Is a Government-Backed Loan Right for You?

What is a government-backed home loan? 

Are you ready to unlock the doors to your dream home but face hurdles pursuing traditional home loans? Imagine a pathway that not only welcomes you but empowers you, regardless of credit scores or down payment limitations. Enter the world of government-backed loans – a realm with lots of possibilities and few barriers.

So what exactly is a government-backed mortgage? As the name implies, it’s a home loan that’s guaranteed by the federal government. If you ever find yourself unable to keep up with mortgage payments, the government will compensate your lender for the portion of your mortgage covered by the program.

Read on to learn about the different types of government-backed loans, eligibility criteria, and the pros and cons that come with this type of financing.

In this article (Skip to...)

• What draws buyers to government-backed loans?
• Types of government-backed loans
• Who qualifies for a government-backed loan?
• Pros and cons of a government-backed loan
• Is a government-backed loan right for you?
• The bottom line

What draws buyers to government-backed loans?

Since government loans are federally backed, lenders can extend loans to applicants who would otherwise struggle to get their mortgage applications approved.

These loans cater to individuals with credit scores as low as the 500s. They may have only a small (or no) down payment. Or their existing debt burden may be a little bigger than a purely private mortgage could permit.

In other words, government-backed loan programs allow numerous Americans who couldn’t otherwise get a mortgage to turn their homeownership dreams into reality.

Loans that aren’t directly backed by the government are called “conventional loans.” And a subgroup of those, which conform to rules laid down by Fannie Mae and Freddie Mac, are called “conforming loans.”

What are the different types of government-backed loans and how do they work?

There are three types of government-backed loans. So, let’s quickly look at each.

FHA loans

FHA loans are provided by the Federal Housing Administration (FHA), which operates under the umbrella of the U.S. Department of Housing and Urban Development (HUD). These loans accessible to individuals across the nation.

To qualify, you’ll need to meet relatively straightforward criteria, which are detailed in the next section.

If your down payment is less than 20% of the purchase price, you’ll have to pay monthly mortgage insurance premiums. And, unlike with some other types of mortgages, you’ll have to do so until you sell the home or refinance the mortgage.

Most mainstream lenders accept applications for FHA loans. However, it’s important to gather quotes from multiple lenders whenever you apply for any mortgage. Different lenders will present varying offers, ensuring you secure the best possible deal.

Indeed, in April 2023, federal regulator the Consumer Financial Protection Bureau reported on its own recent research:

“Mortgage borrowers are paying around $100 a month more depending on which lender they choose, for the same type of loan and the same consumer characteristics (such as credit score and down payment).”

So, to ensure that you’re not overspending by $100 a month on your FHA loan, always comparison shop across several lenders.

VA loans

VA mortgages are government-backed loans administered by the United States Department of Veterans Affairs. And, as you’d expect, they’re available exclusively to veterans, current service members, and a few closely related groups.

If you meet the eligibility criteria for one of these loans, it’s likely to be the best mortgage you can get. They typically come with some of the most competitive mortgage rates in the market, a 0% down payment, and no continuing mortgage insurance after an initial funding fee.

Many mainstream mortgage lenders offer VA loans. There are even a few specialist lenders, often run by former military personnel, that focus on catering to these mortgages.

USDA loans

USDA loans are backed by the United States Department of Agriculture (USDA) under its rural development program. They’re available only to those on low and very low incomes.

Moreover, the home you wish to buy must be in a place designated as a rural area. But the definition of “rural” is more broader than you might think. You might even be eligible if you’re buying in a suburban location of a city with population of less than 20,000.

Not sure whether your income and the home’s location mean you’re eligible? Visit the USDA Income and Property Eligibility Site to find out.

It’s worth the effort. That’s because USDA loans require zero down payment, usually come with competitive mortgage rates, and have reduced rates of mortgage insurance.

Not all mainstream mortgage lenders offer USDA loans. But plenty do. So, shop around to find several and ask each for a quote. That way you can find the best deal possible.

Who qualifies for a government-backed loan?

Each type of government-backed loan has its own eligibility criteria. So, let’s look at them one by one.

You should note that individual lenders are free to impose their own, stricter criteria. But they can’t loosen the relevant government department’s rules.

If you find a lender who denies you a government-backed loan even though you meet the basic standards for it, simply move on to other lenders that might be more accommodating.

FHA loans

To qualify for an FHA loan, the following criteria apply:

• A credit score of 580 or better (unless you have at least a 10% down payment, in which case, a score of 500 or higher may be acceptable)
• A down payment of 3.5% or more of the home’s purchase price. Check to see if you can get down payment assistance
• Debt-to-income ratio (DTI) of 50% or less
• Steady income stream backed up by a solid employment history

In addition, you should not have undergone a foreclosure in the previous three years. And you must intend to use the home you’re buying as your primary residence.

VA loans

For a VA loan, you’ll first need a certificate of eligibility (COE) from the Department of Veterans Affairs. This will confirm that your past or present military service reaches the threshold necessary to get a VA loan, including an honorary discharge where applicable.

Once you have your certificate, you’ll need the following:

• A respectable credit score. The VA doesn’t set a minimum but many lenders insist on 640-660. If your score is lower, seek out a more flexible lender, even if it’s in the 550-580 range
• Zero down payment
• A maximum DTI of 41%
• To pay a funding fee at closing, which is 2.3% of the loan amount for first-time VA loan users with zero down. This effectively exempts you from paying mortgage insurance each month
• A job history going back a couple of years
• Evidence of a steady income flow

If your funding fee and other closing costs possess a challenge, you may be eligible for down payment assistance programs. Some of these programs provide closing cost assistance, too.

USDA loans

To get a USDA loan, you’ll have to have a modest income (no more than 115% of the area median income where you’re buying) and be purchasing a single-family home as your principal residence in an area designated as rural by the USDA.

In addition, you’ll need:

• Zero down payment
• A credit score, ideally around 640, though the USDA offers direct loans (no private lender), which may be available with lower scores
• DTI of 41% or less
• To purchase a home that meets (or will be made to meet) the USDA’s safety requirements
• To be a U.S. citizen

USDA mortgages may not be as famous as other government-backed loan programs. But, for the right buyer, they can be an excellent choice.

Pros and cons of a government-backed loan

If you get a mortgage with less than a 20% down payment, you usually have to pay mortgage insurance premiums each month. Only VA loans come with no mortgage insurance in those circumstances.

That’s the general rule. But read How to avoid PMI without 20% down to see if you can use a workaround.

With conforming loans, you can typically stop paying those premiums when the equity in your home reaches 20%. Specifically, equity is the difference between what your home is worth and what you owe your lender. Here’s how to calculate it.

But that doesn’t apply to FHA loans or USDA loans. With those, you must continue to pay for mortgage insurance until you sell the home, refinance the mortgage, or fully repay your loan.

And that’s costly. Some would argue you should avoid FHA and USDA loans solely on that basis. They suggest waiting until your credit score reaches 620, which will allow you to get a Fannie or Freddie loan.

That might be true if you can do so quickly and home prices aren’t rising too fast. But, for many borrowers, FHA, VA, and USDA loans are their only routes to homeownership.

And those with FHA and USDA loans believe mortgage insurance is a price worth paying to get their feet on the first rung of the property ladder. If you can get a USDA loan, its mortgage insurance rate is lower than the FHA’s.

To sum up, continuing mortgage insurance is the biggest downside of FHA and USDA loans. However, their main upside is that they tend to be more accessible than conventional and conforming loans.

How to know if a government-backed loan is right for you

If you’re eligible for a VA loan, it’s likely to be the most beneficial choice. And, if you’re eligible for a conventional or conforming loan (and you’re not in line for a VA one), one of those will often outperform a USDA or FHA loan.

VA loans are great because they reward heroes for their service to the nation. But other types of government-backed loans primarily serve individuals who might otherwise struggle to step into homeownership.

Just be aware that those are just rules of thumb. To be sure you’re getting the type of loan that suits you best, talk things through with a mortgage lender. They are they to offer guidance tailored to your situation.

The bottom line

When home prices are rising sharply, homebuyers are often better off getting a government-backed loan rather than waiting until to qualify for a conventional or conforming one. If home prices are falling or stagnant where you want to live, you may be better off waiting until you’re eligible for a wholly private mortgage.

VA loans are different. Although rate differentials vary, these are often more competitive than conventional and conforming loans — sometimes by a wide margin. And they have no mortgage insurance.

The great thing about conforming loans is that you can stop paying monthly mortgage insurance premiums once your equity stake reaches 20%. However, you’d have to get a new mortgage (sell or refinance) for that to happen with an FHA or USDA loan. With those, you keep paying the premiums until your last mortgage payment, perhaps 30 years on.

Remember that all these facts differ for each individual. So, to be sure you pick the type of mortgage that suits your needs best and talk your personal situation through with a mortgage lender.

How do you find mortgage companies that will work with individuals in situations like yours? We can help with that. Fill in an easy form and we’ll introduce you to some helpful lenders.