Buying a home for the first time is one of the most important — and most significant — purchases you will make in your life. The first step to buying a home involves budgeting and saving up for the down payment that you will initially put on it. Down payments using conventional bank loans usually require upwards of 20% of the purchase price of the home. It means that if the home costs $330,000 and the down payment is on the upper end of 20%, then the down payment will cost $66,000. 

For many people, coming up with the average down payment is tough. Not only that but to even qualify for a conventional loan usually requires a good to excellent credit score. 

Fortunately, the government has set in place a special type of loan catered towards people looking to pay the lowest amount for a down payment. Also, who may not have a good credit score due to various reasons. Are you’re ready to buy a home but may not qualify for a conventional loan due to bad credit or low income? Then a Federal Housing Administration (FHA) loan may be the best option for you.

What is an FHA loan?

In 1934, the government implemented the FHA loan program as a way to offset the devastation caused by the Great Depression in the 1930s. The goal was to allow low-income citizens the chance to buy homes while at the same time, address the unemployment problem with the construction of additional homes. Today, FHA loans are still a popular alternative to conventional loans, partly due to the recent recession in 2008. 

So what exactly is an FHA loan? It’s mostly a type of insurance placed on mortgage loans that are being borrowed by higher-risk home buyers. The Federal Housing Administration makes deals with approved banks to lend mortgages to borrowers, at the same time insuring the loan to decrease the risk for lenders. FHA loans have very low down payment requirements. While conventional loans usually require a down payment of 10-20% of the home’s purchase price, FHA loans require anywhere from 3-10% down on average. On top of that, a bad credit score does not automatically disqualify you from an FHA loan. 

There are two main aspects to an FHA loan that make them a lower risk for lenders. Upfront Mortgage Insurance Premiums (UFMIP) and Annual Mortgage Insurance Premiums (AMIP). Overall, the MIP is an additional cost paid by the borrower, which helps protect lenders from accounts defaulting. UFMIPs, as the name suggests, are upfront costs usually rolled into the down payment, or they can roll up into the total loan amount. They typically cost up to 2% of the home’s purchase price. An AMIP is a separate monthly payment that totals up to 1% of the purchase price. For a home costing $230,000, the UFMIP would be $6,600 added to the down payment or loan total, and the AMIP would be an additional $3,300 for the year or $275 per month for the life of the loan. 

How do you qualify for an FHA loan?

Since FHA loans are designed for lower-income borrowers, FHA loan requirements are far more relaxed than with conventional loans. For one, the down payment is reduced from 10-20% to 3-10%. It dramatically reduces the barrier to entry for many individuals and is a popular choice for first-time home buyers. 

Obtaining the lowest possible down payment with an FHA loan is still somewhat determined by a credit score. Scores that are as low as 500 can still qualify for an FHA loan, but the down payment requirement will be on the higher end of 10%. A score ranging anywhere from 580 to 620 may be eligible for a down payment of only 3% of the total purchase price.   

Aside from the credit score and down payment, additional FHA loan requirements are very basic and most of you will qualify. You will need a social security number, proof of U.S. citizenship or residency, and you will need to be old enough to borrow based on state laws. Furthermore, borrowers will need a debt-to-income ratio of 50% or less. 

There are also limits to the amount you can borrow with an FHA loan. For instance, most low-cost counties have a limit of about $315,000, while high-cost counties have a limit of $725,000. These limits vary state-to-state, county-to-county.

Pros

Low down payment and credit score requirements make FHA loans great for low-income or first-time buyers.

FHA loans are more accepting of gifted down payments, such as those from friends or family.

FHA loans are meant to protect buyers, and for this reason, there are many fail-safes in place when qualifying.

Despite being a requirement, the debt-to-income ratio limit of 50% for FHA loans is much higher than for conventional loans. Conventional loans usually require a debt-to-income ratio of about 36% or less.

Cons

Interest rates are higher on average, but not by much.

Mortgage Insurance Premiums cannot be avoided, even if paying a down payment closer to 20%. On the other hand, conventional loans may waive insurance if the down payment is high enough.

Depending on the cost of living in specific state counties, there are limits to the amount of mortgage you can borrow.

FHA loans are bad for investment purposes since lenders limit the type of home being purchased. The home must be safe and structurally sound, not requiring a whole lot of repairs and upkeep. For this reason, FHA loans are bad for purchasing vacation homes or fixer-uppers that you intend to “flip.”