FHA and mortgage insurance are government programs intended to help first-time homebuyers and other borrowers in need of obtaining home loans. If you have a low credit score and can’t make a large down payment, you might consider getting 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 a financial advisor to help you make a wise decision.
FHA loan basics
FHA stands for Federal Housing Administration, which is part of the US Department of Housing and Urban Development (HUD). According to the HUD website, the FHA insures mortgages offered by FHA-approved lenders.
FHA does not actually lend money to borrowers. Instead, they arrange and secure the loan from a private lender, such as a bank or credit union. Sharing an FHA allows the lender to offer you a better deal. The program aims to help borrowers with low 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 default on your payments or stop making them altogether. If you default on a mortgage that is covered by FHA mortgage insurance, the FHA will pay a principal balance claim. This insurance makes the loans less risky for the lender, allowing them to offer mortgages to people who might not otherwise qualify.
If you have FHA mortgage insurance, that doesn’t mean there aren’t consequences for you if you stop making payments or miss payments. It is still possible to lose your home and see a hit on your credit score if you default on or default on your mortgage. Mortgage insurance exists to protect the bank, credit union, or other entity that is lending to you—not you.
Mortgage insurance is not necessary for all mortgages, but it is always required for FHA loans. It’s also common for borrowers who can’t make a down payment of at least 20% 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 will need to take out insurance at the same time you get the loan. Your credit score does not affect the cost of the insurance, but you will likely see a small increase in the rate if your down payment is less than 5%.
The total cost of FHA mortgage insurance has two parts: the initial cost and the monthly cost. The initial cost is usually paid with your home’s closing costs, but you can roll the fee onto your mortgage if you can’t pay it up front. This will increase your total loan amount. The mortgage insurance premium upfront is 1.75% of the principal loan amount — so if your total loan is $200,000, your mortgage insurance advance would be $3,500.
The monthly cost of mortgage insurance premiums is a bit more complicated. It is determined by the size of your down payment, the term of your mortgage, and the loan-to-value ratio. You will make all FHA mortgage insurance payments directly to the FHA.
An example of FHA mortgage insurance
Let’s say you have a low credit score of 580 and you save $250,000. You are looking for your first home. You find a $400,000 home that you really want to buy – but with a 5% down payment and lackluster credit score, you don’t qualify for any loans.
First, you can check the FHA mortgage limits for your county via a simple search on their website. You find that the $400,000 home is actually within the cost limits in your county. You can then use HUD’s lender listing search to find an FHA-approved lender in your area.
Now, while the back side 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 own debts. Use your income ratio to determine whether or not to give you the loan.
Once the lender approves your loan, you’ll go through the normal steps of buying the home — and you’ll need to get FHA mortgage insurance. You’ll pay a $7,000 down payment at the same time you pay the closing costs on your home, and then you’ll make your monthly payments over the life of the loan.
In a positive scenario, you can successfully pay off your mortgage and own your home outright. You no longer owe mortgage insurance premiums and will enjoy life as a first time homeowner! On the downside, let’s say things take a bad turn and you can no longer make your mortgage payments. Your home will be taken, your credit score will be choked and the FHA will pay the lender that granted you the mortgage the principal balance that is still due.
While FHA mortgage insurance does not protect you from losing your home, it does protect lenders and allow them to offer a mortgage for which you may not qualify. This allows people who may have lower credit scores or smaller down payments to become homeowners. Make sure you know that you can afford both mortgage payments and mortgage insurance payments over the life of the loan before taking out an FHA-backed mortgage.
If you’re struggling with saving for a down payment or with other financial plans for the future, you may find it helpful to talk to a financial advisor. Finding a qualified financial advisor doesn’t have to be difficult. The free SmartAsset tool matches you with up to three financial advisors serving your area, and you can interview your own advisors at no cost to determine which one is right for you. If you’re ready to find a counselor who can help you achieve your financial goals, get started now.
Want to know what your mortgage payments might look like and what difference a higher down payment might make? Use the SmartAsset Mortgage Calculator to estimate your monthly payments along with taxes, fees and insurance.
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Else What is FHA Mortgage Insurance? It first appeared on the SmartAsset blog.