Buying a home is likely the biggest purchase you’ll ever make, and a big roadblock to doing so is saving up for the down payment. Many people assume that a 20% down payment is required, which can put a lot of people off buying a home altogether.
The good news is that many different government-backed programs allow those with smaller down payments to buy a house. The traditional 20% down expectation is no longer a requirement.
One government-backed loan program is the FHA loan program. This is a popular method of buying a home that makes it easier for people with low to moderate income to get a foot on the property ladder.
What is an FHA loan?
Federal Housing Administration (FHA) loans are mortgages insured by the government. The government does not lend the money itself, instead, FHA-approved lenders such as banks do.
The main benefit of an FHA loan is that it requires a lower minimum down payment when compared to conventional loans.
Applicants with lower credit scores can also benefit from FHA loans since the rules are more lenient in this regard as well. This means that someone who would be turned down for a conventional loan may have better luck with an FHA loan. As a result, they are popular with first-time buyers on lower incomes as it’s one of the most affordable mortgage options available.
How do FHA loans work?
As FHA loans are insured by the government, this means that lenders can afford to be a bit more lenient over eligibility requirements. Lenders have more confidence to approve mortgages thanks to the government’s assurance.
However, like any loan program, there are pros and cons to think about before you decide to apply for an FHA loan.
Pros of FHA loans:
- Low down payment requirements (as low as 3.5%)
- Lower credit scores are accepted
- Down payment help is allowed if you receive help from gifts or down payment assistance
- Sellers can help with the closing costs of an FHA loan
- No income limits to applying for an FHA loan
Cons of FHA loans:
- Mortgage insurance is usually required for purchases with low down payments
- There’s a limit on how much you can borrow, which depends on the area of the property
How to buy a home with 3.5% down
The eligibility requirements for an FHA loan are much more relaxed than other loan types. However, there are still some criteria you need to meet before you can get a loan approved.
For the down payment, you must be able to put at least 3.5% down. However, you can only make a down payment this small if you have a credit score of at least 580. A lower credit score won’t necessarily stop you from getting an FHA loan, but any lower than 580 means you will have to put down a bigger down payment.
Beyond the down payment and credit score requirements, applicants must be able to prove they have sufficient income to cover the monthly repayments. Lenders will look at proof of income such as pay stubs, bank statements, or tax returns to determine affordability.
Lenders will also want to know details of any debts you have to ensure you can afford the mortgage. Each lender will have its own debt-to-income (DTI) ratio limit, but most will prefer a DTI ratio below 40-50%.
Should you take out a 3.5% down loan?
Putting a small down payment on a house purchase seems ideal and can help you become a homeowner much sooner than you thought.
The main downside to this is that any down payment below 20% usually requires private mortgage insurance (PMI).
PMI is used to protect the lender’s investment in the home rather than the homebuyer. The costs usually range from 0.25% to 2% of the total loan balance per year and this depends on the size of the down payment, how big the loan is, your credit score, and the total loan term.
This means that the costs can vary greatly and it could be a big expense to pay each month that many people don’t factor into their budget.
However, when weighed up against increasing rental costs and the knowledge that you will be building equity in the meantime, many people believe that owning a home sooner is more beneficial.
Another consideration is the down payment’s effects on your loan’s interest rate. With a lower down payment, you could face higher interest rates.
However, it’s up to you to decide whether it’s worth it to buy a house sooner rather than later.