Following the Great Depression of 1929, few families were able to purchase homes, and many who had previously owned homes lost them to forced sales and foreclosure. Mortgage terms were difficult to meet, and loans were limited to 50% of the property's market value. After three to five years of interest-only payments, a final balloon payment that essentially amounted to the entire principal of the loan became due.

In 1934, the Federal Housing Administration was created to help pull the nation out of the Depression and boost homeownership by making mortgages available to more people. The FHA program lowered down payment requirements; qualified borrowers based on their ability to repay a loan (rather than on whom they knew); established the loan amortization schedule, in which both principal and interest payments are made each month; and introduced longer loan terms.

Today, the FHA provides mortgage insurance on loans for single-family and multi-family homes made by FHA-approved lenders in the U.S. and its territories. It's important to note that the FHA is a mortgage insurer, not a mortgage lender: The FHA insures loans so lenders can offer better deals. Many first-time and repeat homebuyers can qualify for FHA loans that typically have lower down payments, reasonable credit expectations and more flexible income requirements. Here, we take a look at the top reasons why an FHA loan might be right for you.

Lower Down Payments

If you don't have much money saved for a down payment, an FHA loan might be a good choice. The down payment on an FHA loan could be as low as 3.5% of the purchase price of the home. So, for example, if the purchase price is $200,000, you could get a mortgage with as little as $7,000 down ($200,000 X 3.5% = $7,000). You'll pay 20% down (or $40,000 for the same $200,000 house) on many conventional mortgages. For some people, an FHA mortgage could be the difference between becoming a homeowner and continuing to rent.

Low down payments do come at a cost. Whether you have a conventional or FHA loan, you'll have to pay for mortgage insurance if you put down less than 20%, either in the form of private mortgage insurance (PMI) for conventional loans or a mortgage insurance premium (MIP) for FHA loans. (FHA loans also require a one-time, up-front fee when the loan is issued.) The rate you pay depends on the length of the loan, the loan-to-value ratio (LTV) and the size of the loan.

Recent changes affect how long borrowers are required to pay MIPs on FHA loans. If your FHA loan originated before June 3, 2013, the FHA requires that you pay the MIP for a full five years before they can be dropped if your loan term is greater than 15 years, and then only if the loan balance reaches 78% of the home's original price (the purchase price stated on your mortgage documents).

For loans that originated after on or after June 3, 2013, new rules apply: If your original LTV was 90% or less, you'll owe the MIP for 11 years or until the end of the loan, whichever occurs first; however, if your LTV was greater than 90%, you'll pay the MIP for the entire loan term or 30 years. This is more costly than PMI for a conventional loan, which can usually be canceled when your equity in your home reaches around 20%. See How To Get Rid of Private Mortgage Insurance for details.

High Debt-to-Income Ratio

A debt-to-income ratio (DTI) measures the amount of debt you have relative to your overall income. Lenders, including mortgage lenders, use DTI as a way to assess your ability to manage the payments you make each month and repay the money you have borrowed.

To calculate your DTI, add up your total recurring monthly debt (including mortgage, student loans, auto loans, child support and credit card payments) and divide by your gross monthly income (what you earn each month before taxes and other deductions are taken out). If your total recurring monthly debt, for example, is $2,000 and your gross monthly income is $6,000, your DTI would be 33% ($2,000 ÷ $6,000 = 0.33 or 33%).

A low DTI demonstrates a good balance between debt and income. Lenders like the number to be low since borrowers with a lower debt-to-income ratio are more likely to manage monthly debt payments. A high DTI, on the other hand, shows that you have too much debt for your income.

In general, 43% is the highest DTI you can have and still get a conventional mortgage. The FHA, however, has some flexibility and allows certain borrowers to have DTIs as high as 56% or 57% – for example, those who can make a large down payment, or those who have significant savings and solid credit histories. If you have the same gross monthly income of $6,000 from the previous example, your total recurring debt might be able to be as high as $3,420 to qualify for an FHA loan, versus $2,580 for a conventional loan.

Lower Credit Scores

A credit score is a number that helps lenders evaluate your credit report and estimate how risky it is to extend credit or lend money to you. Lenders get your credit score from the three major credit reporting agencies – Equifax, Experian and TransUnion. The most widely used credit score is the FICO score, which is based on five factors:

  1. 35%: payment history
  2. 30%: amounts owed
  3. 15%: length of credit history
  4. 10%: new credit and recently opened accounts
  5. 10%: types of credit in use

In general, credit requirements for FHA loans are more relaxed than those for conventional loans. Although other factors are taken into consideration, a credit score of at least 580 is needed to receive maximum financing. If your credit score is between 500 and 579, you'll likely still be approved (depending on the other factors), but you will have to make a larger down payment (such as 10%).

If you have a non-traditional credit history or insufficient credit, you may still qualify for an FHA loan if you meet certain requirements; in fact, your lender may be able to approve an FHA loan even if you don't have a credit score. These situations are evaluated on a case-by-case basis (consult your lender for details for your particular situation).

The Bottom Line

The FHA insures home loans throughout the U.S. and its territories, including Guam, Puerto Rico and the U.S. Virgin Islands. In order to qualify for an FHA loan, the property must be your primary residence and must be owner-occupied (i.e., you have to live there). Many first-time and repeat homebuyers can qualify for FHA loans, even with lower credit scores and/or higher debt-to-income ratios than you need for a conventional mortgage.

There are many types of FHA loans, and the rates and exact requirements may vary by lender. A mortgage is a long-term financial obligation, and care should be taken to understand the different loan products available and your particular options before making any decisions. Read Is An FHA Mortgage Still A Bargain? before you commit to one.

Related Articles
  1. Credit & Loans

    Is An FHA Mortgage Still A Bargain?

    If you're putting down less than 20%, the FHA's mortgage insurance premium could cost you more than private mortgage insurance with a commercial lender.
  2. Retirement

    Understanding FHA Home Loans

    Don't be overwhelmed when filling out these forms. Find out what you need to do here.
  3. Home & Auto

    The FHA's Minimum Property Standards

    If you're thinking about purchasing a home with an FHA loan, here are some standards that must be met for the deal to go through.
  4. Home & Auto

    Applying For An FHA 203(k) Loan

    If you have the time and energy, the 203(k) loan is often the only way to finance a property needing significant repairs.
  5. Home & Auto

    An Introduction To The FHA 203(k) Loan

    If you're looking at a fixer-upper, the Federal Housing Administration rehab loan may be the mortgage for you.
  6. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  7. Home & Auto

    Economics of Owning a Rental Property

    Learn how to find suitably priced rental property and the right rent level. Determine what maintenance costs to expect and what tax breaks are available.
  8. Savings

    How Parents Can Help Adult Children Buy a Home

    Owning a home isn't easy thanks to stringent lending standards. Thankfully, there's ways parents can help their kids buy a home.
  9. Credit & Loans

    HARP Loan Program: Help for Underwater Mortgages

    If you are underwater on your mortgage, this program may be just what you need to help build up equity in your home.
  10. Insurance

    6 Reasons To Avoid Private Mortgage Insurance

    This costly coverage protects your mortgage lender - not you.
  1. Can FHA loans be used for investment property?

    Federal Housing Administration (FHA) loans were created to promote homeownership. These loans have lower down payment requirements ... Read Full Answer >>
  2. Do FHA loans have private mortgage insurance (PMI)?

    he When you make a down payment from 3 to 20% of the value of your home and take out a Federal Housing Administration (FHA) ... Read Full Answer >>
  3. How many FHA loans can I have?

    Generally, the Federal Housing Administration (FHA) does not insure more than one mortgage per borrower. This is to prevent ... Read Full Answer >>
  4. Are FHA loans assumable?

    Loans insured by the Federal Housing Administration (FHA) on or after Dec. 15, 1989, are assumable by qualifying borrowers. ... Read Full Answer >>
  5. How accurate are online mortgage calculators?

    Online mortgage calculators are accurate to the extent that the calculator itself is asking for the right pieces of information ... Read Full Answer >>
  6. Are mortgage rates negotiable?

    Mortgages are just as negotiable as any other product or service. Whether it's a new home purchase or refinancing of an existing ... Read Full Answer >>
Trading Center