FHA mortgages and mortgage insurance are government programs designed to help first-time homebuyers and other needy borrowers obtain loans to purchase homes. If you have a poor credit score and can’t make a large down payment, you may want to consider an FHA-backed loan—and with an FHA loan comes FHA mortgage insurance. It’s important to understand how both loans and insurance work, so this page walks you through exactly what you need to know.
Buying a home is an important financial decision, so consider consulting with a financial advisor to help you make a wise choice.
FHA Loan Basics
FHA means the Federal Housing Administration, part of the US Department of Housing and Urban Development (HUD). According to HUD’s website, the FHA insures mortgage loans made by FHA-approved lenders.
The FHA does not actually loan the money to borrowers. Instead, they regulate and insure the loan from a private lender, such as a bank or credit union. FHA participation allows the lender to offer you a better deal. The program aims to help borrowers with lower credit scores or down payments as low as 3.5% qualify for a mortgage.
What is FHA mortgage insurance?
When you have a low credit score or a small down payment, lenders see you as a riskier borrower. Mortgage insurance protects the lender if you fall behind on your payments or stop making them altogether. If you default on a mortgage covered by FHA mortgage insurance, the FHA will pay a claim on the remaining principal. This insurance makes the loans less risky for the lender, allowing them to offer mortgages to people who might not otherwise qualify.
Having FHA mortgage insurance doesn’t mean there are no consequences for you if you stop making payments or miss a payment. You can still lose your home and see your credit score take a hit if you fall behind or default on your mortgage. Mortgage insurance is there to protect the bank, credit union, or other entity making the loan, not you.
Mortgage insurance is not required for all mortgages, but is almost always required for FHA loans. It’s also common for borrowers to be unable to put down at least a 20% down payment on their home, even if their mortgage isn’t FHA-backed.
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How does FHA mortgage insurance work?
FHA mortgage insurance works like this: you’ll need to get insurance at the same time you take out the loan. Your credit score doesn’t affect the price of insurance, but you’ll likely see a small price increase if your down payment is less than 5%.
The total cost of FHA mortgage insurance consists of two parts: an upfront cost and a monthly cost. Upfront costs are usually paid with the closing costs of your home, but you can roll the fee into your mortgage if you can’t pay it upfront. This will increase your total loan amount. The upfront mortgage insurance premium is 1.75% of your principal loan amount — so if your total loan is $200,000, your upfront mortgage insurance payment would be $3,500.
The monthly cost of mortgage insurance premiums is a bit more complicated. It is determined by the amount of your down payment, the term of your mortgage and your loan-to-value ratio. You will make all of your FHA mortgage insurance payments directly to FHA.
Example of FHA mortgage insurance
Let’s say you have a low credit score of 580 and have $250,000 saved up. You’re looking for your first home. You find a $400,000 house that you really want to buy, but with a 5% down payment and poor credit, you don’t qualify for any loans.
First, you check the FHA mortgage limits for your county by simply searching their website. You discover that a $400,000 house is actually within the cost limits in your county. You can then use HUD’s Lender List search to find an FHA-approved lender in your area.
Now, while the FHA-back aspect of an FHA mortgage will help you qualify for a loan even with a lower credit score and smaller down payment, the lender will still look at things like your work history, your payment history, and your debt-to-income ratio to determine whether to give you the loan or not.
Once the lender approves your loan, you’ll go through the normal steps of buying the house — and you’ll need to get FHA mortgage insurance. You’ll pay your $7,000 down payment at the same time you pay your home’s closing costs, and then make your monthly payments over the life of the loan.
In a positive scenario, you successfully pay off your mortgage and own your home outright. You no longer owe mortgage insurance premiums and can enjoy life as a first time home owner! On the downside, let’s say things take a turn for the worse and you’re no longer able to make your mortgage payments. Your house will be repossessed, your credit score will be changed, and the FHA will pay the lender who gave you the mortgage the principal that is still outstanding.
The bottom row
While FHA mortgage insurance doesn’t protect you from losing your home, it protects lenders and allows them to offer you a mortgage that you might not qualify for otherwise. This allows people who may have lower credit scores or smaller down payments to become homeowners. Make sure you know you can afford both the mortgage payments and the mortgage insurance payments over the life of the loan before taking out an FHA-backed mortgage.
If you’re struggling to save for a down payment or have other financial plans for the future, you may find it helpful to speak to a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisor matches for free to decide who’s the best fit for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Want to know what your mortgage payment could look like and the difference a higher down payment can make? Use SmartAsset’s mortgage calculator to calculate your monthly payments with taxes, fees and insurance.
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