Young people aren’t buying homes like they used to. According to CNBC, the overall homeownership rate has dropped to the lowest level since 1965—in large part due to millennials’ lack of interest in (or, more likely, inability to afford) houses of their own.
With the cost of housing skyrocketing in many US cities (especially those where young people are likely to live and where the vast majority of high-paying jobs are), and the average student loan burden ballooning to more than $30,000 per person, young people are financially stretched—worried more about just making ends meet than saving 20% for a down payment.
For these pressed young people, an FHA loan might offer a way forward—and it’s gotten easier (but not necessarily cheaper) to get one over the past few years. But are FHA loans a good idea? And are the reduced standards worth the extra costs?
What is an FHA loan?
FHA loans are guaranteed by the Federal Housing Administration (FHA). Since the FHA insures these loans, that means if borrowers default on the loan, the government will pay the lender for any losses. The FHA does not itself lend money; it merely guarantees the lender will not face losses.
By insuring the lender against loss, the FHA hopes to encourage homeownership among people who might otherwise not be able to afford it. FHA-backed loans usually have more lenient requirements than conventional loans—lower credit scores are required and your down payment can be as low as 3.5%.
The FHA loan is reserved for first time home buyers and only available through FHA lenders. The Federal Housing Authority sets maximum mortgage limits for FHA loans that vary by state and county.
The fine print on FHA loans
In 2016, the FHA loosened their requirements—namely, the minimum credit score to qualify for the lowest minimum down payment fell from 620 in 2014 to 580 this year. This opens up FHA loans to those who are rebuilding their credit, or who haven’t yet had the opportunity to establish good credit. Other requirements:
- Must have a steady employment history for the past two years, a valid Social Security number, and lawfully reside in the US
- Must put at least 3.5% down (down payment money can be a gift from a family member)
- Must make the property your primary residence
- Must have a credit score of at least 580 (in order to qualify for the 3.5% down payment; lower credit scores will be required to put down more)
When borrowers find a property, it must be examined by an FHA-approved property appraiser. FHA loan limits depend heavily on the housing type and the state. Since it varies from state to state, you can view loan limits in your particular area here.
Bankruptcy—or Chapter 13 bankruptcy—does not automatically disqualify you from getting an FHA loan. But, as of January 2016, you must wait at least two years after the discharge date of your Chapter 13 before applying for an FHA mortgage.
What’s the catch?
These less stringent requirements don’t come for free.
Borrowers will also need to pay FHA mortgage insurance—similar to private mortgage insurance (PMI) that lenders require on traditional mortgages when borrowers put less than 20% down.
FHA mortgage insurance is paid in two ways—upfront as a part of your closing costs, and then as part of your monthly payment. The upfront cost is 1.75% of your total loan amount, and the monthly cost varies based on the amount of your down payment, the length of your loan, and the initial loan-to-value ratio. It could be as low as .45% or as much as .85% of the loan amount.
These mortgage premiums are how FHA supports itself, and are deposited into a fund which is then used to pay lenders for any defaults. In 2013, the FHA faced an unprecedented loss, and instituted changes to their mortgage insurance that made it more expensive.
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Are FHA loans a good idea?
Standards for FHA loans are more generous than they’ve been in years. Millennials who have debt, less-than-perfect credit, or who have endured other financial bumps in the road may have a shot at homeownership through an FHA loan.
However, it’s important to consider some of the drawbacks of taking out an FHA loan to see if the pros outweigh the cons. While you may be approved for an FHA loan with a lower credit score, you also might have to deal with a higher interest rate on your mortgage.
Putting as little as 3.5% down on your home can be risky as well since you aren’t starting out with much equity. If the value of your home starts to decrease or you can no longer afford your mortgage payments, you could be underwater for a while.
Insurance requirements make FHA loans less attractive
The biggest drawback of an FHA loan, however, is the mortgage insurance premium (MIP), which adds to a buyer’s upfront costs considerably and to their monthly costs throughout the life of the loan.
Private mortgage insurance, which is required for conventional mortgages with less than 20% down, is eventually canceled once the borrower builds up enough equity (i.e. once the outstanding loan amount is less than 80% of the home’s value).
This used to be the way FHA loans worked as well. But as of the 2013 changes, they now have different—and less appealing—rules.
The new insurance premium lasts anywhere from 11 years (if you start with at least 10% down) to the entire life of the loan (if you put down less than that, i.e. the 3.5% minimum). The only way to “cancel” it, in these cases, is to refinance. (And FHA does have a process for refinancing that actually refunds some of your upfront MIP.)
For a starter home in an area that’s not too expensive, this additional expense may not be so bad. But in expensive cities like Boston where housing costs are crazy high, the mortgage insurance premium adds on considerable expense and no extra value.
For a two-bedroom condo costing $430,000, a 3.5% down payment would be $15,050, leaving $414,950 to be financed. The upfront MIP of 1.75% would tack on an additional $7,261 to your closing costs, bringing upfront costs to $22,311. The annual payments (at .85% of the loan amount) would add another $3,500 to your yearly costs, or just under $300 a month. That’s a lot of money just to set your lender’s mind at ease.
Typically, the upfront MIP is added to your loan amount (though it does not affect your loan-to-value ratio), meaning that you’ll be exceptionally close to underwater on your new house from the minute you sign your papers. That seems unnecessarily stressful!
In contrast, private mortgage insurance requires little to no payment upfront (and thus doesn’t have to be financed), and goes away as soon as your loan-to-value ratio hits .78 (and you can request they cancel it as soon as it hits .80).
Depending on your credit, private mortgage rates might also be lower—as low as .5% of your total loan amount per year. If you’ve got the credit necessary for a more conventional loan, and can scrounge up closer to 10% for a down payment, a conventional loan is a better deal.
And if your credit isn’t great, or you don’t yet have that much, there’s nothing wrong with taking a few years to fix it before buying a house.
Renting is not wasted money—mortgage insurance mostly is. After all, when you rent, you get a place to live in exchange for your rent money.
We at Money Under 30 are pretty pro-renting. We don’t think it’s wasted money, and we think one should only buy a house when a) you know you can afford it and b) when you plan to stay in that house for a good long while.
If you’re super ready to buy a house, know you’ll be staying there for at least five years, and are shopping in an area without sky-high housing costs, then an FHA loan may put a house in reach when it wouldn’t otherwise be an option.
However, we strongly advise you to consider all the costs before you take the leap.