Is an FHA-Insured Mortgage Right for You?

The days of putting little money down to buy a home aren’t over.

After years of risky mortgages backed up by small down payments, most lenders aren’t underwriting mortgages without a significant sum up front and a high credit score. But a decades-old loophole can still put home buyers in a house for next to nothing. Mortgages insured by the Federal Housing Administration (FHA) allow borrowers to get approved with a down payment as small as 3.5% of the agreed selling price of the house and don’t require a high credit score.

As millions of Americans have come to realize, getting into a house for little money down has its disadvantages. Borrowers who’ve pumped little equity into their home are often more willing to walk away from it during lean times that keep them from making payments; this risk is further elevated when home values are in decline and troubled borrowers are unable to refinance or sell the home at a price that covers their losses.

Still, FHA-insured mortgages are far less risky than the subprime mortgages that lenders originated before the housing bust. FHA-insured mortgages require documentation and verifiable proof that the borrower is capable of making their monthly payments. (Most subprime mortgages didn’t require such proof.)

The looser terms of FHA-insured mortgages have helped make them more popular. Today, FHA-insured mortgages make up about 25% of the mortgage market, up from 3% in 2006, FHA commissioner David Stevens said in a speech earlier this month. In June, the FHA insured 194,000 loans – the highest monthly total in the agency’s history, according to Stevens. For fiscal year 2009, the dollar amount of FHA-insured mortgages is likely to reach 30% of mortgage originations, up from around 4% in 2005 and 2006, says Stu Feldstein, the president of SMR Research, a mortgage-data tracking firm.

“FHA-insured mortgages are one of the only games in town, especially if you can’t qualify for a traditional mortgage,” says Gibran Nicholas, the chairman of the Ann Arbor, Mich.-based CMPS Institute, which trains and certifies mortgage lenders and brokers. “Now that the subprime market is gone, FHA is filling the gap.”

Here’s how to determine if an FHA-insured mortgage is right for you.

Most borrowers of FHA-insured mortgages have stable sources of income and need more flexibility with their credit history and debt load than a conventional mortgage loan might allow, says Lemar Wooley, a spokesman for the Department of Housing and Urban Development (HUD), which FHA is part of.

“When analyzing the borrower’s credit, we expect lenders to examine the overall pattern of credit behavior rather than isolated occurrences of poor performance or relying solely on a credit score,” says Wooley. This includes a borrower’s rental or mortgage payment history, debts, collections, previous foreclosures and bankruptcies. Borrowers with a credit score less than 500 must make a 10% down payment to be eligible, he says.

Today, 78% of FHA-insured purchase-mortgages belong to first-time home buyers, thanks to looser requirements and the comparatively small 3.5% down payment, says Wooley. (Another perk is that borrowers are permitted gift assistance for the down payment from their family, employer or a government entity, but not the seller.)

Rigorous documentation requirements are designated to mitigate the risk associated with making a small down payment – a stark contrast from the glory days of subprime mortgages, when documentation was rarely required and verified, Nicholas says. FHA-insured mortgage borrowers will have to prove they have the cash to close the mortgage by presenting their most recent bank statements. They’ll also have to prove they can repay the mortgage by showing W2 statements and paystubs.

In addition, borrowers’ total mortgage payments (including principal, interest, taxes and insurance) debt-to-income ratio can’t exceed 31% of their gross monthly income, and total debt-to-income (total mortgage payment plus all other debts) ratio can’t exceed 43% of their gross monthly income.