USDA loans are mortgages backed or funded by the U.S. Department of Agriculture. Also called USDA rural development loans or rural housing loans, USDA home loans feature low or no down payments and low interest rates compared to conventional loans.
How Do USDA Home Loans Work?
With a USDA home loan, borrowers can finance property with no down payment, as long as they buy in eligible locations. To borrow with a USDA home loan, the property must be in a designated rural area. But it doesn’t have to be a farm.
“A common misconception about USDA loans is that they can only be used to purchase farms,” says Ron Haynie, senior vice president of mortgage finance policy at the Independent Community Bankers of America.
You might also be surprised to learn that most of the U.S. landmass meets the requirements for USDA eligibility, home to over 100 million Americans. The easiest way to find out if a property is eligible for a USDA loan is to enter its address into the USDA’s helpful interactive map.
You can use a USDA loan to buy a single-family home, town house, condo, manufactured home, or, yes, a farm. In fact, most of the country is considered eligible for USDA lending, says Scott Fletcher, chief credit officer at Fairway Independent Mortgage Corp.
Borrowers with USDA loans can pay less upfront by forgoing a down payment, and interest rates may be lower than rates for conventional loans. However, you will pay a “guarantee fee,” which functions like a mortgage insurance premium. You’ll also pay closing costs.
Direct and Guaranteed Loan Programs
Buyers can choose from two types of USDA loans: direct loans and guaranteed loans.
Direct Loan Program
The USDA funds direct loans, which are reserved for borrowers with income at or below the low-income limit for your area. The loan term can be as long as 33 or 38 years, depending on income, and the interest rate is 4.875% as of July 1, 2024. The rate may effectively be reduced to 1% after subsidies are applied. Borrowers typically make no down payment and owe no mortgage insurance premium.
Guaranteed Loan Program
You must earn less than 115% of the area’s median income to be able to qualify for a USDA home loan guarantee. Private lenders fund these mortgages, while the USDA insures 90% of each loan against default. That guarantee protects lenders, allowing them to offer mortgages with below-market interest rates and no down payments.
But borrowers must pay two forms of mortgage insurance: an upfront guarantee fee of 1% of the loan amount and an annual fee of 0.35% of the principal balance.
Who Is Eligible for USDA Home Loans?
When you apply for a USDA loan, the lender will check that you and the property are eligible. In community property states, a non-purchasing spouse’s income and credit profile are evaluated as well. Requirements include:
— Geographic area. The home must be within eligible geographic limits as determined by the USDA. But USDA loans are not just for farms. Most of the U.S. land mass is geographically eligible (and about a third of its population).
— Property type. For a direct loan, the home must be modest in size and can’t have an in-ground pool. Its market value can’t exceed the area’s loan limit, and the home can’t be designed for income-producing activities. For a guaranteed loan, the property must be modest, decent, safe and sanitary, be a single-family home, condo or modular or manufactured home, and meet requirements set by the U.S. Department of Housing and Urban Development.
— Occupancy. The property must be for your principal residence.
— Credit score. The program has no minimum credit score requirement, but many lenders set their minimum at 620 or 640.
— Income. For both direct and guaranteed USDA loans, your income can’t exceed program limits, which vary depending on where you live. You can check your eligibility easily on the USDA’s Income Eligibility lookup tool.
For direct loans, the income limit is based on your geographic area and the number of people in your household. You also must show you have no other options for a mortgage and that you don’t have safe housing.
For guaranteed loans, the income limit is 115% of your area’s median income and varies based on location and household size.
For both the guaranteed and the direct programs, loan applicants must:
— Be a U.S. citizen or an eligible noncitizen.
— Prove that they can participate in federal programs.
— Have a maximum front-end debt-to-income ratio of 29% and a back-end ratio of 41%. The back end is the portion of your monthly income that goes toward paying debts plus your mortgage, while the front end is the amount spent on your mortgage only.
You can see specific income limits for USDA direct loans in your area using the worksheet available on the USDA website. It lets you enter your state, county and income and get a detailed explanation.
USDA Home Loan Interest Rates
Your rate will depend on the type of USDA loan you get. The USDA sets interest rates for Direct Loan Program but does not get involved with rates in the Guaranteed Loan Program.
The effective interest rate may be as low as 1% after factoring in USDA payment assistance. On the other hand, individual lenders determine rates for USDA guaranteed loans, “just like traditional mortgages, with the lowest rate going to the borrower with the highest credit, lowest (loan-to-value ratio) and DTI,” says Bill Parker, director of lending at the Alabama Central Credit Union. Interest on USDA guaranteed loans must be a 30-year fixed rate.
Interest rates for guaranteed USDA loans “are very competitive with conventional mortgage products,” Parker adds. Lenders can offer such low rates because the government guarantee protects the lender against loss.
For guaranteed loans, comparing quotes from several USDA loan providers can help you find the best deal. You could also get better terms if you have a higher credit score, even though you don’t need a minimum credit score to qualify for a USDA loan.
How to Apply for a USDA Loan
The application process differs depending on whether you’re applying for a USDA direct loan or a USDA guaranteed loan. For a direct loan, contact your local Rural Development office. You can shop with private lenders, such as banks and credit unions, for a guaranteed loan.
Here’s the general process you may follow:
1. Get preapproved for a USDA home loan. Before searching for homes, find a USDA-approved lender, as not every lender offers USDA loans. The USDA maintains a list of active lenders on its website. Complete an application for mortgage preapproval and submit any documents and information the lender requests. The lender checks your credit and verifies your income, debt and assets. If approved, you’ll be issued a preapproval letter that tells you how much you can borrow.
Underwriting for USDA loans can take longer than with conventional mortgages, so it’s smart to be preapproved before home shopping. With a mortgage preapproval (also called credit approval), you should be able to close on any property in your price range that meets the lender’s guidelines.
2. Shop for a USDA-approved home. Look at the USDA’s property eligibility map. “You can use that map and overlay eligible areas against something like Zillow or Realtor.com,” Fletcher says. “Or find a property and then check if it’s in the eligible area.”
3. Update and finalize your loan approval. After you’ve found a home and the seller accepts your offer, you can apply for a full mortgage approval. An underwriter reviews your purchase contract, orders a home appraisal and evaluates the property to make sure it meets guidelines. You may be asked for updated documents to finalize your loan approval.
4. Get approved by the local USDA office. The USDA will review your application and documents after the lender signs off on your loan. The agency will make sure you and the property fit eligibility requirements.
The closing timeline varies by lender, but the extra review adds at least a few days, Fletcher says. Once the USDA approves your loan, you can head to the closing table, where you’ll sign the paperwork and pay your cash to close.
Keep in mind that unlike with conventional loans, funds for USDA home loans come out of the federal budget, so it’s possible for the program to run out of money before you get your loan.
[Read: Best Mortgage Refinance Lenders.]
Pros and Cons of USDA home loans
Pros
— No money down. You can get a USDA loan with no down payment.
— Competitive interest rates. Rates for direct loans are lower than the national average, and rates on guaranteed loans are competitive.
— No minimum credit requirement. There’s no credit score you need to reach to qualify for a USDA loan.
— No private mortgage insurance. Unlike with conventional loans, you won’t need to pay PMI on a USDA loan, even if you put nothing down.
Cons
— Strict income limits. If your income exceeds the limit for your area, you won’t be eligible for a USDA loan.
— Upfront and annual fee. Although you won’t pay PMI, you may have to pay a guarantee fee upfront and an annual program fee after that.
— Property requirements. The property must meet the requirements of the USDA loan program, including location and condition.
USDA Home Loan Alternatives
Sometimes, a USDA loan isn’t the right loan for your situation or isn’t available to you. You might consider these other options.
USDA vs FHA
Like USDA loans, FHA loans are government-backed — in this case, by the Federal Housing Administration. They’re designed for buying a primary residence and you may be able to put down as little as 3.5%, but you’ll need a credit score of at least 580. It’s possible to qualify for an FHA loan with a credit score of 500 if you put down at least 10% of the loan amount.
USDA vs Conventional
Conventional loans have much fewer restrictions than USDA loans. They typically require a credit score of at least 620. Depending on the lender, you may be able to put down just 3%, although you’ll generally have to pay PMI if you put down less than 20%. But private mortgage insurance isn’t permanent. It drops off automatically once you’ve paid your loan down to 78% of your purchase price, or you can request cancellation when your loan balance hits 80% of the property value.
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originally appeared on usnews.com
Update 07/22/24: This story was published at an earlier date and has been updated with new information.
