Is an FHA loan a great option for first-time homebuyers?

31 Jan

FHA loans can be a great option for first-time homebuyers. They often offer a fantastic interest rate as well as a lower down payment requirement. Due to the fact that these loans are backed by the Federal Housing Administration, interest rates can drop down as low as 3.5 percent.

While a traditional mortgage usually requires a 20 percent down payment, down payments on a FHA loan can go as loan a 3.5 percent, depending on your credit rating. This can be a huge help to young home buyers who are saddled with student loan or credit card debt. 

Your Credit Score is Important

How low your down payment requirement can get revolves around your credit score. It is the biggest factor the FHA considers when looking at a loan. If your credit score is 580 or higher, the minimum required for a down payment can be as low as 3.5 percent. If your credit score falls below that you will need to bring 10 percent to the table to qualify for an FHA loan. 

This difference can have huge implications for potential homebuyers. As an example, if the home you are considering is priced at $250,000 the down payment at 3.5 percent is only $8,750 but jumps up to $25,000 if your credit score is less than stellar. This is a $16,250 spread which is a significant amount of money to save. 

While FHA loans are backed and insured by the Federal Housing Administration, they are issued by regular mortgage lenders who have been approved by the FHA. While these loans come with a variety of benefits, there are requirements homeowners have to meet even after their loan is approved and the biggest one is a Private Mortgage Insurance (PMI) requirement that stays in place for the life of the loan. 

Mortgage Insurance Requirements for FHA Loans

FHA loans differ from a traditional loan by requiring homeowners to pay mortgage insurance for the entire life of the loan. PMI is typically required if a home buyer has less than 20 percent down. This is due to the fact that the lender is taking on more risk, if the lender defaults on the loan, the PMI will make the lender whole. 

These loans are designed for low to moderate income people which means that in order to get some of the perks (lower down payment, lower interest rate) home buyers have to deal with somewhat stricter requirements and loan caps. 

A traditional loan allows a homeowner to stop paying for PMI once they have 20 percent equity in the home, an FHA loan on the other hand requires PMI for the life of the loan or until you refinance to a traditional loan or sell the home. 

PMI insurance on an FHA loan work a bit differently than a traditional loan, it requires two premiums:

Upfront Mortgage Insurance Premium: FHA loan applicants are required to pay 1.75 percent of the loan amount when they get the loan. This premium can be rolled into the loan, so you don’t absolutely have to come up with this money upfront. Using our $250,000 example this comes to $4,375.

Annual Mortgage Insurance Premium: This premium is due annually and is either 0.45 (15-year loan) percent of the loan amount or 1.05 (30-year loan) depending on the term of the loan. Using our $250,000 example, this breaks down to $1,125 for a 15-year loan or $2,626 for a 30-year loan. This amount is usually broken down into monthly payments. 

Unfortunately, this premium must be paid for the life of the loan, not just until you have 20 percent equity. In many cases, if your finances and credit score can handle it, refinancing to a traditional loan after your hit the 20 percent equity mark is a good idea. 

Down Payment Gifts and Loan Caps

It is possible to get down payment gifts from friends, family members and others if you don’t have enough of a down payment but there are rules as to who can gift money.

Acceptable Gifts:

  • Friends
  • Family members
  • Labor unions and employers, 
  • Non-profit organizations 

Most states also offer assistance programs for down payment help for both for both first-time and low-income home buyers. 

Unacceptable Gifts:

  • Homebuilders
  • Sellers
  • Real estate agents or brokers
  • Anyone who has a vested interest in selling the house

FHA loans also have loan caps that are revised on a yearly basis and vary depending on where you are looking to buy a home. Here are the current limits:

The upper limit for FHA loans on single-family homes in low-cost counties is currently $331,760. This is the largest FHA loan that can be taken out in areas that are considered low cost markets. As an example, Dubuque County in Iowa is a low-cost market so the top FHA loan is limited to $331,760.

However, if you are looking to buy in San Francisco, $331K is not going to go far. In high-cost markets such as this, the limit jumps up to is $765,600. This is the maximum FHA loan amount anywhere in the country. 

Other markets may fall somewhere in the middle. A good example of this is Denver in Colorado where the maximum FHA loan amount is $575,000.

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