FHA Loans 101
September 12, 2011
An FHA loan is one of the tools available if you want to buy a home but don’t have much money for a down payment. I actually bought my home with the help of a FHA loan. However, it is important to consider the pros and cons of a FHA loan before jumping in.
What is an FHA Loan?
The FHA loan is backed by the Federal Housing Administration. With a FHA loan, the government guarantees the loan, so that a lender is at a lower risk should you default. FHA loans were not terribly popular before the financial crisis of 2008, since it was possible to get 0% down home loans fairly easily.
Now, though, with many mortgage lenders tightening requirements, the 3.5% down payment requirement for a FHA loan seems attractive to many. It is important to note that the 3.5% down payment option is only available to those who have a credit score of at least 580. If your credit score is between 500 and 579, you will need a 10% down payment. FHA loans are not available to those with credit scores are less than 500.
You do need to show sufficient income to be approved for a FHA loan, and some of the guidelines are stricter than what was available prior to the financial crisis.
Private Mortgage Insurance
When you borrow for a mortgage that’s not an FHA loan, banks and other lenders ask for at least 20% down on the home to protect themselves against a default. If you don’t have enough money to make a 20% down payment, they may still lend you the money but you’re required to buy private mortgage insurance.
Private mortgage insurance (PMI) usually amounts to between 0.5% and 1% of the entire loan amount each year. If you have a $200,000 loan, and the PMI is 0.75%, you will pay $125 a month each year until your loan to value ratio drops to 80%. Although the existence of PMI does extend home ownership as an option to many that might not be able to afford it, that monthly fee can add up to a big expense for the homeowner.
PMI vs FHA Insurance Premiums
If you borrow money with an FHA loan, you don’t pay PMI but you do have to pay into a fund that guarantees FHA loans. This fund is an escrow account setup by the U.S. Treasury Department. Lenders are still exposed to the risk of default (even more so since the down payment is so small) but the Federal Housing Administration is agreeing to back the loan with the escrowed funds paid into by FHA borrowers.
When you have a FHA loan, you will need to pay 1% of the loan amount up front (Upfront Mortgage Insurance Premium), and then an annual premium depending on the term of the loan and how much you put down. (You can add the 1% up front premium to the loan amount.) You have to pay the premium for at least five years, and you stop paying the premium once your loan to value ratio reaches 78%.
The table below is based on the rates on the FHA website for new loans after April of 2011. The table shows the annual premium for an FHA loan according to the length of the loan and the size of your down payment.
Loan Term <= 15 Years > 15 Years
< 5% 0.50% 1.15%
Down Payment >= 5% 0.50% 1.10%
< 10% 0.50% 1.10%
>= 10% 0.25% 1.10%
So, to figure out how much mortgage insurance you’d pay with a conventional loan vs FHA loan you’d first figure out your monthly premium based on your loan term and the size of your down payment. Multiply that times the number of months it would take you to pay down the loan to less than 78% loan to value ratio. Then add that number to the amount of your Upfront Mortgage Insurance Premium and you’ll have the total cost of insurance for your FHA loan.
There are many variables involved in this decision. In addition to the term of your loan and the amount you have to put down, you also have to factor in what the appraised value of the property will be. In terms of determining if you can afford the monthly payments, you’ll also need to know what interest rate you’ll pay. The combination of the interest rate and the term of the loan will determine what your monthly payments will be – which you need to know in order to figure out how long it will take you to pay down your loan to the point where you have at least 20% equity in your home. I haven’t seen a good calculator that compares a conventional loan vs an FHA loan but if I find one I’ll be sure to write about it.
Saving Up for a Down Payment
Right now, with tighter lending standards, a FHA loan can be quite tempting. You have a lower down payment requirement — and a lower credit score requirement. However, you might end up paying more. A bigger down payment can save you money in the long run, since you will be financing less, and paying mortgage insurance premiums for a shorter period of time.
What you decide depends on your priorities: Do you want to buy now and long in a lower home price and lower interest rate? Or do you want to save up for a down payment and borrow less? In the end, it depends on whether you want the home now, without saving up, or whether you want to wait until you have a bigger down payment.
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