What are guaranteed mortgage loans?

Guaranteed loans are a critical part of the mortgage marketplace, offering borrowers lower down payment terms and giving lenders more confidence. These loans are backed by a third party, most often the government, who agrees to cover a part of the loan if the borrower defaults.

While conventional loans usually require a 20 percent down payment, guaranteed loans require a much lower percentage or no down payment at all. A guaranteed mortgage can also help buyers who have enough cash but struggle to get approved because of a rough credit history.

What is a guaranteed mortgage?

Before we get into mortgages in particular, let’s look at loans in general. A guaranteed loan is any loan that’s backed by a party other than the lender. That third party assumes some of the responsibility for the loan to the benefit of the lender.

What is a loan guarantee going to do, specifically? If the borrower defaults (i.e., stops paying back the loan), the guarantor pays the lender in the amount of some or all of the outstanding debt.

So, how does a guarantee for a home loan work? The third party guarantees, or agrees to be responsible for, some or all of the mortgage if the borrower defaults. These kinds of mortgages are most often guaranteed by the government and serve to protect the lender when granting a loan to a borrower who isn’t making a substantial down payment or otherwise might present more risk. The government might extend the mortgage guarantee to all or a portion of the loan.

How guaranteed mortgages work

While lenders look for a down payment to protect themselves in the event of default, they also want something else: to originate as many loans as possible. That’s where a guaranteed mortgage loan comes in.

Many borrowers, simply put, don’t have the down payment funds necessary to qualify them for a loan. In fact, the typical first-time purchaser in 2021 bought a home with just 7 percent down, while repeat buyers put 17 percent down — both below that ideal 20 percent, according to the National Association of Realtors.

In short, without guaranteed mortgages, there would be a lot fewer home sales. So, lenders are willing to accept less money down from borrowers who have a guarantee for a home loan from a third party. The most common guarantors are the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA), which back FHA loans and VA loans, respectively. The Department of Agriculture also guarantees USDA loans in eligible areas.

One point of distinction: The VA loan program is generally considered a “guarantee,” while the FHA loan program is viewed more as “insurance.” From the borrower and lender’s perspective, however, they each provide third-party backing that helps borrowers qualify for a loan.

Despite the lower down payment, a guaranteed mortgage loan must meet underwriting standards established by the lender and the third party. Lenders often have additional requirements beyond what the guarantor mandates, a practice known as “overlaying.” For instance, the FHA requires a minimum credit score of 580 to allow a borrower to put just 3.5 percent down, but some lenders set the minimum higher, at 620.

What is the difference between guaranteed and non-guaranteed loans?

Once your guaranteed mortgage loan is established, it will function just like any other: You make your monthly payments and pay back what you borrowed over time.

Ultimately, the main difference between guaranteed and non-guaranteed loans comes down to qualifying for the loan. Specifically, a guaranteed mortgage loan means:

• Looser eligibility requirements. Because the third party promises to step in if you can’t or don’t repay what you borrow, the lender has a security net. As a result, lenders generally extend looser qualification requirements for a guaranteed mortgage loan — from credit score to income — than with a non-guaranteed loan.
• Lower down payment. A guarantee for a home loan often incentivizes lenders to accept a larger loan-to-value (LTV) ratio, allowing for a smaller down payment — or potentially none at all, if you’re eligible for a VA loan.
• Rates and terms. Exploring a guaranteed mortgage might help you land a lower interest rate or terms that are otherwise more favorable.
• Use cases. Depending on the guarantor, you might be limited in how you can use the loan. You can only get a USDA loan, for example, if you purchase a home in a qualifying rural area.
• Additional protection. While the guarantee for the home loan does provide protection for the lender, the guarantor of the loan might require you to pay into the pot. For example, you might need to pay for mortgage insurance.

Types of guaranteed home loans

There are three types of government-guaranteed mortgage loan programs. Each has its own requirements, but all are easier to qualify for overall.

FHA loans

The FHA loan program is popular for several reasons:

• Borrowers can purchase with as little as 3.5 percent down, provided they have a credit score of 580 or better. For borrowers with a credit score between 500 and 579, the program requires 10 percent upfront.
• Borrowers can qualify with a 43 percent debt-to-income ratio (DTI); however, a large portion actually qualify with a higher DTI ratio, sometimes over 50 percent. This is due to “compensating factors,” such as cash reserves or a higher credit score, that augment a borrower’s creditworthiness.
• FHA interest rates are sometimes lower than those of conventional loans, which aren’t guaranteed or insured by the government.

However, if you choose this kind of mortgage guarantee, be ready to pay two insurance premiums: one premium paid upfront that’s equal to 1.75 percent of the loan principal and an annual premium ranging from 0.45 percent to 1.05 percent of the balance, paid monthly. In some cases (depending on the size of your down payment), the mortgage insurance goes away after 11 years. Otherwise, the annual premium can’t be removed unless you refinance to a different type of loan or pay off your FHA loan completely.

VA loans

VA loans are available to eligible active-duty servicemembers, veterans and surviving spouses to help finance or refinance a home with zero down — a benefit that can be used more than once. The VA guarantee for a home loan promises a certain amount to a lender should a VA loan borrower default.

VA loans give borrowers and lenders a lot of leeway. For example, VA guidelines don’t include minimum credit score standards or loan limits. Instead, lenders set their own credit score requirements and loan money to the extent the borrower is financially qualified.

VA loans also have a residual income standard that helps lenders determine how much a borrower needs, after expenses, to qualify for a loan.

When purchasing or refinancing, VA loan borrowers have to pay an upfront funding fee, although the fee can be waived under certain circumstances.

USDA loans

USDA loans are also available to lower- and moderate-income borrowers with no money down, but only in defined rural areas. (The term “rural” can be surprisingly broad, so check your area to find out if it qualifies.)

A USDA loan has both an upfront and annual fee, which are a percentage of the loan principal, in order to sustain the guarantee from the USDA. These fees are charged to the lender but usually passed on as a cost to the borrower.

Is a guaranteed loan right for you?

If you can’t qualify for a conventional loan, but you’re financially ready to buy a home, a mortgage guarantee can make that possible. With that guarantee, a lender might extend looser eligibility requirements for LTV and DTI ratios, along with lower credit score and income thresholds.

If you’re in a position to qualify for both a conventional and a guaranteed loan, do the math. The guarantee for a home loan might make it possible to get more favorable loan terms, like a lower interest rate. But it could also mean needing to pay mortgage insurance. See if one path makes more financial sense for you.

Speaking with a loan officer can help you find out which option is right for you and what you’re likely to be preapproved for based on your credit and financial situation.