MCS Mortgage services the states of Florida, Maryland, and Virginia. While MCS Mortgage offers all kinds of loans to homebuyers – from VA loans to fixed-rate to adjustable-rate mortgages (ARM) – one of the most popular loans to apply for is the FHA home loan.
As a loan that’s sponsored by the Federal Housing Administration (FHA), which is part of the US Department of Housing and Urban Development, the FHA loan is one of the easiest to apply for. It requires lower credit score minimum than most loans, but it’s also ideal for first-time homebuyers and homebuyers who have been impacted by bankruptcy, poor credit, and other financial hardships.
Though the FHA loan is one of the easiest to qualify for, it still has some requirements.
Minimum Credit Score Can’t Be Too Low
While it is true the FHA loan has a lower minimum credit score requirement, it also can’t be too low. So, what exactly is a credit score and why is this important for qualifying for a loan? A credit score is a three-digit number determined by FICO and ranges from 300 to 850 with 300 being poor and 850 being excellent. A score above 720 is considered good while a score above 580 is considered fair.
Since credit score is informed by a borrower’s credit report, lenders use the borrower’s credit score to determine the likelihood of them repaying the loan consistently and on time. As such, the credit score is used to help lenders make smart decisions about who to lend money to, as well as protect their own assets. The higher a borrower’s credit score, the more likely they’ll be approved for a loan.
In the case of qualifying for an FHA loan, homebuyers need a minimum credit score of 500.
A Higher Credit Score Translates into a Lower Down Payment
One of the most attractive qualities of the FHA loan is that it requires a smaller down payment than most home loans. In most cases, a homebuyer will only need to make 3.5% down payment, but only if they have a credit score of 580 or higher. For homebuyers with a credit score between 500 and 579, they will often need to make a 10% down payment. Why this difference in down payment depending on credit score?
Since a down payment is the money a homebuyer pays upfront, this reduces risk to the lender on a few key points: first, saving enough money for a down payment requires good budgeting practices on behalf of the homebuyer. Second, a homebuyer investing their own money into a property will make them less likely to default on monthly payments. Third, a down payment can limit a lender’s potential losses if the property has to be foreclosed and resold for less than the amount of money still owed.
Considering what a down payment does for the lender, homebuyers with a higher credit score are less likely to default on their monthly payments and are therefore low-risk to the lender. As such, they can make a lower down payment. In the case of homebuyers with a lower credit score, they tend to be more high-risk to lenders. To account for the likelihood of defaulting, homebuyers with lower credit scores make slightly higher down payments due to that high-risk factor.
Debt-to-Income (DTI) Ratio Still Needs to be Low
One detail that has a significant impact on credit score is the debt-to-income (DTI) ratio, which is the sum of every monthly debt payment divided by gross monthly income. To qualify for most home loans, a homebuyer’s DTI ratio needs to be lower than 43%. The same is true for qualifying for an FHA loan. Why is that?
In the same way that a borrower’s credit score is used to determine the likelihood they will default on their monthly payments, a borrower’s DTI also informs lenders on the potential risks of lending them money. If a borrower is paying more in debt than what is being earned in gross income, their DTI ratio will be higher. As such, a DTI ratio of 43% or higher increases the likelihood of a borrower defaulting on a monthly payment.
What types of debts inform DTI ratio? Anything from credit card debt, student loan debt, car loan debt, personal loan debt, and even mortgage debt. In the same way that owing too many debts lowers a borrower’s credit score, owing too many debts also increases a borrower’s DTI ratio. As such, credit score and DTI often go hand-in-hand with each other. By paying off as many debts as possible, this will both increase a homebuyer’s credit score and lower their DTI ratio.
A Homebuyer Must Have Steady Income
Related to the points about credit score and DTI ratio is a steady flow of income. In the same way many home loans require proof of employment or a steady flow of income, the FHA loan also requires it. The type of employment a homebuyer has will determine the documentation needed.
For homebuyers employed by an organization, they will need to provide recent pay stubs or W-2 forms from the past two years. The same applies for part-time and seasonal employees. For homebuyers who are self-employed, they will either need to provide an IRS Form 1040 or an IRS Form 1120 if incorporated. Other forms of income documentation include business income statements from the past two years, or profit or loss statements from the past two years.
The Home Needs to be a Primary Home
One requirement that’s unique to the FHA loan is that it’ll only be given to homebuyers looking to purchase a primary home. It will not be used for purchasing secondary homes, vacation homes, or investment properties. This is because the FHA loan is designed to assist low-to-moderate income homebuyers purchase a home.
A Homebuyer Is Required to Pay a MIP
Another unique requirement of the FHA loan is that all homebuyers who apply for this loan will be required to pay a mortgage insurance premium (MIP). This is because the Federal Housing Administration guarantees lenders protection against losses by insuring the FHA loan. The insurance on the loan is paid for by the homebuyer through the MIP.
To find out if the FHA loan is right for you, be sure to contact MCS Mortgage at 833-415-LOAN or by email at Hello@MCSMLS.com.