Q: I am trying to get an FHA Loan. Should I use most of my cash to pay off credit card debt or put more money toward the down payment?
A: If you are seeking an FHA loan, you actually need to be concerned with both things – paying off credit card debt and having a big enough down payment to qualify for the loan.
That’s because FHA loans require that you meet certain debt-to-income ratios, which will be calculated based on how much credit card debt and other monthly bills you have outstanding, compared with how much income you make.
Additionally, FHA loans require a minimum down payment of 3.5% of the home’s purchase price. So in your case, it probably is not a case of “either” pay off debt “or” have a bigger down payment. More likely, you need to use your cash to achieve both of these goals. Here’s what else you need to know to get that FHA loan.
How FHA Loans Work
When you put down less than 20% for a home, you usually have to pay for mortgage insurance.
This is insurance that you buy to protect your lender against your defaulting on your loan. With conventional loans, mortgage insurance is called PMI, or Private Mortgage Insurance.
If you take out a federally-backed loan, such as those insured by the Federal Home Administration (FHA), you pay a monthly MIP, or mortgage insurance premium.
With the help of the Federal Housing Administration (FHA), you can buy a home with just a 3.5% down payment. The FHA itself doesn’t lend you money. Instead, it “guarantees” your mortgage. This means that the FHA promises your lender – either a bank, credit union, mortgage banking company, or another institution – that if you default on the loan for any reason, the FHA will step in, pay off the mortgage, and take over the house.
With FHA backing a loan, lenders are willing to make mortgages available to borrowers with modest down payments.
Qualifying for an FHA Loan
To qualify for an FHA loan, you need to have a steady income, one that is sufficient to support your mortgage loan. In fact, because the FHA has no maximum income limits, FHA loans are available to practically all working homebuyers.
The house you select must be up to code and “suitably located as to site and neighborhood.” Of course you must come up with the 3.5% down payment and your closing costs. On this last point, the FHA is quite lenient.
Your down payment doesn’t have to come out of your own pocket. You can receive gift funds from family members, housing grants from city housing programs, or down payment assistance from non-profits and other entities.
Also, you can roll your closing costs into your mortgage, so you pay those expenses over time, rather than all upfront.
Another advantage of FHA-backed loans is that they frequently carry lower interest rates than conventional, or non-governmental, mortgages.
Calculating Your Debt-to-Income Ratios
Shane Backer is a New York real estate broker with Robbins & Lloyd Mortgage in Manhattan. In addition to doing business in the five boroughs of New York City, Backer has clients in New Jersey, Connecticut, and Florida.
He says one huge plus concerning FHA loans is that you can get a mortgage even if you have poor credit.
“It’s not a credit score program. It’s based on DTI,” says Backer. The debt-to-income ratios that FHA allows are 31/43, meaning your front-end ratio, your entire housing payment, can’t be more than 31% of your gross monthly income.
Also, all of your other long-term debts, combined with your mortgage payment, can not exceed 43% of your gross monthly pay. “The good thing about this program is that you can literally get 100% financing with a 550 credit score,” Backer adds because “the down payment can come from a gift – and it doesn’t have to be seasoned,” meaning the money doesn’t have to be sitting in a bank someplace like conventional loans require.
The Downside to FHA Loans
However, FHA loans have several drawbacks. One is the amount of paperwork required for these loans. Real estate agents, mortgage brokers, and bankers often complain that the mountain of documents required make FHA-backed loans far more complicated than other loan options.
Additionally, experts say FHA loans are stricter when it comes to home appraisals. So, in some instances, you might agree to pay a seller’s asking price, and then have an FHA appraiser say that the house isn’t worth that price, throwing a monkey wrench in the whole deal.
Another downside is that FHA mortgages require you to pay a mortgage insurance premium (MIP). As of this writing, the insurance totals 2% of the loan amount. You pay an upfront premium of 1.50% of the loan amount at the closing (which can be added to your mortgage).
There is another monthly MIP amount of .50% added to the principal, interest, taxes, and insurance you pay. As a first-time buyer, however, you can cut your FHA mortgage insurance premium by .50% just by taking a housing counseling class. Also, in January 2010, the FHA asked Congress for the authority to increase to 2.25% the mortgage insurance premiums it charges to home buyers.
New Restrictions on the Way for FHA Loans
Paying for mortgage insurance on FHA loans is no different than buyers with less than 20% down payments paying for PMI, or private mortgage insurance, on conventional, non-governmental loans. What is different, however, is the cost between the two forms of insurance.
When you pay 10% down on conventional mortgages, private mortgage insurance often costs just .50% of the loan amount, and then can fall to as little as .30% of the mortgage during subsequent renewal years.
One final disadvantage of FHA-backed mortgages is that other restrictions may soon occur with these loans. As of this writing, the Federal Housing Administration has issued a proposal to force borrowers to have at least a 580 FICO score in order to qualify for a 3.5% down payment.
Those individuals with lower credit scores would have to come up with a 10% down payment. Also, the FHA was seeking to decrease to 3% from 6% the maximum contribution or concession that a home seller could make to a buyer in order to get a sale done.
For more information about FHA loans, call the FHA in Washington D.C. at (202) 755-6600 or contact a local FHA office. They’re listed in your phone directory under U.S. Government, Housing and Urban Development, which oversees the FHA. You can also simply ask your lender if they process FHA loans.