Do Loans from The Government Come with an Ease?

The premise behind FHA, VA, and USDA loans is straightforward: they offer a pathway to homeownership for individuals facing potential hurdles with stricter mortgage programs. With government backing, these loans aim to extend homeownership opportunities to buyers who might otherwise struggle to qualify for conventional mortgages.

However, data from the Home Mortgage Disclosure Act (HMDA) in the third quarter of 2023 presents a nuanced picture. It reveals that applications for FHA, VA, and USDA loans experienced higher denial rates compared to conventional loans.

So, why the higher rejection rates if these loans are touted as more accessible? Delve deeper into how government-backed loans function, how lenders evaluate applications, and discover strategies to navigate the application process successfully, ultimately securing approval to realize your homeownership dreams.

Government-backed loans for home purchases don’t entail borrowing directly from the government. Instead, these programs are sponsored by the government to guarantee or insure mortgages. In such arrangements, private lenders—like banks, credit unions, or mortgage companies—provide the funds, and the government promises to reimburse part or all of the outstanding balance if the borrower defaults. FHA loans, VA loans, and USDA loans fall under this category, each with its specific requirements. Generally, they offer favorable options for borrowers with imperfect credit or moderate incomes.

Conventional loans, on the other hand, lack government guarantees. Originated and backed solely by private sector lenders, they carry all associated risks. Conventional loans typically include conforming loans, which adhere to limits set by the Federal Housing Finance Agency. These require a minimum credit score of 620 and a down payment of at least three percent of the purchase price. Additionally, non-conforming products like jumbo loans and non-QM loans also fall under this category.

Government-backed loans, also known as guaranteed mortgages, can be easier to obtain in two main ways:

  • They don’t require borrowers to have excellent credit.
  • They don’t require borrowers to have a lot of cash.

Creditworthiness: While conventional loans require credit scores in the “good” range—generally 600 or higher—government-backed mortgages accept applicants with lower scores, even in the “fair” range. For example, FHA loans have minimum credit score requirements of 580 or 500, depending on the down payment. Additionally, some government-backed loans approve borrowers with higher debt-to-income ratios than conventional loans. This means that even with substantial monthly debts, such as student loans, car loans, and credit cards, you may still qualify for a mortgage.

Coming up with cash: Government-backed loans are more lenient regarding down payments, often accepting smaller amounts or none at all. For instance, VA and USDA loans typically don’t require a minimum down payment. In contrast, conventional loans usually require a 20 percent down payment, though some lenders accept less but charge private mortgage insurance as an extra monthly fee. As a result, government-backed loans are often an attractive option for young, first-time buyers who may lack substantial savings or high credit scores.

Government-backed loans are more accessible for those who have faced significant financial difficulties in the past.

“Borrowers who have experienced events like foreclosures, short sales, or bankruptcies will find that government programs typically have a much shorter waiting period to qualify for a new loan compared to conventional programs,” says Darren Tooley, senior loan officer at Cornerstone Financial Services in Southfield, Mich.

For instance, while conventional loans may impose a seven-year waiting period after a foreclosure, FHA loans generally require a three-year waiting period, and VA loans only a two-year period. Additionally, both FHA and VA loans can reduce this period to just one year under “extenuating circumstances,” according to Tooley.

The same principle applies to bankruptcies: depending on how you file, the waiting period for a government-backed mortgage is typically one to two years, compared to the two to four years required for a conventional mortgage.

Despite the apparent ease of obtaining government-backed loans, approval is not guaranteed, and these mortgages come with their own challenges.

FHA Loans: According to Matt Dunbar, senior vice president of the southeast region at Churchill Mortgage, FHA loans often have higher denial rates due to more comprehensive evaluations of a borrower’s ability to manage mortgage payments. Additionally, FHA loans require mandatory mortgage insurance regardless of the down payment size, which increases monthly costs and affects overall loan affordability. Another significant limitation is the borrowing cap: the limit for FHA loans on single-family homes in most areas is $498,257. While this is not a small amount, it can be challenging in expensive housing markets. In comparison, conventional conforming loans go up to $766,550 in most areas.

VA Loans: VA loans have the lowest denial rates among government-backed loans, slightly higher than conventional loans. However, they are restricted to service members, veterans, and eligible spouses, limiting the pool of applicants. VA loans also require special paperwork, including a certificate of eligibility (COE) and adherence to complicated entitlement rules. Additionally, VA loans can only be used to purchase single-unit primary residences, unless the borrower plans to live in one unit of a multi-unit property.

USDA Loans: In addition to finding a home that meets the USDA’s definition of “rural,” borrowers can face several approval issues. One surprising obstacle is earning too much money. USDA guidelines cap household income at no more than 115 percent of the area median income, which can be a problem for higher earners.

Another reason government-backed loans can be challenging is that the criteria may change unexpectedly. “Since government-backed mortgages offer leniency with factors like minimum credit scores and higher debt-to-income ratios, they can carry high amounts of risk for the lender,” says Darren Tooley. These loans can’t be sold to Fannie Mae or Freddie Mac, though the Government National Mortgage Association (Ginnie Mae) does buy them. Despite federal guarantees, some lenders may still hesitate to accept applicants with lower credit scores or high debt levels.

While the government sets guidelines for these loans, lenders often impose additional criteria known as overlays. “An overlay is an extra guideline or requirement that lenders add on top of the standard rules set by government-backed programs like FHA, VA, and USDA loans,” explains Greg Clement, founder and CEO of Realeflow. For example, the FHA might accept a credit score as low as 580 for a 3.5 percent down payment, but many lenders might require a minimum score of 620 or higher.

Some lenders apply overlays, while others adhere strictly to government guidelines, highlighting the importance of shopping around, according to Jennifer Beeston, senior vice president of mortgage lending at Guaranteed Rate Lending. “If you are turned down for an FHA or VA loan, it is always good to check with another lender, as you may have been turned down because of a made-up lender guideline that another lender will not have,” says Beeston. She notes that Guaranteed Rate does not impose overlays on FHA or VA loans.

Buying a home is always a lengthy process, but getting the clear-to-close call for a government-backed loan can take even longer, according to Matt Dunbar.

“The application process for government-backed loans typically requires more documentation and results in longer timelines than conventional loans,” says Dunbar. “This complexity arises from the need to thoroughly assess both the borrower’s financial stability and the property’s compliance with specific program standards.”

Outside of your own credit history and financial profile, the condition of the home you’re trying to buy can significantly impact your ability to secure a government-backed loan. These loans are known for having stricter appraisals and inspections.

“FHA loans mandate thorough appraisals to ensure properties are safe and structurally sound, complicating approval for older or fixer-upper homes,” says Matt Dunbar. “The FHA 203k program addresses this by financing both the purchase and necessary renovations, albeit with a rigorous inspection process. VA and USDA loans have their own sets of restrictions, such as primary residence requirements and rural area stipulations, which may limit buying options.”

However, as Darren Tooley points out, issues with a property’s livability are not exclusive to government-backed mortgages. “While FHA appraisals may be considered stricter than those required for conventional mortgages, it’s important to remember that conventional mortgages also have appraisal standards,” he says. “Items considered a ‘health and safety issue’ on an FHA appraisal will most likely come up on a conventional appraisal as well.”

Nonetheless, government-backed loans typically require problems to be fixed before funds can be issued and might even mandate a second inspection.

So far, we’ve discussed purchase mortgages—loans used to buy a home. While the initial process can be a stressful marathon, it’s never too soon to think ahead about refinancing. Refinancing a government-backed mortgage can be much faster and easier than refinancing a conventional loan, which essentially means getting a new mortgage.

For example, FHA streamline refinances often don’t require a credit check, income verification, or property appraisal. Similarly, a VA IRRRL (Interest Rate Reduction Refinance Loan) involves significantly less paperwork. Both options are available only to current holders of FHA and VA loans. So, if you’re buying when rates are high and anticipate needing to refinance in the future, this makes government-backed loans an appealing option.

Government-backed mortgages, such as FHA, VA, and USDA loans, can provide a better pathway to homeownership if your credit isn’t perfect or you lack a substantial down payment.

However, in practice, some lenders may impose additional terms, making the criteria for government-backed loans similar to those for conventional loans. Even without these overlays, securing a government-backed mortgage is no guarantee. The application process can be challenging, involving a detailed examination of every dollar entering and leaving your bank account.

Therefore, don’t make assumptions. As you shop around, compare offers for both types of loans, considering every detail from interest rates to the closing process. Despite the hype, the easiest mortgage for you may not be the obvious choice.