Purchasing your first home is one of the most important financial decisions of your life. If you’re currently renting in an expensive housing market, the one thing standing in your way is likely the down payment – easily a six-figure lump sum at the traditional 20%.
But what if you could lower the required down payment percentage to as low as 3.5%? Sounds appealing, right? It’s possible with a Federal Housing Administration (FHA) loan, but you should understand all the facts before signing on the dotted line.
Making Home Ownership Accessible
The FHA loan has been around since 1934, when the U.S. government launched the program to jumpstart a lagging housing market. Since its inception, FHA has insured more than 34 million home mortgages, with 4.8 million single-family mortgages in its portfolio today. FHA loans aim to make home ownership more accessible to all Americans by offering down payments as low as 3.5% and low interest rates for borrowers with low credit scores.
It’s a “government-backed” loan, meaning the government doesn’t actually lend the money – it insures the mortgages. If a borrower can’t repay the loan, the FHA reimburses the lender. This allows mortgage lenders to confidently offer loans to applicants who might otherwise be denied.
Because FHA is providing insurance, borrowers pay a mortgage insurance premium (MIP) – just like any other kind of insurance. Luckily, the U.S. government reduced MIPs for the first time since 2001 this year – an MIP is required for the life of an FHA loan and the expense should be carefully considered.
MIPs are split into two parts:
- Upfront Mortgage Insurance Premium (UFMIP): UFMIP is paid at the time of closing and is equal to 1.75% of your loan. So for every $100,000 of your mortgage loan, your UFMIP is $1,750.
- Annual MIP: Your annual insurance rate varies between .7 and .85 percent, based on the length of your loan, the amount you’re borrowing, and your initial loan-to-value ratio.
Choosing between a conventional loan and an FHA-backed mortgage requires some financial soul searching. A conventional lender will demand a higher credit score, larger cash down payment, and lower debt-to-income ratio – as a rule of thumb, anyone with a credit score below the mid-600s or desiring a down payment less than 5% will likely be better served by an FHA loan, even with the MIP payments. FHA.com (not affiliated with FHA) offers an MIP calculator to understand your additional costs.
The dream of home ownership is a lasting American ideal. The FHA Loan is a fantastic way to open the doors to your own dream, but as with all financial decisions, make sure you understand what you’re signing up for.