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USDA loans: What they are and who's eligible

Whether you're moving to the suburbs or the country, this federal mortgage program could save you thousands.

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Have you stumbled upon USDA loans during your mortgage search? USDA loans are backed by the US Department of Agriculture -- yes, you read that right -- as part of its Rural Development program, which promotes homeownership in smaller communities across the country. If you don't have enough money saved for a down payment or if you've been denied a conventional loan, you have a good chance of qualifying for a USDA loan. 

Contrary to popular belief, these loans are not just designed for homebuyers in completely rural areas -- in fact, 97% of the land in the US is eligible for a USDA loan. This means even if you're moving just outside of a city, chances are pretty high that you're moving to a USDA-designated area. That's great news for the increasing number of buyers looking to jump ship from crowded urban apartments to homes with more square footage and land, following the pandemic. 

Let's find out if this rural development home-buying program is right for you.

What is a USDA loan? 

USDA loans are backed by the Department of Agriculture and feature interest rates that are often lower than what you'll find with a traditional mortgage. And in contrast to conventional and FHA home loans, which both generally require a down payment, you can get a USDA home loan with 0% down. They're also easier to qualify for -- even if you've been turned down for a traditional mortgage. 

So why have you never heard of them? There's one major downside: These loans are available only for lower-income buyers in designated USDA rural and suburban locations. And while most of the US landmass is technically considered rural, over 80% of the population live in the 3% of cities and urban areas excluded from this loan program.

Types of USDA loans

We're going to mainly focus here on USDA-guaranteed loans since they're the most common. But know there are two other types: direct and home-improvement home loans. The lowest-income buyers who may be unable to get a conventional loan might be eligible for a USDA direct loan, financed by the USDA with rates as low as 1%. And, if you're looking to improve a home you already own, you can also apply for a USDA home-improvement loan or grant.

Back to USDA-guaranteed loans. These mortgages are obtained through a private lender -- like a conventional loan -- but are backed by the government. This offers a major benefit for private lenders because if you default on your loan, the USDA vouches to repay the lender. Just like a conventional loan, if you put down less than 20%, you'll need to pay for mortgage insurance. Because of that government backing, USDA mortgage insurance is cheaper than other mortgage types.

What are the USDA loan requirements?

There are three main factors the USDA considers when determining your eligibility. First, you'll need to buy a home in a designated area. Next, your household income cannot exceed USDA income thresholds for your place of residence -- 15% above the local median income. Finally, you'll also need a credit score of at least 640, though contributing some cash toward a down payment can negate this requirement. If you meet the first two specifications but have a low credit score, you might still qualify for a USDA direct loan or FHA loan.

Otherwise, the requirements are pretty pedestrian. You'll need to be a US citizen, green-card holder or noncitizen national. Your mortgage payment cannot exceed 29% of your monthly income, and your debt-to-income ratio must be no more than 41% of your monthly salary. You'll also need to use the home as your primary residence, not have a record of breaking mortgages or commitments to other federal programs and meet any other lender-specific requirements.

How to apply for a USDA loan

When applying for a USDA loan, you'll need to submit documentation to prove your identity and income levels, just as you would for any financing agreement. Plan on submitting a copy of your driver's license or passport, your Social Security card, your previous two years' tax returns and pay stubs, and recent bank statements.

You may also be asked to turn in additional documentation if you do not have a credit score, apply with nontraditional credit or have unpredictable income. You can review the complete list of requirements on the USDA website.

Advantages of USDA loans

No down payment requirements

You might be able to become a homeowner sooner without this obstacle in your way.

Lower interest rates

You can lock in a lower interest rate with a USDA loan than a conventional loan, especially if you have a good to excellent credit score. This could save you tens of thousands of dollars in interest over the lifetime of the loan.

Less expensive mortgage insurance 

Although USDA loans do require mortgage insurance called a guarantee fee, it's much more affordable than private mortgage insurance and FHA insurance. You'll pay an upfront fee at closing equal to 1% of your loan amount and 0.35% of the loan amount annually (as of 2021). 

More thorough appraisal

Lenders order an appraisal to determine a property's value before finalizing your loan. This ensures they are not lending you more money than the home is worth, protecting their investment. USDA appraisals have stricter guidelines than conventional loans, which could save you from pulling the trigger on a home requiring expensive repairs.

Designed for low-income buyers

If a conventional lender has turned you down because of your income, a USDA loan might be the right option towards homeownership. 

USDA loan limitations

Strict income eligibility requirements

USDA loans are not for everyone. They are designated for low-income Americans who cannot qualify for a traditional mortgage

Limited to properties in rural areas

If you live in a city or outside a designated area, you won't be eligible for a USDA loan.

Longer buying process

Guaranteed USDA loans typically have longer application and closing processes since the loans are underwritten twice -- once by the private lender and then by the USDA. 

Pay more over time

Although USDA loans are designed to make homeownership more affordable, the mortgage insurance requirement could mean that you pay more over the lifetime of your home loan.

No option to cancel mortgage insurance

You can cancel PMI on conventional mortgages (and even sometimes on FHA loans) once you reach a certain equity level. The guaranteed fee on USDA mortgages might be cheaper, but it lasts for the loan's lifetime.

Is a USDA loan right for you?

These mortgage programs are more affordable than traditional mortgages, but they're only possible if you do not exceed the income maximums and buy a home in a designated rural area. If you're just above the income threshold or want to live in a city, you'll need to explore other mortgage options.