FHA loans have flexible guidelines. You can even get a loan with a credit score as low as 500. That opens up doors for a lot of people that otherwise wouldn’t qualify for a mortgage. But, what’s the catch? There has to be something, right?
First, let’s look at the FHA guidelines so you can understand how easy it is to qualify. FHA loans require:
- Minimum 580 credit score with a 3.5% down payment
- Minimum 500 credit score with a 10% down payment
- Maximum housing ratio of 31%
- Maximum total debt ratio of 41%
- Proof the home is your primary residence
- No defaulted federal loans in the past
- Stable income and employment
That’s all FHA loans require. You don’t need to be a veteran, live in a rural area, or be a first-time homebuyer. You can even accept 100% of your down payment as gift funds if you have a credit score of at least 580.
It all sounds amazing, so there has to be a catch, right? We discuss the potential downsides below.
The Downsides of the FHA Loan
So you can get a loan with a low credit score and high debt ratio. But what do you have to do in exchange for the loan?
It comes down to mortgage insurance. Lenders take a big risk lending you money when you have low credit scores and high debt ratios. That’s a true recipe for default. In exchange for the flexible loan, the FHA requires you to pay mortgage insurance. This isn’t mortgage insurance like you would pay on a conventional loan. It’s insurance you pay for the life of the loan. In other words, unless you refinance the loan or sell the house, you’ll pay mortgage insurance.
You pay the mortgage insurance directly to the FHA. They charge it in two ways:
- Upfront mortgage insurance
- Annual mortgage insurance
Upfront mortgage insurance is a one-time charge. You pay it every time you take out an FHA loan. Right now, borrowers pay 1.75% of the loan amount. If you have a $200,000 loan, you pay $3,500 at the closing. You can get assistance from the seller, a family member, or a down payment assistance program if you don’t have the funds. You may also be able to wrap it into your loan amount. Just be careful if you choose this option. When you increase your loan amount, you increase your monthly payment as well as the amount of interest you pay over the life of the loan.
Annual mortgage insurance is what you pay for the loan’s term. It’s equal to 0.85% of your loan amount. You pay this amount based on the average principal balance for the year. This means the amount you pay does decrease slightly every year as you pay down the principal balance, but you’ll pay premiums until you pay the loan off in full.
Compare this option to conventional loans. Yes, you have to have higher credit scores, but you are rewarded for those higher scores with mortgage insurance you can cancel. You can put down as little as 5% on a home and you will pay mortgage insurance. But, you can cancel it once you owe less than 80% of the home’s original value. In order to get out of FHA mortgage insurance, you must refinance into a conventional loan.
The final ‘catch’ or downside is the fact that some sellers don’t like FHA loans. They still believe the common myths that sellers have to pay all of the closing costs or that their home has to be perfect. Neither is true, but it’s a reputation that FHA loans have carried through the years. You may come across sellers that won’t accept FHA financing, which may limit the houses you can buy.
The FHA Advantages
Of course, FHA loans have so many advantages that greatly outweigh the downsides including:
- Low down payment requirements
- The ability to accept gift funds
- The ability to get financial assistance from the seller
- High debt ratio allowances
- Low credit score requirements
FHA loans are among one of the most flexible programs available today. It’s worth looking into and comparing it to your other options, especially if you don’t have the credit score (typically at least a 680) to qualify for conventional financing. FHA financing is often the next best option for borrowers.