The most common way to finance a home purchase for first time buyers is with a loan through the Federal Housing Administration (FHA). The 3.5% down payment required by FHA is the lowest down payment option in the marketplace available to the population at large. (Zero down payment loans are only available to veterans and certain other specific groups.)
Related: Do I Qualify for an FHA Loan?
As a further help to homebuyers, FHA allows up to 6% of the loan amount to be paid toward loan costs by the seller. This would have to be agreed to in the sales contract. It could drastically lower the out of pocket costs of buying a home.
After the meltdown in the subprime mortgage market, FHA loans became the default choice for first time homebuyers and practically anyone who wanted to make a small down payment on their home purchase. But as FHA’s market share increased dramatically, changes were put in place that make it less of an obvious choice today.
Related Article: Low Down Payment Mortgage Options
Mortgage Insurance and Interest Rate
FHA loans require a mortgage insurance premium (MIP) to be paid both as an upfront closing fee and as part of the regular monthly payment. The upfront premium (typically 1.75% of the loan amount), can be financed into the loan, so it does not increase the cash needed at closing. It can also make up part of the seller contribution.
But the monthly amount, which in recent years has more than doubled, can really decrease the affordability of an FHA loan. For a minimum down payment FHA loan, the monthly MIP amount is 1.35%. Unlike mortgage insurance on conventional loans, FHA MIP remains in force for the entire life of the loan.
Base interest rates on FHA loans are usually lower than on conventional loans. But the MIP can make the true cost of FHA financing higher even when the interest rate is lower.
Suppose you are offered an FHA loan at 4.0%, and a conventional loan at 4.5%. The mortgage insurance factor on the conventional loan is 0.7%. Thus the true monthly cost of the conventional loan would be 5.2%, while the true cost of the FHA loan would be 5.35%. The payment on the conventional loan will be lower even though the interest rate is higher.
FHA Loans and Down Payment Assistance
Conventional financing requires at least a 5% down payment. If 3.5% is the maximum amount you have saved to put down, then an FHA loan provides the right down payment assistance for you. But if you can save the extra money, you should consider a conventional loan, particularly if you have excellent credit.
For anyone with less than perfect credit, FHA financing has additional advantages. Most banks will write FHA loans to borrowers with scores as low as 640 or even 620 with very minimal, if any, additional fees. Conversely, those with scores in the 600s will see their conventional loan rate, costs and mortgage insurance premiums spike dramatically.
FHA loans are not for everyone. Due to the new mortgage insurance rules, they are also not necessarily a loan you want to plan on keeping for 30 years. But they are a great way to get into a first house, even for those who have not been able to save a great deal to put towards a down payment, or who still have some work to do to fix their credit rating. A few years paying on a mortgage has a positive impact on credit scoring. Paying the mortgage down will also start to build equity. You may be able to refinance into a conventional loan, removing mortgage insurance for good, much sooner than you first expected.
Related Article: Mortgage Dictionary: Learn the Lingo of Loan-speak
Photo credit: © iStock.com/Lise Gagne, © iStock.com/efenzi, © iStock.com/Feverpitched