FHA loans can be a good option for first time home buyers who do not meet the criteria for a conventional loan. They are not without their drawbacks, however. You will want to evaluate the pros and cons of FHA loans before you decide if this is the best choice for you.
What is an FHA Loan?
Congress established the Federal Housing Administration (FHA) in 1934 as a branch of the US Department of Housing and Urban Development (HUD). The purpose of the FHA was to encourage homeownership which, at the time, had fallen to an all-time low. Still reeling from the Great Depression, only about 1 in 10 Americans could afford to buy a home.
The FHA encourages homeownership by providing mortgage insurance to qualified lenders. Because these loans are backed by the FHA, lenders are more willing to provide them to individuals who might otherwise be deemed too risky. Buyers with lower credit scores or down payments, for example, may still qualify for an FHA loan and be able to buy their first home.
Who Qualifies for an FHA Loan?
In order to be eligible for an FHA loan, you must meet the following criteria:
- You must have a credit score (FICOⓇ) of 500 to 579 and 10 percent down payment OR a FICO score of 580+ and a 3.5 percent down payment
- You must provide proof that you have been employed consistently for the last two years
- You must provide documents to show you have been receiving income for the last two years (pay stubs, tax returns, etc.)
- You must spend no more than 31 percent of your gross income on housing costs (this is your front-end debt to income ratio)
- You must spend no more than 43 percent* of your gross income on total monthly debts, including mortgage, credit card payments, student loans, etc. (This is known as your back-end debt to income ratio)
- If you have had a bankruptcy, you must wait 1-2 years before applying
- If you have had a home in foreclosure, you must wait three years before applying**
*Some lenders may allow up to a 50 percent back end debt to income ratio
Pros and Cons of FHA Loans
Pros of FHA Loan
Lower Down Payment Requirements
In many conventional loans, borrowers must save up at least 20 percent for a down payment. This can be a deal breaker for many individuals, especially first time buyers who don’t have equity in a current property to bargain with. With an FHA loan, your down payment may be as little as 3.5 percent (so long as your credit history is fairly solid).
Credit Score Leniency
FHA loans allow those with rockier credit history to still qualify for a loan. Conventional loans typically require a FICO score of at least 620. FHA loans will consider credit scores as low as 500, so long as other requirements are met.
Better Interest Rates
As a rule, FHA loans tend to have better interest rates when compared to conventional loans. They are still determined by the overall housing market, but other factors, such as your income, outstanding debt, location, and amount borrowed will determine the final rate.
Lower DTI Requirements
Conventional loans usually max out at 36 percent when it comes to debt-to-income ratios. You are eligible for an FHA loan with a DTI ratio of 43 percent or more, in some cases (up to 50 percent).
Cons of FHA Loans
At this point, you may be wondering what the catch is for an FHA loan. As with any financial arrangement, there are certain drawbacks to consider:
Higher Insurance Premiums
Since they are typically awarded to objectively “riskier” clients, FHA lenders require two separate insurance premiums. The first is an upfront sum that must be paid at the time of closing (it is often rolled into closing costs).
The second is an annual insurance premium. If you have provided at least ten percent in a down payment, your annual insurance premiums will end after 11 years. If your down payment was less, you will be paying this insurance for the entire life of your loan.
By contrast, conventional loan insurance premiums (Private Mortgage Insurance) end once you’ve built up 20 percent in equity. Still, PMI rates can be just as high or higher as FHA rates, depending on your credit score and other factors.
Lower Loan Amounts
FHA loan amounts are restricted to a certain amount, depending on the area in which you live. In 2022, the loan cap amount for an FHA for a single family home in a high income area is $970,800. The low-income cap is $420,680. You will want to thoroughly research how much you can borrow based on your income and the area you are looking to purchase in.
The FHA Stigma
Because FHA loans are often given to buyers with lower down payments or credit scores, there is often an unfair stigma attached. Sellers may be more hesitant to accept an offer from a buyer with an FHA loan versus a cash offer or a conventional loan. This is not always the case, but it is something to consider.
Ready to Buy Your First Home in Colorado?
If you are ready to make the exciting journey into homeownership in Colorado, contact Brenda Kellogg Meyer. Brenda has experience working with clients with all budgets and loan types. Her compassionate approach helps keep the process fun and stress-free while you shop for your dream home. Call or go online today to get started!