As home prices continue to rise, affording a down payment has become a bigger hurdle for prospective home buyers. But there are a few options that can help: government-backed loans that allow borrowers to buy a home with little or even no money down.
The US government doesn’t loan the money directly to borrowers. But three government agencies – the Federal Housing Administration, the US Department of Agriculture and the US Department of Veterans Affairs – insure loans to protect lenders from loss. That insurance reduces the risk for the lender, so they feel more comfortable offering low- or no- down payment loans and lowering credit requirements.
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Despite the overheated and competitive housing market of the last year, fewer homebuyers have been opting for these kinds of loans. In January, 9% of loans that were closed were backed by the FHA, 5% were backed by the VA and 84% were conventional, according to ICE Mortgage Technology. The year before, in January 2020, 16% were FHA, 8% were VA and 71% were conventional.
For those who qualify, these products can make the difference in whether or not they can become a homeowner.
“The goal across all these programs is helping people get into a home, knowing that homeownership is a key driver for removing the wealth divide,” said Ed Barry, chief executive of Capital Bank, a bank headquartered in Rockville, Maryland, which operates Capital Bank Home Loans. “These programs are out there, but many people don’t even know that they qualify.”
For example, you don’t have to be a farmer to get a USDA loan. A fee that may push some veterans away from a VA loan is waived for disabled veterans. And while many people with lackluster credit may think they can’t get a mortgage, borrowers with credit scores as low as 500 are eligible for FHA loans.
Here’s what you need to know about government-backed loans:
It is easier to qualify for an FHA loan than for a conventional mortgage. Borrowers can get loans with lower credit scores, higher debt-to-income ratios and smaller down payments.
You can qualify for an FHA loan with a score of 580 and a down payment of as low as 3.5%. With a credit score like 500, a borrower will need to put more money down. Those guidelines are set by FHA and individual FHA-approved lenders may impose different requirements, including higher credit scores.
Regardless of your credit score or the size of your down payment, there are limits to how much you can borrow on an FHA loan. Those caps range between $356,362 and $822,375 for 2021 and are determined by your location. You can look up the limit in your area on the Department of Housing and Urban Development web site.
For many people, the low down payment on an FHA-backed loan isn’t the biggest draw since some conventional loans already allow as little as 3% down. The big advantage is that you can qualify for the loan with a lower credit score and a higher debt-to-income ratio.
“But those things are not always best for the buyer,” said Jordan Nietzel, a certified financial planner and founder of Trek Wealth Planning in Kansas City. “You can get in over your head.”
He said the lower rate you might get with an FHA loan could be outweighed by the insurance you will need to pay over the life of the loan.
While the private mortgage insurance that is required for borrowers with conventional loans who put down less than 20% goes away when the homeowner gains a certain amount of equity, mortgage insurance is required for all FHA loans for longer periods, regardless of home equity.
Borrowers with an FHA loan and a down payment of less than 10% will pay FHA mortgage insurance throughout the life of the loan. Those who put down 10% or more will pay the insurance for 11 years on a 30-year mortgage.
He said that depending on what your credit score is, it may make more sense to take the time to improve your score and get a more conventional loan.
“You want to look at the whole picture, make sure you’re ready,” said Nietzel. “Don’t let the fact that you can get a loan without 20% down and your current credit score be the reason you do.”
VA loans are only available to veterans, with a few exceptions, like surviving spouses of veterans.
Borrowers will still need to have the required credit and income for the loan, but a VA loan may offer better terms than a conventional loan, including 100% financing.
“The advantage of the VA loan is the option to make no down payment,” said Nietzel. “The thing that people need to watch out for is the debt-to-income ratio, which can go higher on a VA loan than a conventional loan. It can qualify you for a higher loan than you may be prepared to handle.”
The make-or-break for some veterans is the VA funding fee, which can be as much as 2.3% of the amount borrowed when the down payment is less than 5% and goes down from there for larger down payments.
For example, if you’re getting a VA-backed loan and you’re buying a $200,000 home with a 5% down payment of $10,000, you will pay a fee of $3,135, or 1.65% of the $190,000 loan amount. The fee is waived for those with a service-connected disability.
But often a lower interest rate on a VA loan will make up for the VA funding fee, said Nietzel.
The USDA loan program offers 100% financing, requires no down payment and aids low- and moderate-income households purchasing in rural areas.
To be eligible, the buyer’s household income must not exceed 115% of the median income of the local area and they must be buying a primary residence.
In addition, there are eligibility requirements for the property as well, determined by population density. Buyers can search for eligible areas on the USDA website.
“People tend to think a USDA loan is for farmers,” said Barry. “That isn’t the case. It is designed for rural purchases. But that is defined by population density, not agricultural use. So you have eligible areas even 30 miles out of Washington DC.”
He said he has seen people use these loans to buy an affordable home farther out from a city.
If the borrower and the property are eligible, a USDA loan could be a path to homeownership for those struggling to come up with a down payment or whose credit score is too low to qualify for a traditional mortgage.
Barry’s advice to those looking for any of these government-backed loans is to look around for a lender who has a proven track record in handling these programs, since the application process can be more involved than conventional mortgages.
“The challenge is finding someone who is knowledgeable in this space,” said Barry. Not only about the type of loan, but about the areas where you are looking. “Usually this is more than just a transaction. It can be a super complicated process. A little hand holding is helpful.”