HUD vs. FHA Loans: What’s the Difference?
You may have heard that “government loans” are available for would-be homeowners who are saddled with bad credit and/or a history of bankruptcies or foreclosures. In reality, though, it’s not quite that simple.
The federal government is not in the home-loan business. However, in the interest of promoting home ownership – especially for low-income Americans – it may be willing to guarantee a mortgage for you if you have less-than-optimum credit. In other words, the government promises the lender that it will make good on the loan if you don’t.
FHA vs. HUD
The federal government agency charged with encouraging individual home ownership is the U.S. Department of Housing and Urban Development (HUD) through one of its offices, the Federal Housing Administration (FHA). While HUD does some loan guarantees on its own, its focus is on multifamily units, not individual homes (with the exception of HUD section 184 loan guarantees, which are available only to Native Americans buying homes or other real estate). It is solely the FHA that insures mortgages for single-family-home buyers.
Qualifying for an FHA Loan
To secure an FHA-guaranteed mortgage, you have to go to an FHA-approved lender, typically a bank. One thing that makes an FHA-guaranteed home loan particularly attractive is that if you have a FICO score of at least 580, you are only required to put down 3.5% of the purchase price in cash.
If your FICO score is below 580, however, you will need to come up with 10% of the purchase price for the down payment. Still, that’s better than the 14.8% of the purchase price that the average home buyer put down on closing last year. Research by RealtyTrac shows that in the first quarter of 2015 (the most recent data available), the average dollar amount paid on closing with a conventional mortgage was $72,590, whereas the average FHA insuree put down only $7,069.
Do not, however, mistake FHA-insured loans for “easy credit” lending, cautions FHA mortgage expert Dennis Geist, who is engagement director at Treliant Risk Advisors in Washington, D.C. “There is a misconception that FHA loans are subprime. Nothing could be further from the truth,” says Geist. “Although FHA loans provide flexible qualifying guidelines, including lower credit scores and higher debt-to-income ratios, the demonstrated ability to repay is a significant factor in the approval of any FHA loan.”
If your FICO score is below 580, securing an FHA-guaranteed loan can be tough, Geist adds. “Approval of borrowers with credit scores between 500 and 580 is subject to higher down payment requirements and additional underwriting scrutiny,” says Geist. “It’s important to note that ‘nontraditional credit’ can’t be used to offset negative ‘traditional’ credit.”
He adds that although you may see information holding out hope for FHA-insured loans to would-be buyers with credit scores under 500, the chances of that actually happening are nil.
Another plus of an FHA-insured loan is that, unlike a conventional bank loan’s terms, an FHA loan allows you to get the cash needed for the down payment as a gift from friends, family or a charity. The FHA will even allow the seller to pay your closing costs, although if they do so, it may boost your mortgage’s interest rate, since not having enough money for the down payment makes you less loan-worthy.
Before you decide to pursue an FHA-guaranteed loan, do consider some of the downsides. First, your options are more limited than with a conventional mortgage, because you can only do business with an FHA-approved lender. That limits your ability to shop around for the most favorable rates and terms. “A careful and complete comparison of loan products, fees and mortgage insurance is an important step in determining which loan product is best for you,” notes Geist.
FHA-insured loans have caps on the amount of the loan that vary by region. The absolute top amount the FHA will insure is $625,000, which in major metropolitan areas can be limiting. Further, many condos developments are not FHA approved, so some less-expensive housing options are off the table for you with an FHA loan.
Consider also that although the cash needed up front may be low, the required FHA insurance premiums will add considerably to your monthly mortgage payments, since you are contributing to a HUD reserve fund that is used to pay off the banks when an FHA-guaranteed mortgage goes bad. And mortgage insurance payments may not always be tax deductible, depending on your income.
Up front, you will pay a mortgage insurance premium (UFMIP) of 1.75% of the base loan amount. Then, on a 30-year mortgage, which is the most common FHA loan term, the annual premium can run as high as .85% of the loan amount if you choose the lowest down payment option. At the opposite end, on a 15-year loan with 10% or more down, the premium drops to .45%.
That’s why some FHA loan-guarantee recipients later seek to refinance their properties with a conventional bank loan once their credit history has improved. To do that, and say good-bye to the FHA mortgage-insurance payments, you will have to get FHA approval. “The FHA mortgage insurance continues for the full term of the loan,” says Geist, “so the primary reason to refinance an FHA-insured loan with a conventional loan would be to eliminate mortgage insurance and/or to reduce the term of the loan.”
On the upside, however, is the fact that FHA-insured mortgages are assumable, meaning that whoever buys your property next can take it over from you, while conventional mortgages generally are not.
“An assumable FHA loan could create a competitive advantage when it’s time to sell, especially if current interest rates are higher than the existing rate on the FHA loan,” says Geist. “Assumption costs are also lower than costs associated with a new loan.” So your FHA loan could potentially be an incentive if you find yourself selling in a buyers’ market with rising interest rates.
The Bottom Line
FHA-guaranteed loans are part of HUD’s mandate to encourage home ownership. HUD itself doesn’t do loan guarantees for individual homes, with the exception of HUD Section 184 loan guarantees, which are available only to Native Americans buying homes or other real estate. If you have reasonably good credit but are short on funds for a down payment, an FHA-insured loan can help you become a homeowner. But because of limits on property price, housing type, and loan choices – plus the added cost of mortgage insurance—you’re probably better off with a conventional mortgage if you have enough cash on hand. It all comes down to exploring your options fully and doing the math of the upfront and lifetime cost of each loan you are considering.