Want to Buy a Home With Just 3.5% Down? 9 Things to Know About FHA Loans

A happy young couple pose in front of their new home.
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You’ve probably heard over and over that you need a 20% down payment before you can ever think of buying a home.

But there’s a way to finance a home even if you don’t have the means to put down 20% of its value in cash: the increasingly popular FHA loan.

What’s an FHA loan? FHA loans are backed by the U.S. government through the Federal Housing Administration. The FHA doesn’t lend you money; it insures the loan. That means the FHA will pay your lender if you stop making mortgage payments. As a result, it’s less risky for lenders to give mortgages to buyers with lower credit scores and down payments.

You can get an FHA mortgage with just 3.5% down if your credit score is 580 or higher. If your credit score is between 500 and 579, you’ll be required to put 10% down.

“Buying a home with an FHA loan can help buyers get into the real estate market before they’re priced out, particularly in cases where prices are rising,” said Beatrice de Jong, a California real estate broker and director of residential sales for Open Listings.

How to Get an FHA Loan: 9 Easy Tips

An FHA loan can be a great option if you have debt, your credit has seen better days or you’ve had some financial bumps but don’t want to get shut out of homeownership. Here are nine things to know before you apply for one.

1. You Need to Show Consistent Income

There are no income or salary requirements or limits to qualify for an FHA mortgage, but you’ll need to show steady earnings.

Pay stubs and consistent tax returns are important when you apply. FHA lenders want to make sure you have worked in the same field of work for at least a couple of years. Consistent work for a year or more with the same employer helps, too.

2. You Might Not Get Approved if You Have Lots of Debt

FHA loan officers won’t approve your loan if there’s a good chance you won’t be able to afford the mortgage and your other debt, such as car and credit card payments.

A good rule of thumb is that your mortgage payment shouldn’t be more than 31% of your income before taxes. Your mortgage payment PLUS your other monthly debt payments usually cannot be more than 41% of your income, though in certain cases you can get approved if your debt obligations total 50%.

3. Aim Higher Than the 580 Minimum Credit Score

You need a FICO score of 580 for the FHA to insure your loan with a 3.5% down payment, but every lender has its own requirements. Many will require a score above 580.

The closer your score is to 640, the more likely you are to get approved and the better your terms will be.

“Improving your credit score before finalizing your loan will help buyers qualify for the lowest possible interest rates,” de Jong said. “Buyers can improve their credit by paying down debt and making on-time payments for credit cards and auto loans.”

You’ll typically need to have at least two lines of credit — for example, a student loan and a credit card.

If you’re not sure where you stand, check your credit score for free to find out if you need to improve it before applying for a mortgage.

FROM THE HOME BUYING FORUM

4. Think Beyond Single-Family Homes

FHA loans aren’t just for people looking to purchase a single-family home. You can use them to buy condos, duplexes, manufactured homes and more.

You can even use an FHA loan to purchase a multifamily housing property with up to four units if you plan to rent out spaces. The only requirement is that buyers live in the FHA loan property for at least one year.

5. … but Don’t Expect to Buy a Mansion With an FHA Loan

You may see a swimming pool and a big house for you and your family. But be realistic. There are limits to how much you can borrow with an FHA loan.

These limits vary by county and are based on home prices in the area. If you can afford a home that costs more than the limits, chances are you don’t need an FHA loan and can qualify through for a conventional loan, i.e., one that isn’t backed by the government.

6. Expect to Pay More Than 3.5% of the Home’s Value Upfront

The minimum FHA loan down payment is 3.5%, but you’ll usually need more money than that because FHA loans don’t cover closing costs. Sometimes, though, there’s a workaround:

“Depending on the terms of your individual loan, you may be able to have the closing costs built into your total loan rather than having to front the cash at the time of closing,” de Jong said.

Of course, rolling closing costs into your loan will increase your monthly mortgage payments slightly.

If you can’t fold them into your loan, be prepared to pay closer to 6% upfront to account for closing costs. These include your upfront mortgage insurance premium, which protects the FHA and your lender if you stop making payment. The upfront premium is equal to 1.75% of the loan amount.

7. Work Mortgage Insurance Into Your Monthly Budget

In addition to that 1.75% upfront cost, you are required to pay a monthly mortgage insurance premium that is incorporated into your mortgage payments.

Mortgage insurance often reads as mortgage insurance premium (MIP) on your FHA loan statements and usually costs you around 0.5% to 1% of your loan value each year. That could translate to around $130 a month for a home loan of $210,000, for example.

8. You’ll Need Mortgage Insurance as Long as You Have an FHA Loan

Canceling mortgage insurance on an FHA loan isn’t possible.

There are only two ways to get rid of the requirement: You can sell the home. Or you can refinance your loan into a conventional loan, e.g., one that’s not backed by the government.

To refinance, you’ll need to have accumulated at least 20% equity in your home, either through your payments or because your home’s value has risen, or a combination of the two. You may need to get an appraisal (at a cost of $400 to $600) to show that your home’s value has increased enough to put your equity above 20%

Be prepared to pay closing costs again when you refinance, so make sure this works for your budget and that the reduction in your monthly payments is substantial.

If this isn’t feasible in the short term, there might be another way to save money and reduce your FHA loan monthly payment that we’ll discuss in the next step.

9. You May Have Another Option for Lowering Your Mortgage Payments

The FHA loan streamline refinance process allows you to refinance your FHA loan to take advantage of lower Interest rates. Your mortgage must remain an FHA loan, and you have to be current on your payments.

The good news is that many lenders are currently offering this program with no closing costs.

This program doesn’t require income and employment verification, credit checks or appraisals because your loan is staying intact as an FHA loan.

Dropping your interest rate by even half a point through this process can lower your monthly payment and give you peace of mind if you can’t get rid of your mortgage insurance anytime soon.

Is an FHA Loan Right for You?

To decide if an FHA loan is right for you, you need to make sure you can afford your monthly mortgage payment, including mortgage insurance, plus the down payment and closing costs.

Just remember to stay true to how much you can really afford each month and how a home loan impacts your monthly budget. If an FHA loan can get you into a house when there’s no other viable option, say goodbye to escalating monthly rent payments and welcome to homeownership!

Kurt Schultheis is a Florida-based writer.