What is a Government-Backed Mortgage Loan and Who Qualifies?

If you are considering purchasing a home in the United States, you'll probably be one of the 87% of buyers who choose to finance rather than pay in cash. In this case, it's a good idea to learn about your financing options and payment requirements.

Everything You Need to Know About Government-Backed Mortgage Loans

The majority of potential homebuyers will seek a conventional loan, but some choose to pursue a government-backed loan. The latter is less accessible to the average homebuyer due to strict guidelines but can be a great option if you are eligible. For example, some guidelines consider the location of your home, or whether you are/were an eligible member of the US military. Read on to learn more about these mortgages and the requirements to qualify.

Government-Backed Mortgages vs Conventional Loans

Depending on the types of loans offered, a government-backed home loan could work for borrowers with credit scores as low as 500 or no credit score at all. Compare this to conventional mortgages which require applicants to have a minimum credit score of 620.

Mortgage insurance is optional for conventional mortgages, depending on the size of your down payment and your loan-to-value ratio (LTV). For most types of government home loans, mortgage insurance is mandatory. The insurance stays for the life of the loan unless your initial down payment is more than 10%. In that case, the mortgage insurance premiums will fall off after 10 years.

A government home loan also limits the type of home financing to the owner's primary residence. This means that borrowers may not finance a second home or an investment property, which is possible through a conventional loan.

How Do Government-Backed Mortgages Work?

The government does not directly fund government-backed loans. Instead, a government agency will insure, or guarantee, a loan from an approved private lender. This lessens the risk for the lender in case the borrower defaults on the loan (in other words, they can't pay their debt). In turn, the mortgage lender feels more comfortable decreasing or even eliminating the minimum requirements for credit scores and down payments.

Three different federal government agencies insure mortgages: the Federal Housing Administration (FHA), the United States Department of Agriculture (USDA), and the Department of Veterans Affairs (VA).

FHA Loans

FHA loans are the most accessible of the three options, with no restrictions on the home's location or buyer's military background. These types of loans are popular among first-time homebuyers who are still building up their savings and credit scores.

Whether for repeat or first-time buyers, FHA loan limits vary depending on your county. In 2022, the maximum amount is generally $420,860 for single-family homes in low-cost areas and $970,800 for pricier markets.

Credit Score and Down Payment

Your minimum down payment for an FHA loan can be as low as 3.5% if your credit score is at least 580. If your credit score falls between 500 and 579, your down payment must be at least 10% of the home purchase price. Note that while the FHA sets the minimum credit score required for a borrower to be considered, different private lenders may choose to bump up that number.

Income and Debt

To be considered for an FHA loan, your debt-to-income (DTI) ratio must be 50% or lower, with a credit score of 580 or higher. If you don't meet that credit score requirement, your DTI will need to be even lower. In addition, your front-end debt ratio or payment-to-income (PTI) ratio can be as high as 40%. Again, that's if your credit score is at least 580.

When it comes to your total income, there are no minimum or maximum guidelines for an FHA loan. You will need to have at least two established credit accounts (such as a car loan and a credit card) and verify any cash gifts that will be used toward the down payment. Interestingly, an FHA loan allows up to 100% of the down payment to be attributed to cash gifts. Conventional loans limit this to 20%.

USDA Loans

Contrary to what some might think, USDA loans are not limited to those in the agricultural industry. If you would enjoy living in a rural area and are unable to pursue a traditional mortgage, this type of loan might be for you.

USDA loans are issued through the USDA Rural Development Guaranteed Housing Loan Program. To figure out if a property is in an eligible rural area, you will need to visit the USDA website and search for your preferred address. Don't let the term “rural” scare you away! You may not be able to live in a bustling metropolis, but many eligible rural areas are located right outside of city limits.

Credit Score and Down Payment

While it is always beneficial to have an adequate credit score, USDA loans may also approve borrowers with no credit score at all. The borrower will have to demonstrate their credit history through other means, such as consistent utility payments.

If your credit score is above 640, the loan approval process becomes much easier. You could even end up with a down payment as low as zero.

Income and Debt

Adjusted income limits depend on your location. As with most mortgages, you will need to demonstrate dependable income for at least two years. Your PTI ratio must be 29% or less, and your DTI ratio must be 41% or less if your credit score is less than 680.

VA Loans

Those who wish to apply for a loan backed by the VA must meet at least one of the following requirements:

• 90 days of active service during wartime
• 181 days of active service during peacetime
• 6 years of service in the National Guard or Reserves

Even if none of these apply, you could be eligible depending on how you were discharged from service. You may also qualify if you are a spouse of a deceased service member who died during active duty or from a service-related injury.

Credit Score and Down Payment

The VA doesn't set any minimum credit score or down payment for borrowers. However, private lenders may set their requirements, with 620 being the typical minimum credit score. This will vary from lender to lender, so it's good to shop around.

Income and Debt

Qualifying veterans or spouses will need to maintain satisfactory residual income every month as required by the VA. This means that after all major monthly expenses have been taken care of, your residual income can cover the rest of your household's needs such as groceries and transportation. Lenders will also examine your debt-to-income ratio. There is no strict number, but you need to demonstrate healthy finances and the ability to pay off a loan.

Take Your Next Steps with The Sutton Team

Not everyone is eligible for a government-backed mortgage, but it’s a great option to consider if you do qualify. Once you’re ready to start your home search, The Sutton Team at Coldwell Banker Chesapeake Real Estate will be there to help every step of the way. Contact us today!