The FHA loan has the nickname ‘first-time homebuyer’s loan.’ It’s not just for first-time homebuyers, but it can be a great way for those that have never owned a home or had a mortgage to get the financing that they need.
What’s so great about the FHA loan for first-time homebuyers? The list is long, but the most important features are the low down payment requirements and the low credit score requirements. The FHA loan makes it easier for first-time homebuyers to become homeowners much sooner than many other programs allow.
Keep reading to learn how the FHA loan can help you become a first-time homebuyer.
The Required Down Payment
Let’s start with the part that everyone fears – the down payment. A lack of funds is usually what holds people back from buying a home. Many people assume they need a 20% down payment, which for many, is unachievable. On a $200,000 home, you would need a $40,000 down payment. Without a home with equity to sell, saving $40,000 can be difficult.
FHA loans, though only require a 3.5% down payment. On that same $200,000 home, you would only need a $7,000 down payment. That’s $33,000 less than you’d need for a 20% down payment. That’s a lot easier to achieve.
Even better news, though, is where the FHA allows the down payment to originate. The perfect scenario is for you, the borrower, to have the funds, but if you don’t, you may receive the entire 3.5% down payment as a gift. The FHA doesn’t require borrowers to put in any of their own funds for the down payment. Gift funds may come from:
- Immediate family members
- Family members through marriage
- Close friends that you can document a longstanding relationship
As long as you can prove that the funds are a gift and no repayment is required (it’s not a loan), you may be able to use gift funds. This makes it easier for fist-time homebuyers that don’t have a home to sell, come up with the necessary down payment. We’ll discuss gift funds in detail below.
Proving Your Gift Funds
It’s not enough to just get gift funds from a relative or friend. You have to provide proof of the funds’ origination. In other words, the lender needs to make sure there isn’t a loan buried in there somewhere. The donor can provide proof of the funds with their last two months of bank statements or proof of where the funds came from, such as the sale of an asset.
With the proof of the funds, proof of transfer to you (copy of the check), and proof of the deposit in your account (deposit ticket), you should be able to use the funds given to you as a gift. Always make sure you keep a paper trail though – you cannot just accept funds and assume the lender/FHA will allow the use of them for qualifying purposes.
The Required Credit Score
Now, the next dreaded factor – the credit score. FHA loans don’t require you to have perfect credit. In fact, they allow credit scores that are far from perfect. You may qualify for an FHA loan with a credit score as low as 580. Compare that to the minimum 680 score needed for conventional loans and you’ll see the leniency.
Along with a 580 credit score, your credit history should be ‘decent.’ This means:
- Timely payments on all debts
- No collections
- No defaulted federal debt
- Credit utilization rates less than 30% (less than 30% of your available credit should be outstanding)
The FHA is flexible with credit score requirements, but some lenders may have stricter requirements. Since FHA lenders can make the rules ‘harder,’ you may need to shop around for a lender that doesn’t have stricter rules when looking for an FHA loan.
Keep in mind that some lenders may want to see some type of housing history. Because you’re a first-time homebuyer, you won’t have a mortgage payment reporting. But if you pay rent (even if it’s to your parents) providing proof of on-time rent payments for at least the last 12 months can help you get approved.
The Required Debt Ratios
Another aspect of the loan qualifications you must follow is the debt ratios. This is a comparison of your debts to your gross monthly income (income before taxes).
Lenders look at your debt ratio in two ways:
- Housing ratio – This compares your intended mortgage payment to your gross monthly income. The FHA allows a housing ratio of up to 31%.
- Total debt ratio – This compares your current monthly debts along with the intended mortgage payment to your gross monthly income. The FHA allows a total debt ratio of up to 41%.
You can determine your debt ratios by looking at your gross monthly income first. If you earn a salary, you can easily calculate this figure by dividing your annual salary by 12 months. If you work hourly or on commission, you should average the last two years of your income together (from your tax returns) and then divide that number by 12 months.
You should then look at your intended mortgage payment as provided to you by the lender on your Loan Estimate. The lender will send you a Loan Estimate within three business days of you applying for the loan. On the Loan Estimate you’ll see the total housing payment, which should include principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance.
Use the following formula to figure out your housing ratio:
Housing Payment/Gross Monthly Income = Housing Ratio (should be less than 31%)
Next, total up your monthly debts. You only need to include the following:
- Minimum credit card payments
- Installment loan payments
- Student loan payments
You only need to include the debts that report on your credit report. In other words, debts such as utilities, insurance, groceries, and household items don’t need to be included in your debt ratio.
Use the following formula to figure out your total debt ratio:
Total new mortgage payment + Existing monthly debts/Gross Monthly Income = Total Debt Ratio (should be less than 41%)
Qualifying for an FHA loan as a first-time homebuyer isn’t as hard as it seems. The FHA offers flexible guidelines, making it easy for first-time homebuyers to get the loan they need.