Guaranteed loans are a critical part of the mortgage marketplace, and it’s easy to see why. Generally, lenders prefer homebuyers purchase a home with 20 percent down, but many borrowers simply don’t have the cash to meet that threshold with today’s home prices.
For the borrowers who can’t make 20 percent happen, a guaranteed mortgage can help. Here’s what to know.
What is a guaranteed mortgage?
Guaranteed mortgage definition
A guaranteed mortgage is a home loan that a third party guarantees, or agrees to be responsible for, 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.
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.
Many borrowers, simply put, don’t have the down payment funds necessary to qualify them for a loan. In fact, according to the National Association of Realtors, the typical first-time purchaser in 2019 bought a home with just 6 percent down, while repeat buyers put 16 percent down — both below that ideal 20 percent.
In short, without guaranteed mortgages, there would be a lot fewer home sales. So, lenders accept less money down from borrowers who have a guarantee 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, guaranteed mortgages 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 “layering.” 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.
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, 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 typically lower than those of conventional loans, which aren’t guaranteed or insured by the government.
However, because FHA loans are insured by the government, borrowers pay two insurance premiums: one premium, paid upfront, 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. 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 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 as an agency guarantees 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 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 sustain the guarantee from the USDA. These fees are charged to the lender, but usually passed on as a cost to the borrower.
With guaranteed mortgages, the funds come from private-sector lenders, but the loan is backed by a guarantor, typically a government agency, so that lenders can qualify borrowers with limited down payment funds or a riskier credit profile. The FHA, VA and USDA, the most common guarantors, generally don’t provide funding.
Buy a home with a guaranteed mortgage, and you’re likely to find more accommodative DTI ratios, lower credit score requirements and, of course, smaller loan-to-value ratios. If you’re considering a guaranteed mortgage, speak with a loan officer about which option is right for you, and what you’re likely to be preapproved for based on your credit and financial situation.