FHA is the Way to Go with Less Than Perfect Credit and Low Downpayment

If you are in the market for a mortgage and have concerns about your financial qualifications, an FHA mortgage may be your key to a new home.

With a relatively low minimum down payment of 3.5% and a more liberal attitude towards debt-to-income ratios, an FHA mortgage is a prime loan for somebody with less money available for a down payment, more debt, and a less than stellar credit score. While conventional loans require potential homebuyers to come up with at least a 5% down payment, FHA Mortgages allow them to slide by with a minimum down payment of just 3.5%. Unlike conventional loans, FHA loans have a low, minimum qualifying credit score of 640 and do not charge a higher interest rate for a low credit score. 

The term FHA Mortgage is a bit of a misnomer as the Federal Housing Administration (FHA), doesn’t actually provide the loan. Instead, the loan is financed through a conventional lending institution like a mortgage company, bank, or savings and loan, and then HUD insures the mortgage, allowing the homebuyer to get a lower rate than otherwise would be possible.

The only catch, if you can call it that, of the FHA mortgage is that the homebuyer has to pay mortgage insurance, which adds to the cost. To protect the lender, private mortgage insurance is typically required on any mortgage where the down payment is below 20%.

“The mortgage insurance is split up into two pieces.   First, you pay a lump sum upfront, which is 1% of the entire loan. Then, you have the monthly cost, which is presently at a factor of .9%.  To get a rough estimate of this monthly mortgage insurance cost, take the loan amount, multiply it by .9%, and then divide that number by 12. You can expect that cost to go up in the upcoming year as the FHA has plans to change it to a factor of 1.15% in April.

Comparing an FHA Mortgage to a Conventional Mortgage


If you are trying to decide between a conventional mortgage and an FHA mortgage and you have less than 10% to put down for the deposit, an FHA loan may be your best choice.

The issue that stands out with an FHA, is that with a conventional mortgage, you not only have to go through the loan approval process, but also the mortgage insurance approval process.  In other words, you have to get approved by the mortgage insurance company, which is different from the mortgage lender.

With an FHA loan, it doesn’t matter, the mortgage insurance is controlled by the FHA. If you need to get mortgage insurance on a conventional loan, it goes into a tailspin because there are maybe five or six mortgage insurance companies out there. And from what I’m seeing, with 5% down it's hard to get mortgage insurance even with a credit score between 680 and 700.

So, if you are doing a conventional loan with mortgage insurance and you put 10% or less down, it’s hard to get approved for that insurance unless your credit score is 700 or above. So if you have a credit score  699 or below with 10% down, an FHA is usually going to be your better loan.

Like any product that is designed to assist homebuyers with bad finances, the FHA Loan can easily be abused. Just because you can scrape together a 3.5% down payment and have the minimum credit score, it doesn’t mean that you should pursue an FHA loan.

I think that this economy has created a new breed of loan officer. When you get those kinds of clients with a low credit score and not much money in the bank, maybe it's better to give them a little more advice versus thinking about closing a loan so that you can get paid.

For a financially responsible person who wants to get into a home but doesn’t have a great credit score or the savings for a sizeable down payment, the FHA loan may be their only option for getting into a house. For many people, this is the ideal financial product. As great as it is, though, if you can afford to wait to save up more for a down payment, you probably should.

I advise all of my clients, first-time homebuyers or not, that anytime that they can avoid paying private mortgage insurance they should. Ideally, 20% down is the best way to go.