What Is A USDA Loan?

Dock David Treece is a former licensed investment advisor and member of the FINRA Small Firm Advisory Board. His focus is on breaking down complex financial topics so readers can make informed decisions. He has been featured by CNBC, Fox Business, Bloomberg, and MarketWatch.

Dock David Treece

Dock David TreeceContributor

Contributor

Rachel WitkowskiCorrespondent/Editor

Rachel Witkowski is an award-winning journalist whose 20-year career spans a wide range of topics in finance, government regulation and congressional reporting. Ms. Witkowski has spent the last decade in Washington, D.C., reporting for publications including The Wall Street Journal, American Banker and Bankrate. Ms. Witkowski's deep knowledge of government and policy aided a series of investigative stories that triggered congressional hearings on employee claims of discrimination at a federal agency and how indirect auto lenders were being reviewed by regulators.

Reviewed

Rachel Witkowski

Rachel WitkowskiCorrespondent/Editor

Correspondent/Editor

Reviewed

Updated: Jun 12, 2020, 5:40pm

Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.

Getty

USDA loans are home loans issued or guaranteed by the United States Department of Agriculture. These loans are part of the USDA’s Rural Development program, meant to encourage homeownership in small communities across the U.S. by offering low-interest, low-down-payment mortgages to borrowers with low to moderate incomes.

To get a USDA loan, borrowers must live in a rural area, which the USDA defines as having a population of fewer than 35,000 residents. Borrowers can potentially take out a mortgage at 100% of their home purchase price. They must use those loans to finance a primary residence and must purchase two types of mortgage insurance, as well.

Additionally, USDA-guaranteed home loans require that applicants’ income not exceed a certain limit—15% above the median salary for their area. This works out to $90,300 for households with one to four people in most areas. Income limits for loans issued directly by the USDA are even lower, as legislation requires at least 40% of direct-issue loan funds be appropriated for loans to low-income households.

How USDA Loans Work

The USDA offers three different types of home loans. The most popular USDA loan is the Section 502 guaranteed loan, which allows homebuyers to finance up to 90% of their home’s purchase price. These loans are issued by USDA-approved lenders and insured by the agency, similar to how many conventional mortgages are backed by Fannie Mae and Freddie Mac—the government-sponsored entities that purchase most conventional mortgages from lenders and package them as bonds for sale to investors.

In addition to the USDA guaranteed loan program, the department also offers two direct-issue programs—the Section 502 direct home loan and the Section 504 home improvement loan. These loans can be used by borrowers with lower incomes to finance larger portions of their home purchase or improvement. However, borrowers must meet property, income and mortgage insurance requirements. Loans are also subject to size limits and rate requirements that vary by program.

USDA Loan Eligibility

While loans through the USDA Rural Development program can be extremely beneficial, this type of mortgage loan is only available for certain borrowers and in certain areas.

Some specific USDA home loan requirements include:

Loan must be used for a primary residence
Property must be in a rural area, defined as having fewer than 35,000 residents
Borrowers must meet down payment requirements (down payments may be zero for some programs)
Borrowers don’t have to have a minimum credit score to qualify, you must be able to demonstrate you can manage debt
Borrowers must not have incomes that exceed pre-set limits
Borrowers must have a debt-to-income ratio of 41% or lower

The income limits for USDA loans vary by program and by area. For guaranteed loans, borrowers’ incomes can’t exceed 115% of the median income for their area ($90,300 for 2020 in most areas). Income limits for direct-issue loans are much lower—as low as 50% of the median income in certain areas.

USDA Loan Rates

If you can qualify for a USDA loan you can take advantage of one of the loan’s biggest advantages: potentially lower interest rates than conventional mortgage products offer. USDA loans are available to borrowers with credit scores low enough that they might not be able to qualify for a conventional mortgage. And, while other agencies like the FHA also offer home loans to low-income borrowers, rates on USDA loans tend to be 0.5% to 0.75% lower than those available elsewhere.

Rates on loans that are issued by USDA-approved lenders and guaranteed by the agency (but that are not direct issue) are determined by individual lenders based on your income, credit score and other factors. However, these rates can be extremely advantageous for borrowers who qualify.

USDA home improvement loans are actually a combination of grants—which don’t have to be repaid—and loans that carry an interest rate of just 1%.

Types of USDA Loans

The USDA offers three different types of loan programs for qualifying borrowers. All loans must be issued on primary residences in rural areas to eligible borrowers.

USDA-guaranteed loans. These loans are provided under Section 502 of the Housing Act of 1949 and are issued by USDA-approved lenders and guaranteed by the agency in case borrowers default. To qualify, a borrower’s income can’t exceed 115% of the median income for their area. There is no stated maximum on these loans, but loans over $300,000 to $400,000 are rare.
Direct-issue loans. These loans also are provided under Section 502 of the Housing Act of 1949. They are issued directly by the USDA, rather than through intermediary lenders. To qualify for a USDA loan, a borrower’s income can’t exceed 50% to 80% of the median income in their area.
Home improvement loans. Home improvement loans are issued under Section 504 of the Housing Act. They’re actually a combination of loans and grants that can provide borrowers with up to $27,500 ($20,000 as a loan; $7,500 in grants). The loan portion is repaid over 20 years at 1% interest. To qualify, applicants must have a household income below 50% of the median income for their area.

In addition to these three core programs, the USDA has several lesser-known loan programs, such as Section 523 loans, which are used to acquire home sites. Some of these loans can be used in combination with each other—523 loans can be used in combination with 502 loans, for example.

How to Apply for a USDA Loan

The process for securing a USDA loan is very similar to the conventional loan underwriting process. However, there are a few extra steps required for getting a USDA loan to confirm eligibility, as well as some potentially unique documentation items, like well tests, that are unique to rural property.

1. Check Property Eligibility

Loans are only available in rural areas that have fewer than 35,000 residents. So, before you apply for a USDA loan, it’s a good idea to check your property’s eligibility using the USDA’s eligibility map.

2. Check Income Eligibility

Your ability to qualify for a loan will depend on your household income relative to the median income in your area. The USDA provides tools to help you check your income eligibility based on your area.

3. Pick a Lender

If your income is less than 50% to 80% of the median income for your area and you want to apply for a direct-issue loan, you’ll need to apply directly with the USDA. If you’re applying for a guaranteed loan, you’ll need to pick a USDA-approved lender to apply.

4. Complete Application

The process for applying for a USDA home loan varies by lender. If you’re applying for a direct-issue loan, you’ll need to go through the USDA’s application process. When applying for a USDA-guaranteed loan, however, the process is specific to each lender.

5. Provide Documentation

Regardless of whether you’re applying directly with the USDA or through a private lender, you’ll need to provide certain items to document things like your residence and income.

Specific examples of documentation you’ll need to supply include:

State photo ID
Social Security card
A month’s worth of your most recent pay stubs (if employed full-time)
Tax returns for the past two years (if self-employed or retired)
Copy of earnest money check
Personal financial statement
Homeowners insurance policy quote
Termite inspector’s report

If the home you’re purchasing is on well water, you may also need to produce the results of a well test. The results of a septic test may also be necessary in some circumstances.

USDA Home Loan: Mortgage Insurance Required

When you get a USDA loan, you are required to purchase mortgage insurance that will cover your mortgage payments if you lose your job and are unable to pay. There are two different types of mortgage insurance premiums required by the USDA:

1% of the loan amount due at closing
0.35% of the original loan amount per year

USDA Home Loan Vs. a Conventional Mortgage

Unlike a conventional mortgage, USDA home loans have the potential for 0% down payments, as well as below-market rates. In some cases, there are borrowers who can qualify for USDA loans who would not qualify for conventional mortgages (without purchasing private mortgage insurance).

Conventional mortgages, on the other hand, do not have income limits in order to qualify. These loans are also available for properties of all types—not just those found in rural areas.

USDA Home Loan Vs. an FHA Loan

Compared to USDA loans, FHA loans aren’t restricted to rural areas. And, like USDA loans, FHA loan programs require mortgage insurance, but rates are much higher—1.75% at closing and 0.45% to 1.05% per year.