Federal Housing Administration loans, known as FHA loans, are often the first type of loan low-to-moderate income borrowers will consider.
The loans require a lower minimum down payments and credit scores. As of 2020, you can borrow up to 96.5% of the value of your home with an FHA loan. So, if you have a credit score of at least 580, you only need to make a downpayment of 3.5%. If your credit score falls between 500 and 579, you can still get an FHA loan, but you need to make a 10% down payment.
While an FHA loan might seem like the perfect option for home loan borrowers who can’t afford to make a hefty down payment, there’s another thing to be aware of. When you put less than 10% down on your home with an FHA loan, you pay for FHA mortgage insurance for the duration of that loan.
FHA loans have annual Mortgage Insurance Premiums between 0.45% and 1.05%. If a homebuyer is putting as low as 3.5% down on their home through an FHA loan it is important for them to take this into account. Here is an example of the cost breakdown that someone with a down payment of 3.5% would pay on a 0.85% annual premium. If the loan was for $250,000, the monthly mortgage insurance would cost roughly $100 a month over a 30-year repayment plan. The mortgage insurance for this person would end up costing around $36,000 over the thirty years they pay off the loan.
While the price of mortgage insurance may seem high, an FHA loan might be the best option for someone with a lower credit score or someone buying their first home. In this case, there is one viable option for avoiding the cost of mortgage insurance over time. Namely, refinancing.
Unlike FHA loans, conventional mortgages cancel your Private Mortgage Insurance (PMI) once you build up enough equity in your home. If you have at least 20% equity in your home, you could consider refinancing, which could lower your payments by eliminating the need for mortgage insurance.
The one exception to FHA loans’ rules about mortgage insurance is any loan closed after December 13, 2000, or applied for before June 3, 2013. For these borrowers, Mortgage Insurance Premiums can be canceled once the borrower is at a 78% loan-to-value ratio.