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FHA Loans: An Alternative to the 20% Down Payment

Andrew Tavin, CFEI
Andrew Tavin is a personal finance writer who covered budgeting with expertise in building credit and saving for OppU. His work has been cited by Wikipedia, Crunchbase, and Hacker News, and he is a Certified Financial Education Instructor through the National Financial Educators Council.
Read time: 4 min
Updated on May 5, 2022
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Think you can’t afford a mortgage? Maybe you actually can.

Houses are incredibly expensive. The vast majority of Americans do not have the mountains of cash on hand required to buy a home outright, so a loan is almost always required.

A traditional mortgage loan is one of the more common paths to home ownership. A mortgage is a secured loan that uses the purchased home as collateral. In other words, if the payments aren’t made, the bank or lender can seize the home, which is part of the foreclosure process.

However, while a mortgage is far more achievable than trying to buy a home with cash, it is still very costly. Even before you start thinking about monthly payments, you will likely have to provide a significant down payment to seal the deal, which does not include the closing fees, inspection costs, taxes, and other expenses affiliated with purchasing a home. Given the size of these loans, your credit score will also need to vouch for you before a lender will grant you a mortgage.

Is there an option for aspiring homeowners who cannot afford a traditional mortgage or a 20% down payment, or for those who may not have an immaculate credit report? Enter the Federal Housing Administration (FHA) loan.

FHA loan: defined

FHA loans are administered by the U.S. Department of Housing and Urban Development (HUD) and are intended as a means for low-income Americans to become homeowners.

Benjamin Ross, a realtor, landlord, and investment specialist at My Active Agent, says FHA loans can be appealing to first-time homebuyers or individuals with low to moderate incomes.

“FHA loans are perfect for borrowers with little cash in the bank for a down payment, and individuals who have less-than-ideal credit and can't be eligible for a standard loan,” he says. “Repeat buyers could get a Federal Housing Administration loan as well, though it must be used to purchase a primary residence.”

FHA loans: Do you qualify?

As Ross mentions, you can only qualify for an FHA loan if you are using it to buy a primary residence. So if you were considering an FHA loan to pick up a vacation home or a rental property, you will have to find another path to that goal.

FHA loans still require a down payment and specific financial qualifications, but with a minimum down payment of 3.5% of the home’s purchase price, they are easier to manage than most alternative means. However, the 3.5% rate only applies to applicants with a credit score of at least 580. A lower credit score may not prevent you from receiving an FHA loan, but it will likely come with a higher down payment requirement.

Unfortunately, it is possible to have a score low enough to make qualifying at all unlikely, Ross says.

“Individuals with credit ratings under 500 generally are ineligible for FHA loans,” he warns. “However, there might be some wiggle room there. The FHA allows for (under certain conditions) applicants with ‘nontraditional credit rating or inadequate credit’ if the borrower meets other criteria. Ask your FHA loan provider or perhaps a FHA loan specialist if you think you may qualify.”

You will also have to prove that you have been receiving a regular and sufficient income and that you are likely to continue to earn sufficient income to pay off the loan obligations. Paystubs, bank statements, and tax returns may all be necessary to prove your means.

Finally, if you have had a foreclosure or bankruptcy in the last couple of years, you may need to wait for application to receive proper consideration.

You can find an FHA lender near you through the HUD website. The lender will still charge you a closing fee, but there will be a limit to that fee.

“HUD limits just how much FHA lenders may charge in closing costs to a maximum of 3%-5% from the amount borrowed,” Ross says. “Closing costs are different depending on which state you reside in, the size of the loan, and if you pay [extra fees to the lender] to lower the interest rate.”

Alternative options

Renting has gotten a bit of a bad reputation. The main argument against renting a home is that you will not be building equity, or ownership, in that home. Assuming you move one day, you could sell your home and recoup some, all, or more of the money you put it into it. If you rent your home, then you will not be able to recoup any of the rent money when you move out.

Despite this reality, renting may be the best option if you can not qualify for an affordable mortgage. The additional costs associated with buying and selling a home may also not be worth paying if you are considering moving in the short term. While you are renting, you can build up your credit so you will have better options if the time comes to find a mortgage. However, if the idea of home ownership is still appealing to you, there are various mortgage options that may better suit your lifestyle or circumstance.

Regardless, there is no shame in using an FHA loan, continuing to rent until it makes sense to pursue a traditional mortgage, or just renting for the long term. You should do what makes sense for your specific situation.

Article contributors
Benjamin Ross

Benjamin Ross started real estate investing in 2002. He became a self- made millionaire at 38 years old. He is a realtor serving the state of Texas, and owns various rental properties in Fort Worth. He works with investors, finding the right investments for them and assisting them with their acquisition strategies. He is an expert in the real estate field.

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