August 25, 2022
Many people worry that buying a home is out of reach. Factors like a low credit score, high amounts of debt, and little savings in the bank can limit options with a conventional mortgage. Fortunately, the government-backed FHA loan program may be the solution certain borrowers need. In this article we’ll break down the reasons an FHA loan could be right for you.
If you don’t have much credit history
Are you a young first-time homebuyer? It’s possible you haven’t yet built a strong credit history. Your credit report acts as a financial report card documenting your accounts, repayments, and current amount of revolving debt. And the longer your credit accounts are, the more they are considered a reliable picture of your creditworthiness. Without a credit card or loan, credit agencies don’t have enough data to give you a score.
FHA Option: a nontraditional credit report
No credit score isn’t necessarily bad, but it can be challenging to get a conventional mortgage when it comes time to buy a house. That’s where an FHA loan comes in. FHA mortgages are one of the easiest loans to qualify for. If you have no credit history, the FHA may allow you to review a nontraditional credit report with proof of on-time payments for rent and utilities.
If your credit score is low
Late payments, high credit balances, and loan defaults, foreclosures, and bankruptcies are all documented on credit reports and will negatively impact your credit score. While it’s always wise to work to improve your credit score, it can take months, or even years, to bring your score up enough to qualify for a conventional loan with a favorable interest rate. If you’re hoping to buy a house soon, the FHA may be the answer.
FHA Option: alternative credit qualifications
The FHA sets a minimum credit score of 500. But keep in mind, lenders can set their own requirements, called overlays, that raise that minimum requirement. A common overlay is a credit score of at least 620.
To strengthen your FHA mortgage application, you can submit proof of compensating factors to prove your creditworthiness. These include:
- Verified cash reserves - such as stocks, bonds, a money market account, or vested funds in a retirement account
- Minimal housing payment increase - for example, your mortgage payment would be only slightly higher than your current housing payment
- Low debts - such as low credit card balances or a history of on-time payments of small loans
- Residual income - meaning there’s money from your paycheck leftover after paying monthly debts and other expenses
- Substantial nontaxable income - such as child support, public assistance payments, and military allowances
- High earning potential - having a job with a low starting salary but high earnings over time, such as a physician, may work in your favor.
If you haven’t saved much for a down payment
With a minimum down payment of just 3.5 percent, FHA loans are popular options for those with limited savings. It’s even acceptable to use gift funds from a close friend, family member, or organization.
FHA Options: alternative down payment requirements
Your down payment will depend on your credit score:
- If your score is at least 580 you'll need 3.5 percent.
- If your score is 500 to 579, you'll need 10 percent
Can you get an FHA loan with no money down?
Although there is no official “zero down” option like VA loans have, there are ways to get an FHA mortgage even if you don’t have enough savings. This usually occurs through gift funds, where a relative, friend, employer, government agency, or charitable organization provides money for a down payment. It just cannot be expected to be paid back. These gift fund rules are much more lenient than conventional guidelines.
See tips on how to get an FHA loan.
If you want to avoid closing costs
More good news: FHA borrowers can negotiate to have the seller pay up to 6 percent of the property sales price toward the closing costs. These costs are made up of many fees that can really add up, such as:
- Origination fees from the home appraisal, courier fees, and credit checks
- Property taxes
- Escrow fees
Plus, leftover closing costs can sometimes be rolled into the loan – helping you pay as little out of pocket as possible. Just remember to tell your realtor you are interested in an FHA loan so they can negotiate with the seller accordingly.
If your debt-to-income ratio is high
Debt-to-income (DTI) is a ratio lenders look at to ensure you can afford mortgage payments. It proves that even after expenses from other debts, you have enough left in your household budget to cover housing costs.
DTI is calculated by adding up minimum debt payments and dividing that total by your monthly gross (pre-tax) income.
Most lenders prefer a DTI ratio no higher than 43 percent. But some will consider a higher DTI with compensating factors like verified cash reserves, residual income, and increased earning potential. That’s why it’s important to build a relationship with a lender that sees you as more than a number.
When should you not choose an FHA loan?
FHA mortgages don’t make sense for everyone. You may not want an FHA loan if you:
- Have a high credit score
- Have enough savings for a 20 percent down payment
- Want a higher-priced home outside the loan limits in your area
- Don’t plan to occupy the property as a primary residence
- Are looking for a fixer-upper that doesn’t meet the minimum property requirements
There are multiple loan options available and it’s best to compare different mortgage types to decide which is best for you.