Buying a home with an FHA loan means a low down payment. You don’t need the typical 20% down. In fact, you need a lot less than that. FHA loans require just 3.5% of the purchase price down. Here we discuss how this works and how the low down payment affects you down the road.
How the Down Payment Affects You
You can choose any amount equal to or higher than the minimum 3.5% down payment. Here’s an example:
Let’s say you buy a home for $125,000. The minimum amount you can put down is $4,375. A higher down payment may benefit you, though. We discuss how below.
FHA loans require 2 types of mortgage insurance – upfront and annual. You pay the upfront mortgage insurance at the closing. Right now, it equals 1.75% of the loan amount. We’ll use the above example here. You buy a home for $125,000, which means you borrow $120,625. The upfront MIP on this loan (1.75% of the loan amount) equals $2,110. You can pay this amount in cash or roll it into your loan.
The annual mortgage insurance on a standard 30-year loan equals 0.85% of the loan amount. The lender pays this amount annually for you. In exchange, they charge you 1/12th of the balance on a monthly basis. You pay it alongside your mortgage payment. On the $120,625 loan, you pay $1,025 per year or $85.42 per month.
You only pay the upfront MIP one time, unless you refinance. The annual MIP, however, you pay for the life of the loan or until you pay it off. The amount you pay each year decreases slightly as it’s based on your average loan balance for the year. The more principal you pay down, the less MIP you owe.
Does a Larger Down Payment Help?
Now let’s look at what happens if you put down larger than the 3.5% down payment. Using the same $125,000 home, let’s say you put down 5%. This means $6,250. Your loan amount now equals $118,750. Your upfront MIP would equal $2,078 and your annual mortgage insurance equals $961 per year or $80.08 per month. The savings aren’t tremendous.
Let’s look at a 10% down payment. A 10% down payment equals $12,500. The upfront MIP would then be $1,968 and your annual MIP would be $79.67 per month. You only save $142 on the upfront insurance and $5.75 per month. In comparison, you put down $8,125 more.
Choosing the Minimum Down Payment or Higher
Now, how do you decide between the minimum down payment and a higher one? Think of your plans. Is this your long-term home? Will you stay here for more than 5 years? If so, a lower mortgage payment may be a better idea. This means a higher down payment. You minimize the mortgage insurance you pay and pay your principal down faster. If, however, you know you will move in the near future, investing too much right away may not make sense. You won’t benefit from the slightly lower MIP in the short time you live in the home. You may benefit from paying the higher monthly payments and keeping your savings.
A Down Payment as a Compensating Factor
There is one circumstance that warrants a higher down payment. If you pose a high risk to lenders, a higher down payment may be a compensating factor. This means it “makes up” for your risky factors. Let’s say you have a credit score of 630 and debt ratios of 31/43. These are the maximum allowed FHA debt ratios. Combining the higher ratios with a lower credit score shows the lender you are risky. If, however, you have a compensating factor, such as a larger down payment, it may offset the risk.
FHA Loans Offer Flexibility
One of the greatest things about FHA loans is their flexibility. The FHA sets specific standards, but they aren’t as strict as many other programs. Certain FHA approved lenders don’t even allow the low credit scores or high debt ratios the FHA allows. Shopping around with different lenders gets you around this problem, though.
If you have a lower credit score or higher debt ratio, don’t worry. There are lenders out there able to accept risk. The best thing you can do is show your compensating factors. Maybe your low credit score is out of your control. People suffering medical emergencies or a sudden job loss found themselves in financial trouble. Even if those days are behind them, credit scores can increase slowly. This is where FHA loans come in handy. They give these types of borrowers a second chance without plenty. FHA rates are comparable to conventional loans. Borrowers don’t pay extra high rates just because of their previous dire circumstances.
If you consider an FHA loan, look at your options. Talk to your lender about the effects of making a larger down payment. Look at the amortization table and determine just how much you save on MIP with a higher down payment. Often, the differences are negligible. You may be better off saving the money for reserves or other investments. Even if this is your long-term home, you aren’t stuck with MIP for the rest of your life. You have options, including refinancing into a conventional loan.
Consider taking the FHA loan now and working on your credit and debt ratios. As you improve your financial status, you may be eligible for a conventional loan in the future. Of course, waiting until you owe less than 20% of the value of the home saves you even more. This way you skip PMI altogether and strictly pay principal and interest on your loan.
Overall, the 3.5% minimum down payment can help you buy a home. You have options in the future, whether you refinance with the FHA Streamline Refinance or opt for the conventional loan. You have options once you start. The first step is getting you into the home with the 3.5% minimum down payment.