay less than 10 percent, monthly mortgage insurance is paid for the whole life of your loan. So while you may want to refinance your FHA loan before the eleven-year mark, this is still something in your future that can be affected by events you can’t control.
It is also wiser to pay more money down because you’ll eventually pay less in interest and gain home equity faster.
3 – Debt-to-Income Ratio
Aside from credit score, there is another little number that will matter to your mortgage application. It is called the debt-to-income (DTI) ratio.
Your DTI represents how much debt you are paying for and how much money it takes from your monthly income.
For FHA loans, the ideal DTI to have is a figure far below 43 percent. However, depending on how good your credit score is or how much money you’re willing to pay down, 43% is the highest DTI that FHA lenders might accept.
It is important to note that when underwriters compute for your DTI, they only use minimum payments quoted in your statements. For example, if you owe your credit card $1,000, but the minimum charge is just $150 for the month, you only have to note $150 when you compute for DTI. Utilities and such expenses would not count in this calculation unless you borrowed money to pay for these transactions.
4 – Verifiable and stable employment
Another part of your background that the FHA lender will look into is your employment history.
Your monthly payments are expected to come from future income earnings. So regardless of how much money you have saved, if you get a mortgage to pay a home purchase, you will need to have stable employment.
The lender will want to see that you’ve stayed at least two years in your workplace because this tells them that income is steady and you have a well-built career.
They’ll be able to verify your employment through tax records and pay stubs, so you’ll want to prepare documentation.
5 – Property Appraisal
Since the FHA ensures the mortgage, the agency has a say in your house purchase. Let us explain.
An FHA loan requires you to get the house assessed by an FHA-approved appraiser to check for possible problems. In case you default, the lender doesn’t want to be stuck with an unsellable house.
The FHA assumes that you do not have the capability of doing house repair on your own, and they also do not want you to eke out more money for home improvement (although you can make this choice later on). If you are applying for a 30-year mortgage, they’ll want to know if the house is durable enough to meet this period.
The appraiser will also evaluate the fair market value of the house you are buying. So you will find out if you are paying too much or you are getting a bargain. If the appraiser deems the house is worth less than the seller’s asking price, the FHA will not ensure the mortgage. So you can either walk away or see if you can negotiate with the seller.
6 – In case of previous bankruptcy or foreclosure
It is common for FHA loan borrowers to have experienced bankruptcy, foreclosure, or both.
These derogatory items can be tough to remove from your credit report. But on the positive end, these do not hinder you from applying for FHA loans. However, you can only use it after a certain period has passed from these events.
If you’ve been through bankruptcy, you need to wait two years before getting an FHA loan. However, for foreclosure, the interim is a little longer at three years.
7 – Primary Residence
Finally, since FHA loans aim to make American homes more affordable, this mortgage is not meant to be used for an investment. Instead, you can only apply for it if you will stay in the house you are buying.
You are obligated to move into your new home within sixty days after closing the loan to confirm occupancy. You also have to live in the house for at least twelve consecutive months.
Note that it is a federal offense to misrepresent yourself as someone staying in an FHA home. If you get an FHA loan and fail to fulfill the primary residence requirement, it can mean prison time.
Should I get an FHA loan?
The FHA loan program is just an option among the myriad of home loan choices you can find on the market. Aside from the Federal Housing Administration, the Department of Veterans Affairs and the U.S. Department of Agriculture also back their types of loans. However, those mortgages have a lot more restrictions despite the absence of a minimum credit score requirement.
To guide you in making this choice, here are some questions you need to ask yourself:
- What is my credit score?
- Aside from an FHA loan, what other types of mortgages are available for me?
- How much money have I saved up to use as a down payment?
- Do I intend to stay in this new house?
- How long do I plan on living in the home?
- Am I in a hurry to buy a property?
- Finally, am I willing to take steps to increase my credit?
Aside from the COVID-19 pandemic, there are many reasons why even FHA-approved lenders will be hesitant to approve borrowers with poor credit scores. However, if you can wait and see if you can improve your credit, this might be an opportunity to choose a cheaper alternative in the future.