Once you’ve determined to buy a house rather than rent, you need to get approved for a mortgage. Then you need to go through a multi-week underwriting process that climaxes on closing day – the day your dream home officially becomes your home.
The magnitude of the home buying process can’t be overstated. Statistically speaking, your home is likely to be the largest, costliest purchase you ever make. It’s in your best interest to do it the right way.
That starts with the right mortgage loan. Well-known options abound, from conventional mortgages that traditionally require 20% down, to FHA mortgage loans that require as little as 3.5% down, to VA home loans for military servicemembers and their families. Millions of homebuyers qualify for one of these three broad classes of home loans.
What about less common options? Those exist too. One of the most exciting and lucrative home loan options is the USDA loan, a type of mortgage product reserved mainly for residents of rural communities. USDA loans designed for the purchase or refinance of “adequate, modest, decent, safe and sanitary dwellings as their primary residence in eligible rural areas.”
Administered by the United States Department of Agriculture, the USDA loan program is formally known as the USDA Rural Development Guaranteed Housing Loan program. USDA purchase loans are sometimes referred to as Section 502 loans. USDA repair loans and grants are sometimes referred to as Section 504 loans or grants.
If you’re weighing your mortgage options and believe you may qualify for a USDA loan, keep reading. In the following paragraphs, we’ll discuss the different types of USDA loans and guarantees, parameters and basic eligibility requirements, common closing costs, and the major differences between USDA and conventional loans.
What Is a USDA Mortgage Loan?
USDA loans are designed for low- and moderate-income homebuyers and homeowners in eligible areas, which the USDA defines as “rural areas with a population less than 35,000.” To determine whether the region in which you’re looking to buy is eligible, check the USDA Rural Development Program Eligibility Map.
The geographical restriction is overriding: Even if you meet all other eligibility criteria, you can’t qualify for a USDA loan if you’re buying (or fixing) an owner-occupied house outside the eligible territory. Though the vast majority of the United States’ land area is USDA-eligible, most of that land is sparsely inhabited, so most Americans don’t qualify.
USDA loans can be originated by private lenders and guaranteed by the USDA (guaranteed loans), or originated by the USDA itself (direct loans). USDA grants are disbursed from USDA funds.
USDA loans have extremely lax down payment requirements. In most cases, no down payment is required, though putting money down can of course reduce the long-term cost of the loan.
USDA loans also have lax standards for buyers with imperfect credit: FICO scores below 580 aren’t necessarily disqualifying. For buyers with limited or nonexistent credit histories, alternative (non-credit) underwriting methods exist, such as verifying timely and consistent rent or utility payments.
These features make USDA loans ideal for lower-income buyers and owners, buyers with less than perfect credit, first-time buyers, and buyers and owners with minimal personal savings. However, beyond the geographic restrictions, USDA loans have some key drawbacks. Notably, they require buyers to carry pricey mortgage insurance.
Types of USDA Mortgage Loans
USDA loans come in three major flavors depending on your household income, current living situation, and housing needs.
All are designed for owner-occupants. They can’t be used by landlords or second home owners. All have fixed rates – there’s no such thing as an adjustable rate USDA mortgage. USDA mortgage rates tend to be lower (sometimes by as much as an entire percentage point) than comparable conventional mortgage rates. They’re roughly in line with rates on VA home loans and VA streamline refinance loans.
Single Family Housing Guaranteed Loans are issued by private lenders. They’re assumable, meaning they can be transferred from sellers to buyers with minimal modification of their terms.
Up to 90% of the principal is guaranteed by the USDA, and up to 100% of the purchase price can be financed. There’s no hard-and-fast loan limit for guaranteed loans. In most cases, the size of the loan is tied to underwriting considerations such as housing ratio and debt-to-income ratio.
Guaranteed loans can be used for:
- The purchase of a new or existing home
- The purchase of a site on which a new home is to be constructed
- The purchase and subsequent renovation or rehabilitation of an existing home
- The refinancing of an existing home’s eligible mortgage
- Certain site preparation work
- Certain property upgrades (including broadband Internet and energy efficient upgrades).
To qualify, you need to come in at or below the “moderate income” threshold for your area. In most places, this threshold is set between $75,000 and $80,000 of total household income but can be higher for larger households and in higher-cost regions, such as Alaska and Hawaii. Check the Rural Development Guaranteed Housing Income Limit chart for information about your neck of the woods.
Single Family Housing Direct Home Loans are designed for low- and very low-income families who are “unable to obtain a loan from other resources on terms and conditions that [they] can reasonably be expected to meet.” They’re made directly by the USDA and can finance up to 100% of the purchase price, plus eligible closing costs if the home appraises for more than the selling price.
Like guaranteed loans, they’re assumable. Unlike guaranteed loans, direct loans can’t be used to refinance existing loans. Otherwise, the eligible uses are broadly similar to USDA guaranteed loans.
Direct loans are also subject to hard-and-fast loan limits. These limits from county to county, depending on local housing prices, and are subject to change from year to year. In low-cost rural areas, limits can be as low as $115,000 to $120,000. In higher-cost parts of expensive states such as California, Alaska, and Hawaii, limits can exceed $500,000. For specific information about your county, check the Rural Development Area Loan Limit Map.
Homes financed with USDA direct loans must meet certain “modesty” criteria, including:
- Habitable area of 2,000 square feet or less (with some exceptions)
- Market value below the applicable area loan limit
- No in-ground swimming pools
- Not designed or equipped for income-producing activities (such as workshops or hobby farms)
In addition to no-money-down configurations and financed closing costs, USDA direct loans often come with payment subsidies that help very low-income borrowers afford their monthly payments. For the neediest borrowers, these subsidies can dramatically reduce interest rates – as low as 1%, in some cases. However, these subsidies aren’t forgivable – they need to be repaid gradually, over the life of the loan.
Happily, USDA direct loans have long repayment windows. Loans issued to the neediest borrowers can float for as long as 38 years.
Single Family Housing Repair Loans & Grants, issued under the Section 504 Home Repair Program, fall into two broad categories: “loans to very-low-income homeowners to repair, improve or modernize their homes” and “grants to elderly very-low-income homeowners to remove health and safety hazards.”
Repair loans’ interest rates are fixed at 1% over 20-year terms, with a $20,000 maximum principal. Grants are capped at $7,500 per instance. They do not need to be repaid unless the grantee sells the home within three years. Both loans and grants are reserved for homeowners with incomes under 50% of the local median. Grants are restricted to homeowners over age 62.
General Eligibility Requirements
In addition to the product-specific requirements outlined above, there a few other factors influencing eligibility:
- Location: To qualify for a USDA loan, a buyer or homeowner must be looking to buy (or already live) in a USDA-eligible area – typically rural communities and far-flung exurban regions on the edges of bigger cities. If you live within easy commuting distance of major hub cities such as San Francisco, Chicago, or Boston, you likely don’t qualify.
- Citizenship or Residency Status: USDA-eligible homeowners and borrowers must be U.S. citizens or permanent residents, or hold certain long-term visas.
- Federal Program Eligibility: USDA loan and grant recipients cannot be “suspended or debarred from participation in federal programs” due to criminal convictions or past fraudulent activity.
- Credit Risk: The ideal USDA borrower has a FICO score above 640. Borrowers with lower scores may need to provide additional information before qualifying and are likely to face higher interest rates. The likelihood of qualification drops significantly as credit risk increases. Recent delinquencies (12 months or less) can seriously jeopardize borrowers’ applications. However, depending on lender policies, borrowers with poor or limited credit can sometimes qualify by demonstrating longstanding timely payment patterns for obligations such as rent and utilities.
- Steady Income: Ideal borrowers can demonstrate steady income over long periods of time – two years or longer. However, exceptions can be made for borrowers involved in unpredictable or boom-and-bust activities, such as farming.
- Housing Ratio: If you have fair to good credit, you generally need to keep your housing ratio under 29%. That means your total monthly payment (principal, interest, home hazard insurance, mortgage payment protection insurance, taxes) can’t exceed 29% of your income. If you have excellent credit, most lenders will waive the 29% rule, provided they deem your housing ratio reasonable.
- Debt Ratio: Your household debt ratio – the total share of your debt obligations as a percentage of your income – typically can’t exceed 41%. Again, exceptions can be made for borrowers with excellent credit.
What You Need to Qualify
During the USDA loan application process, you’ll need to provide:
- A driver’s license, passport, military ID, or other approved government-issued ID
- Pay stubs (or copies) for at least two months prior
- Income statements, including W-2 forms and 1099 forms, going back three tax years
- Evidence of bank and investment income (statements) going back at least two months
- Evidence of at least two years of steady work (tax forms should suffice)
- If you’re self-employed, a profit and loss statement for the current tax year (to present)
Depending on your personal circumstances, credit history, the loan for which you’re applying, and other factors, additional documentation may be necessary.
Like most mortgage loans, USDA loans carry a slew of closing costs. The bullets below are intended only as a general guide. Costs can vary widely by location, market conditions, down payment size (if any), and lender policies. However, you should prepare to pay some or all of the following closing costs on your USDA loan:
- Mortgage Insurance: USDA loans require an upfront insurance premium equal to 1.00% of the financed amount – for instance, $2,000 on a $200,000 loan. Ongoing annual mortgage insurance premiums equal to 0.35% of the financed amount are then required for the life of the loan. The upfront premium can be rolled into the loan at closing.
- Prepaid Property Taxes: You’re generally required to prepay property taxes set to accrue between your closing date and the following property tax due date. Depending on when closing falls, the home’s value, and local tax rate, this can add up to hundreds or even thousands of dollars.
- Prepaid Hazard Insurance: You’re usually required to prepay your first year’s homeowners insurance premiums. Depending on your home’s value and location, this can range from a few hundred to a few thousand dollars. It’s customary to pay this item outside closing, before closing day.
- Property Survey: You may be required to commission a property survey. In most cases, the survey will be what’s known as a mortgage survey, which is a relatively perfunctory exercise that combs the history of property descriptions for evidence of inaccuracies and adverse claims. Under some circumstances, a location survey is required. This is an on-site survey that locates the precise position of any buildings, easements, survey monuments, and other important features. When the transaction involves a new construction home or recent subdivision, a more comprehensive boundary survey is required. Boundary surveys are on-location examinations that precisely map the property’s contours and parameters while identifying potential signs of adverse use or encroachment. Mortgage surveys typically cost less than $500. Boundary surveys can cost several thousand dollars – but, again, they’re usually not necessary.
- Property Appraisal: Before agreeing to originate a loan, lenders require property appraisals to verify that the home is worth the seller’s asking price and to reduce the risk of loss in the event of foreclosure. For USDA direct loans, the USDA commissions the appraisal on its own account. Appraisals usually cost less than $500.
- Home Inspection: Though technically optional, home inspections are strongly recommended, especially for buyers of older homes. Inspectors thoroughly examine any habitable structures on the property, including the main house and outbuildings, to identify potential safety hazards and items requiring immediate repair. Inspections usually cost less than $500, though they can be pricier for larger homes and properties with multiple outbuildings.
- Title Search: A title search examines the property’s chain of title (ownership) from its initial platting or subdivision until the present. This ensures that the seller is within their rights to list the property for sale and reduces the risk of a claim against the property in the future. Title searches typically cost less than $400.
- Title Insurance: Title insurance, which may cover the cost of a title search, provides financial protection against issues uncovered by the title search, such as old liens and forgotten covenants. It also provides ongoing protection against claims on the property. The cost of title insurance can vary dramatically, but it’s smart to budget at least $1,000 (one-time, paid at closing) for the expense.
- Recording and Transfer: The sale isn’t official until it’s recorded with the appropriate authorities – usually the city or county housing department. This typically involves two separate fees: recording fees and transfer stamps. Together, these items typically cost a few hundred dollars, though the precise amount can vary significantly depending on the location and property value.
- Flood Determinations and Environmental Assessments: Even if you don’t live in an area with obvious flood risk, such as the bank of a river, you’ll need to commission a low-cost flood determination to find your home on current flood zone maps and determine whether flood insurance is necessary. This usually costs less than $100, but ongoing flood monitoring (and, if necessary, flood insurance) can add to the long-term cost. Other types of environmental assessments are required in certain regions – for instance, fire hazard assessments in parts of the western United States.
- Origination Fee: Some lenders charge origination fees to simplify the slew of minor charges and expenses that often accompany closing: attorney’s fees, document fees, courier charges, escrow charges, and much more. Origination fees sometimes exceed 1% of the purchase price, but there are legal and customary limits on their size and composition. When in doubt, ask your lender to explain in detail what’s included in your origination charge. Don’t be afraid to call them out on dubious line items.
Avoiding Out of Pocket Closing Costs
Many USDA borrowers can reduce or entirely eliminate out of pocket closing costs. Some cost-reduction or -elimination methods are unique to the USDA loan program, while others are available to wider swathes of the homebuying population:
- Roll Them Into the Loan: If your home appraises for more than its selling price, the USDA loan program allows you to finance your closing costs – in other words, to roll them into your loan principal. You can only finance the difference between your home’s selling price and its appraised value. For instance, if you put in an offer for $150,000 and the home appraises for $155,000, you can finance closing costs up to $5,000. Any overages still need to be paid out of pocket.
- Get the Seller to Pay: The seller is permitted to pay up to 6% of the home’s selling price toward closing costs – up to $12,000 on a $200,000 house, for instance. That’s usually more than enough to cover closing costs. This tactic is especially common in buyers’ markets, where desperate sellers are willing to part with thousands of dollars to ensure the sale goes through. In hotter markets, sellers are typically less willing to play along.
- Get a Gift from Friends or Family: You’re not allowed to borrow money to cover your closing costs. However, you can accept a gift that doesn’t need to be repaid. Such gifts typically come from friends or family members and can’t accrue interest.
- Get a Lender Credit: The lender sometimes credits a portion of the purchase price back to the buyer via discount points, which are small slices of the loan principal (usually 1%, though discount points can be split into half- and quarter-points). Depending on how they’re used, discount points can offset part or all of the loan’s closing costs. However, there’s a tradeoff: Each discount point raises the loan’s rate by 0.25%, producing higher monthly payments and raising the loan’s long-term cost. This is a good option if you’re short on cash at the moment, but expect your income to rise over time or to refinance your loan relatively quickly.
Key Differences Between USDA and Conventional Mortgage Loans
1. Relatively Loose Credit Requirements
USDA loans have looser underwriting requirements than conventional mortgages. While borrowers with excellent credit (FICO scores north of about 720) unquestionably get the best rates and terms on these loans, applicants with FICO scores as low as 580 stand a good chance of approval. And spotty credit isn’t an automatic disqualifier, as applicants can turn to non-credit verification methods like rent and utility payment histories. That sort of recourse typically isn’t available to conventional loan applicants.
2. Only Available in Rural and Semi-rural Areas
USDA loans are meant for residents of rural and semi-rural areas, far from major city centers. In other words, while the vast majority of the United States’s land area is covered by the USDA loan program, just a fraction of the country’s inhabitants are eligible. Conventional loans aren’t restricted by geography.
3. Low or No Down Payment Required
Most USDA-eligible borrowers can get away without putting any money down – in other words, with financing 100% of the purchase price. Higher-asset borrowers may be asked to put some money down, but nowhere near the historical 20% benchmark for conventional mortgages. Needless to say, this is a huge deal for low-asset borrowers who simply can’t afford conventional loans’ down payments.
4. Potentially Pricey Mortgage Insurance
USDA purchase and refinance loans require mortgage insurance. Regardless of down payment or home value, the upfront premium (which can be rolled into the loan) is set at 1% of the sale price or home value. The ongoing annual premium is set at 0.35% of the remaining principal. Conventional mortgages don’t require mortgage insurance unless the buyer puts less than 20% down.
5. Interest Rates Are Usually Lower
USDA loans’ interest rates are almost always lower than conventional loans’. Depending on the borrower’s credit and other factors, that difference can be as great as one percentage point, and sometimes even more.
6. Closing Costs Can Be Rolled Into the Loan
USDA-eligible borrowers can roll their closing costs into their loans, dramatically reducing or entirely eliminating their out of pocket expenses. Like the no-down-payment feature, this is a huge deal for low-asset borrowers who can’t afford to shell out thousands at closing. It’s possible to roll closing costs into a conventional loan by taking discount points. However, that raises the loan’s interest rate and jacks up its long-term costs.
7. Loans Can Be Assumed by Qualified Buyers
USDA direct and guaranteed loans are assumable. When a USDA-financed home is sold, the loan can be transferred from the seller to the buyer with minimal changes to its rates and terms. Of course, buyers need to go through credit and income checks, and the USDA’s Rural Development office must approve each assumption. Buyers may need to seek additional financing as well. Still, the mere possibility of assumption is a big advantage over conventional loans, which typically aren’t assumable.
8. No Cash-out Refinancing Allowed
The USDA’s guaranteed and direct loan programs don’t allow cash-out refinancing. If you want to borrow against the value of your USDA-backed home, you need to wait until you’ve built up sufficient equity and take out a home equity line of credit. By contrast, conventional refinancing loans allow you to borrow (extract cash) against the value of your home with a refinance loan, provided the loan doesn’t exceed lender or government loan-to-value limits (usually between 80% and 100% of the home’s current value or original purchase price, depending on the lender and loan program).
9. Single Family, Owner-Occupied Housing Only
The USDA loan program is designed for owner-occupants of single family homes. While multi-family housing is rarer in rural areas than urban centers, this is still a potential drawback for people looking to buy duplexes or condos in small towns. Conventional mortgage loans can be used to purchase a much wider variety of housing types and have much looser occupancy restrictions.
The USDA mortgage loan is a niche product. Most families don’t qualify. The good news for city- and suburb-dwellers: Plenty of other options exist for resource-light homebuyers who can’t afford to put 20% down. Choosing the option that best fits your needs might not be as exciting as selecting the home of your dreams, but it could save you thousands (or tens of thousands) in the long run.
If you do qualify for a USDA mortgage loan, count your blessings. Your inclusion in one of the luckiest subgroups of American homebuyers is due entirely to where you’ve chosen to make your life, not perils you’ve faced in the military or personal sacrifices you’ve made as part of the country’s reservist corps. Some city slickers no doubt believe that living in the country is a sacrifice in itself, but if your love of wide open spaces and friendly smiles outweighs your urge to be in the center of it all, who cares what they think?
Do you qualify for a USDA mortgage loan?