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How Does a USDA Mortgage Work and What Are Its Pros and Cons?

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How Does a USDA Mortgage Work and What Are Its Pros and Cons?
4 min. read

Image: IvanMichailovich / Shutterstock.com

If you’re in the market for a new home, it’s good to consider all of your options when it comes to mortgages. USDA mortgages are an extremely attractive option under the right circumstances, but they’re certainly not the best choice for everyone. So, let’s find out how they work, and take a look at the pros and cons.

How Does a USDA Mortgage Work?

The USDA mortgage is a loan made available through the U.S. Department of Agriculture, aiming to promote affordable homeownership in rural areas. Unlike conventional mortgage loans, it doesn’t require a down payment, it has a higher eligibility rate, but it does come with some restrictions on the location of your future home.

It can be granted either as a direct home loan, or through the Housing Guarantee Loan Program. USDA typically has a loan term of 30 years, although in some cases the payback period can be extended up to 38 years.

USDA loans can be a very appealing alternative to conventional mortgages, and if you’re not one for living in the big city, they can bring your dream of becoming a homeowner closer to reality. But are they the right choice for everyone? Let’s take a closer look.

The Advantages of a USDA Mortgage

On the face of it, there’s a lot to love about USDA loans, and the numerous pros are extremely attractive.

0% Down Payment

This is by far the most attractive feature of USDA loans. Conventional, 30-year mortgages require anything between 5% and 20% in down payments, so USDA’s 0% is excellent news for homebuyers who want to cut down on the costs of buying a house.

Low Interest Rates

USDA loans have lower interest rates, depending on the loan type (direct or guaranteed), dwelling type, as well as market rates and payment assistance subsidies. For example, a direct loan for single family housing comes with fixed interest rates that can be as low as 1%.

Lower Credit Score Requirements

The credit guidelines for USDA loans are more flexible than in the case of conventional mortgages. There is no official figure for the lowest credit score required, although you will normally need a minimum score of 640 for guaranteed loans. Another plus to bear in mind is that you can apply for an USDA loan even if you’ve had a mortgage foreclosure, or if you’ve faced bankruptcy.

No Prepayment Penalties

Unlike conventional mortgages, no prepayment penalties apply to USDA loans. So if you’re lucky enough to hit the jackpot, you can simply pay the remaining amount before the term ends.

The Disadvantages of a USDA Mortgage

USDA loans have so many perks that applying for one can seem like a no-brainer. So why do homebuyers still go down the conventional mortgage route? A quick look at the drawbacks will answer that question.

Location Restrictions

The clue is in the name: USDA Rural Development offers housing loans to stimulate homeownership in rural areas. The definition for ‘rural’, according to the USDA, applies to a large portion of the U.S. territory, yet it excludes cities, metropolitan statistical areas (MSA), and towns or suburbs with a population that exceeds 20,000 people.

Of course, this doesn’t mean that USDA loans can only be used to buy a ranch. But if you’re considering buying a house or an apartment in the big city, these loans are not the choice for you.

Income Restrictions

USDA loans aim to support families with low and moderate incomes looking to buy their own home. As a result, there’s a restriction on whether you can apply for one based on your household income. In general, your adjusted household income should not exceed 115% of the median income of the area in which your desired home is located.

Can Only Be Used for Primary Residences

Tying in with the point above, USDA loans aim to increase homeownership rates for first-time buyers. These loans are a lifeline for homebuyers who do not qualify for conventional mortgages and lack proper housing. So if you’re looking for a second home, a vacation house, or even a property you can use for rentals, you will not qualify for this type of mortgage.

Mortgage Insurance Is Required

Given the fact that USDA loans can be granted without a down payment, lenders must take measures to protect themselves in case the borrower defaults on the payments. As a result, mortgage insurance (or guarantee fee) is a requirement. However, the insurance fees are lower than on conventional mortgages. You will be required to pay an upfront closing fee of 1% of the loan amount, followed by a yearly fee of 0.35% of the loan balance, which is split into monthly payments.

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