Let's say you've found the perfect house with a big backyard for your dog and a great patio for amazing summer barbecue parties. And you've managed to save a low down payment to help you buy it.
But what mortgage would be best for you at this point? Well, the answer has changed over the past few years. In the past, lenders probably would have pointed you toward a loan from the Federal Housing Administration (FHA), which is part of the government's Department of Housing and Development (HUD). In fact, the HUD website says FHA loans have been around since 1934 to help those with low down payments, low closing costs, and easy credit qualifying.
But that's just not the reality anymore, said Sonia Garrison, research manager at Evolution Finance, which launched the social network WalletHub last year to help people with personal finance issues.
Garrison authored the 2013 Mortgage Insurance Report for WalletHub and discovered that FHA mortgage insurance premiums have doubled since 2008, making an FHA loan hard to afford for many people, she says.
However, she explains that other types of loans offer a cheaper insurance option known as private mortgage insurance (PMI) for borrowers with a low down payment or less-than-ideal credit.
PMI, bought through a private insurance company, is required on every mortgage with less than a 20 percent down payment. On the other hand, FHA mortgage premium insurance is backed by the government. Both protect the lender in case the borrower defaults on the loan. So how's an aspiring homebuyer supposed to know which to go with? If you have less than 20 percent down saved, keep reading to find out which loan might be the best option for you.
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Why FHA Loans May No Longer Be Your Best Option
FHA loans used to be the most affordable mortgage choice, especially for first-time homebuyers or homebuyers with flawed credit history or not much money saved for a down payment, says Michael Neef, branch manager at Portland Home Loan Expert in West Linn, Oregon.
But because FHA mortgage insurance jumped from .55 percent to 1.35 percent in 2013, he says that many people aren't able to afford the monthly mortgage and insurance.
For instance, on a $200,000 conventional loan, the private mortgage insurance would be about $103 per month. If that same mortgage was drawn up by FHA, the mortgage insurance would be $225 each month, Neef says.
Why did FHA mortgage premium insurance jump so high, so quickly?
Two years ago, Neef says 70 percent of the loans he wrote were for government-backed loans, most of which were FHA loans.
"But FHA was never designed to be 70 percent of the market share. It was designed to help certain people. But it was serving all the people," he says. "By increasing the insurance, FHA has corrected and repositioned itself to be that 18 to 20 percent of the market that they meant to be in the first place. This is a good thing. There are still those who will fit preferably into the FHA bucket."
When Garrison began doing her study, she knew there was going to be a difference in what people paid for PMI and FHA insurance. But it was very surprising, she says, how quickly a large difference accumulated over a period of three to five years for a homeowner.
Take this example: With 5 percent down and a 659 credit score, someone can save $5,000 for five years or $1,000 a year by having a conventional loan with private mortgage insurance instead of an FHA loan, the study shows.
When you're looking for a mortgage, it's really easy to just focus on the interest rate of the mortgage itself, she says. But if you want the best deal, ask mortgage lenders to compare what you'd pay for FHA mortgage insurance and private mortgage insurance.
It's possible that one lender might go through some extra steps to get you approved with a conventional loan with less monthly mortgage insurance, Garrison explains.
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Who Should Still Look Into An FHA Loan?
Even with rising insurance premiums, are there still people who can benefit from an FHA loan?
Of course, says Neef. For example, those who only have down payment assistance from a gift might be better off with an FHA loan, because most conventional loans don't allow for 100 percent of the down payment to be a gift from a family member or friend, he explains.
Or if you have a credit score under 660 or have a high debt-to-income ratio (DTI), you're more likely to get approved for an FHA loan than a conventional loan, says Neef. He explains that FHA loans are a little more flexible when it comes to those qualifications.
According to the HUD website, you don't have to have a perfect credit score to qualify for an FHA mortgage. In fact, even if you've had credit issues, such as a bankruptcy, it's easier for you to qualify for an FHA loan than a conventional loan.
Also, homeowners might choose to take out an FHA loan if they already own one home and want to buy another one, says Neef. Conventional loans require six months of mortgage payments reserved for their current home, and a two months reserve for the new house they are buying. This is an added security measure in case the homeowner defaults on either one of the loans they are carrying. Alternatively, an FHA loan doesn't require any reserves.
For example, if you have a monthly mortgage payment of $1,000 on your current home and a payment of $1,500 on your second home, the bank issuing the second conventional loan would want to see $6,000 in a savings account for the first house and $3,000 more for the second. That's $9,000 in reserves before they would even consider giving you a conventional loan, Neef says.
Other Loans Available With A Low Down Payment
The traditional down payment of 20 percent of the purchase price seems impossible to many folks. That would mean saving $40,000 for the down payment on a $200,000 home. That could be a tall order, especially for first-time home buyers, those who have gone through some financial burden like a divorce, or young college graduates who have high student loans, Neef says.
And now that FHA loans have become quite expensive with their increased mortgage insurance, lenders have to be quite creative to help borrowers who don't have that magical 20 percent, Garrison says.
So check out some loan options that might be the perfect fit for your financial situation:
Conventional Loan: You will need a credit score of 700 or more and at least a 10 percent down payment saved up, Neef says. Comparatively, an FHA loan only requires a bare minimum of 3.5 percent down. "If you have a 660 credit score, it will be a coin toss of what loan will suit you best - an FHA or a conventional. The pricing in terms of monthly payments will probably be the same," says Neef.
[Shopping for a mortgage? Click to compare interest rates from multiple lenders now.]
The Veterans Administration (VA) Loan: This can provide an amazing mortgage loan to military veterans and their families with low or zero down payment, Neef says. The government gives 100 percent of the financing, although there's a .4 percent mortgage insurance that is added on.
USDA Loan: Another government-backed loan is the USDA loan, which, like the VA loan, offers 100 percent financing, Neef says. Plus, the mortgage insurance premium called a "guarantee fee" is lower than that of FHA mortgage insurance or PMI. However, USDA loans do have stricter requirements, such as falling below a certain level of income. "For instance, in my Portland, Oregon area, if you have five people in your household, you cannot earn more than $100,000," he says.
State-Sponsored Loan Programs: On a state-by-state level, there are some programs to encourage first-time homebuyers to buy in areas that were hit hard by foreclosures. You could try calling several loan officers to see if any of those special lending programs are available where you want to buy a home, suggests Bill Redfern, CEO and founder of A Buyer's Choice Home Inspections in Pompano Beach, Florida. These state-sponsored programs enable some borrowers to take out a conventional loan and get down payment assistance. For instance, New York State's Homes and Community Renewal program offers a conventional loan with options of 3 to 5 percent down, plus competitive fixed interest rates for 30 years.
