USDA vs. FHA: Which loan is better for first-time home buyers?

Shashank Shekhar
Shashank Shekhar
The Mortgage Reports Contributor
March 18, 2021 - 10 min read

Is a USDA loan or FHA loan better?

USDA and FHA are two excellent loan options. Either one can get you into a house with few out-of-pocket costs and a low interest rate.

Is one better than the other? That depends on your situation.

USDA loans allow zero down payment, but there are location and income restrictions to qualify. FHA loans are more flexible about income, credit, and location, but have higher upfront costs.

Luckily, there’s an easy way to choose. Just ask your lender about USDA loans and FHA loans.

You might be eligible for one but not the other. And if you’re eligible for both, you can compare rates and fees to see which loan option is better for you.

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USDA vs. FHA eligibility

A large part of the decision between USDA vs. FHA depends on which type of mortgage you qualify for.

Here’s a brief overview of how USDA and FHA eligibility requirements compare:

  USDA Loan FHA Loan
Minimum Down Payment 0% 3.5%
Minimum Credit Score 640 580
Upfront Mortgage Insurance Fee* 1% of loan amount 1.75% of loan amount
Annual Mortgage Insurance Rate 0.35% of loan amount 0.85% of loan amount
Income Limits Max. 15% above local median income None
Location Requirements Must be in a qualified “rural area” None
Loan Limits None Max. $ in most areas
Eligible Mortgage Types 30-year fixed-rate mortgage 30-year fixed-rate , 15-year fixed-rate, or adjustable-rate mortgage
Eligible Property Types Single-family primary residence 1-, 2-, 3-, or 4-unit primary residence

*For both loan types, the upfront mortgage insurance fee can be rolled into the loan amount so you don’t have to pay it upfront

USDA vs. FHA vs. conventional

A USDA home loan is often the best choice for borrowers who meet the U.S. Department of Agriculture’s guidelines.

With no down payment requirement and low mortgage insurance rates, USDA mortgages are often cheaper both upfront and in the long run than FHA loans.

USDA may be cheaper than conventional financing, too, if you have a credit score in the low 600’s and a small down payment.

However, not everyone will meet USDA’s geographic or income requirements. And, the minimum credit score for USDA is 640 — which is even higher than the minimum for conventional mortgages (620).

For those with lower credit, or those who don’t meet USDA guidelines, an FHA loan could be a great choice.

The Federal Housing Administration only requires 3.5% down and a 580 FICO score. That’s about as lenient as credit requirements go for mortgages.

Another option is a 3%-down conventional loan, which has similar upfront costs and offers the potential for lower monthly mortgage payments. If you have good credit, a conventional mortgage may reward you with lower interest rates and mortgage insurance costs.

All that might sound like a lot to consider. We break down each factor in more detail below.

But the key thing to remember is that many lenders offer all three types of mortgage loans. So you don’t have to make a final decision on your own.

Your loan officer or mortgage broker can help you compare USDA, FHA, and conventional loans to find the best mortgage for you.

USDA home loan pros and cons

What if you could get a no-down-payment loan with comparable mortgage rates to FHA? And what if that loan allowed you to finance closing costs, even without an ultra-high credit score?

This loan actually does exist, and it’s called the U.S. Department of Agriculture (USDA) Rural Development home loan. More commonly, it’s known simply as a ‘USDA loan.’

The USDA loan has quickly risen in popularity with first-time and lower-income borrowers thanks to its zero-down allowance and low rates. But not everyone will qualify. Here’s what you should know.

USDA pro: Zero down payment required

USDA loans require no down payment. You may finance up to 100% of the property value, which, sometimes, is above the home’s purchase price. In these cases, the buyer can finance closing costs.

For example, say you make an offer on a home for $200,000. The lender’s official appraisal report states the home is worth $205,000.

The buyer can open a USDA loan for the full value, as long as the excess funds are applied to closing costs such as the title report and loan origination fees.

Excess funds can even be used to prepay property taxes and homeowner’s insurance.

So, in the end, USDA borrowers could get into a home with close to nothing out of pocket.

With FHA, the home buyer must come up with a 3.5% down payment plus closing costs. FHA has no guideline stating that the loan amount can exceed the purchase price.

The only way to get a zero out-of-pocket loan with FHA is to get a substantial down payment gift, down payment assistance, or seller contributions for closing costs.

USDA is more flexible, so buyers with little cash on-hand should look into this option first.

USDA con: You must buy in a ‘rural’ location

USDA eligibility depends on the location of the home. You must purchase a property in a rural area as defined by the USDA.

But the definition of “rural” is quite liberal, and based on U.S. census information from more than 15 years ago. So many suburban areas are still eligible.

USDA publishes online maps buyers can use to check the eligibility of a certain address or geographical area. Buyers will find that some entire states are USDA-eligible. Even highly populated states contain surprisingly vast qualifying areas.

An estimated 97% of the American landscape is geographically eligible for a USDA loan.

Still, some buyers might find that eligible areas are too far outside employment centers, and for that reason choose an FHA loan, which comes with no geographical restrictions.

USDA con: Income limits apply

The Rural Development loan was created to spur homeownership in rural areas, especially among low-income and moderate-income home buyers who might not otherwise qualify.

As such, USDA publishes income limits. Maximums are set at 115% of the median income for your county or area. But, these limits aren’t overly restrictive.

The following are examples of maximum household incomes in various locales around the country.

  • Denver, Colorado: $112,850
  • Portland, Oregon: $105,950
  • Philadelphia, Pennsylvania: $111,100
  • Albany County, Wyoming: $92,450

You can find current USDA income limits for your area here.

Not everyone will fall within USDA income limits. That’s where FHA comes in. FHA loans come with absolutely no income limits for its standard program.

Pros & Cons of USDA Loans

FHA loan pros and cons

While USDA loans stand out for being ultra-affordable, many borrowers prefer an FHA mortgage for its looser underwriting requirements.

There are no income limits when you apply for an FHA loan, and you might be able to get away with a lower credit score and higher debts than USDA or conventional lenders would allow.

Here’s what you should know.

FHA pro: Flexible credit requirements

One of the biggest benefits of the FHA loan program is its low credit score threshold. Most FHA lenders will accept credit scores as low as 580 with just 3.5% down. That’s a far cry from USDA’s 640 credit minimum.

The Federal Housing Administration will even allow FICO scores of 500-579. However, you’ll need to make a 10% down payment — and few lenders will actually approve scores this low.

FHA tends to be flexible when it comes to credit history, too.

For example, FHA guidelines specifically state that lack of credit history is not a reason to deny someone’s loan.

If you have very little information on your credit report — or none at all — because you haven’t borrowed much in the past, an FHA loan is still an option. You’ll just have to prove your financial responsibility in another way, for example, with a 12-month history of on-time rent payments.

USDA has similar rules, but it might be harder to find a USDA lender to approve you. With the FHA program, lenient credit requirements are the norm.

FHA pro: Flexible debt-to-income ratios

FHA is also more flexible than USDA when it comes to debt-to-income ratios (DTIs).

Your debt-to-income ratio compares your monthly debt payments and gross monthly income. Lenders use this number to determine how much of your income is taken up by existing debts, and how much room is left over in your budget for monthly mortgage payments.

Although the U.S. Department of Agriculture doesn’t set loan limits, its income limits effectively cap the amount you can borrow.

For instance, if your monthly pre-tax income is $4,000 and you pay $600 per month toward student loans and credit cards, your existing DTI is 15 percent.

USDA’s maximum DTI — including housing payments — is typically 41 percent. So the most you can spend on your mortgage each month is $1,040.

  • $600 + $1,040 = $1,640
  • $1,640 / $4,000 = 0.41
  • DTI = 41%

The USDA typically limits debt-to-income ratios to 41%, except when the borrower has a credit score over 660, stable employment, or can show a demonstrated ability to save.

These mortgage application strengths are often referred to as “compensating factors” and can play a big role in getting approved for any mortgage — not just USDA.

FHA, on the other hand, often allows a DTI of up to 45 without any compensating factors. In the example above, a 45 percent DTI allowance raises your maximum mortgage payment to $1,300.

A bigger monthly payment increases the amount you can borrow. That means you can potentially buy a better, more expensive home.

If existing debts are an issue for you, you may want to choose an FHA loan over a USDA loan for its flexibility in this area.

FHA con: Higher mortgage insurance rates

The main downside to FHA financing is paying mortgage insurance premiums (MIP).

Both FHA and USDA loans charge borrowers mortgage insurance. So do conventional loans, when buyers put less than 20% down. (This is known as private mortgage insurance or ‘PMI.’) All three kinds of mortgage insurance protect the lender in case of foreclosure.

USDA’s mortgage insurance rates are typically the cheapest of the three.

FHA loans are known for having more expensive mortgage insurance — although, conventional PMI rates might actually be higher if you have a lower credit score and small down payment.

Take a look at how mortgage insurance costs might compare for a $250,000 home with 3.5% down. The borrower in this scenario has a 640 credit score.

  USDA Mortgage Insurance (MI) FHA Mortgage Insurance Premium (MIP) Conventional Private Mortgage Insurance (PMI)
Upfront Fee (% of loan amount) 1.0% 1.75% None
Upfront Fee ($) $2,400 $4,200 $0
Annual Rate (% of loan amount) 0.35% 0.85% 1.65%
Monthly Payment (annual rate / 12) $70 / month $170 / month $330 / month

A few things to note here:

  • Upfront mortgage insurance premiums for USDA and FHA can be rolled into the loan amount
  • The annual FHA MIP rate drops to 0.80% if you put at least 5% down
  • Conventional PMI rates can drop steeply when you have a higher credit score

The other big difference when it comes to mortgage insurance is that conventional PMI can be canceled once a homeowner has at least 20% equity.

By contrast, USDA mortgage insurance lasts the life of the loan. So does FHA mortgage insurance, unless you put at least 10% down. In that case, MIP lasts 11 years.

While this might seem like a deal-breaker, even homeowners with ‘permanent’ mortgage insurance aren’t stuck with it forever. Those with FHA and USDA loans may be able to refinance into a conventional loan with no PMI once they reach 20% equity in the home, due to the loan balance dropping or the home value rising, or both.

So, if you have a credit score in the low 600s and PMI rates would be super high, don’t let the fact that PMI is cancelable sway you. An FHA or USDA loan could still be cheaper in the long run.

The Pros & Cons of FHA Loans

Compare USDA and FHA mortgage rates

There’s one more big benefit of using either a USDA or FHA loan. Both have below-market mortgage rates, meaning you’re likely to get a lower interest rate than you would with a conventional loan.

Today’s rates are at historic lows, so it’s a great time to lock an affordable fixed rate via the FHA or USDA program. Check your mortgage options to see which one works best for you.

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