The down payment is the number one obstacle homebuyers face when it comes to getting a mortgage.
Conventional loans required a sizeable down payment of 20%, which makes the dream of homeownership challenging to attain for many Americans.
However, FHA loans have become popular because borrowers with at least a 580 credit score can secure FHA financing with just 3.5% down.
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What is an FHA Loan?
In 1934 the Federal Housing Administration was created by the Federal Government to encourage homeownership. They do not lend money; the FHA acts like an insurance policy on loan itself, which reduces the risk for lenders allowing them to lend money to more buyers.
Before FHA loans, conventional financing was the only loan available to borrowers. Because traditional financing requires as much as 20% down, many Americans, especially first-time homebuyers, could not afford to become homeowners.
How Your Credit Score Affects How Much You Need Down
Borrowers with a 580 credit score qualify for an FHA loan with just a 3.5% down payment, while borrowers with a 500-579 score need 1% down.
For example: If you are buying a $200,000, your down payment will be 3.5% of the purchase price, or $7,000.
You can read more about FHA down payment requirements on the HUD website.
What is a Down Payment?
When you get a mortgage to finance a house, the down payment is a percentage of the purchase price. A borrower must come up with out of pocket.
FHA finances up to 96.5% of the purchase price. The remaining 3.5% will come from the borrower in the form of a down payment.
For example, if a buyer agrees to purchase a home for $200,000, the down payment is $7,000. The remaining $193,000 will be financed.
How Your Down Payment Affects FHA Mortgage Insurance Premiums
The FHA is an insurance policy that reimburses mortgage lenders if the borrower defaults on the loan payments. And every insurance policy has a premium that must be paid.
The FHA MIP rate varies depending on the amount of the down payment used.
If you just put the standard 3.5% down payment required for an FHA mortgage, then your mortgage insurance rate will be 0.85%.
If you put between 5-10% down, your MIP rate will drop to 0.80%.
And if you use at least a 10% down payment, your rate is 0.80% and is only required for the first 11 years of the mortgage.
If the loan amount is over $625,000, there are different MIP rates you can see in the chart below.
Using Gift Funds
One of the great benefits of FHA home loans is that the down payment can be a gift from a friend or family member.
Up to 100% of the FHA down payment can be gifted from a friend or family member. Meaning you can essentially close on your home with no money out of pocket.
You will need a gift letter from the gifted to provide your mortgage lender.
The Lender will Trace The Down Payment
The main thing you need to know about down payments is that the money must be traceable.
You cannot simply give $6,000 in cash to your lender to cover your down payment. The funds must come from your checking, savings, or an investment account.
The funds also need to be traceable for at least three months prior to closing. If you have cash, make sure you deposit it into your bank account several months before you are expected to close.
The same applies to relatives that are gifting you the funds for your down payment.
They, too, will have to show three months of bank statements showing that money was in their bank account and not borrowed. If the funds cannot be traced, then you will not be able to close.
Down Payment Assistance Programs
FHA allows homebuyers to use down payment assistance programs. You can view available HUD first-time buyer programs on the HUD website.
Your local Government will also have various first-time homebuyer programs and down payment assistance listed on their website.
Check out your local city and county website for available programs.
Where Your Down Payment Can Come From
Your down payment for an FHA loan must come from a verifiable source. It must come from your own savings, 401k, or other investment accounts. It may also be a gift from a friend or family member.
You cannot get a personal loan or use a payday loan to come up with your down payment.
Where Your Down Payment can come from
- From your checking or savings account
- Borrow from your 401k account
- Retirement account
- Investment account
- From a friend or family member with a gift letter
FHA home loans are very popular among first-time homebuyers because of the low credit and down payment requirements.
They’re available in fixed-rate and adjustable-rate mortgage terms. Have a maximum debt-to-income ratio of 43% and a minimum loan-to-value ratio of 96.5%.
The high DTI ratios that can be accepted makes FHA loans a good option for borrowers with low-to-moderate income.
Mortgage insurance (MIP) is required on all FHA mortgages regardless of the LTV ratio.
Other Expenses To Budget For
Closing costs – Closing costs are fees charged by lenders for processing and funding the loan. Typically closing costs range from 2%-5% of the loan amount.
Home Appraisal Fee – Your lender will order a home appraisal to get the current market value of the property. Appraisal fees run between $300-$800.
Up-front Mortgage Insurance Premium – The pro-rated amount of PMI for the year will be added to closing fees.
Your credit score is directly tied to the interest rate you receive on a mortgage loan.
If you have a low credit score, you will have a higher rate and higher monthly mortgage payment.
You should try to maximize your credit scores before applying for an FHA home loan.
Ways you can improve your FICO score
- Pay down your credit card balances
- Get added as an authorized user
- Call your creditors to remove late payments
- Settle collection accounts and try getting them to remove them
- Stay current on your payments and don’t apply for new credit
The Bottom Line
The FHA down payment requirements are quite clear. If you have a 500 credit score, you’ll need 10% down.
If you have a 580 score, you’ll need just a 3.5 percent down payment.
The funds must come from your savings or retirement account, or a friend or family member can gift you the down payment funds.
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