How Does a USDA Loan Work?

The USDA Rural Development Guaranteed Housing Loan Program is a zero-down-payment financing option for homebuyers in qualifying towns or rural areas. Backed by the U.S. Department of Agriculture, USDA loans may offer lower mortgage interest rates than other mortgage types. 

The USDA may distribute these loans directly to low-income borrowers, though it’s more common for USDA loans to be administered through partner mortgage lenders.  

These lenders can set their own rates and terms, and the loan will function just like any other mortgage, providing a lump-sum amount that borrowers repay over a preset loan term. 

Typically, lenders require you to pay private mortgage insurance (PMI) when buying a home with less than 20% down. USDA loans don’t have this requirement, though you’ll pay an upfront guarantee fee and an annual fee.  

This fee comes in two parts: 

• A 1% upfront guarantee fee 
• A 0.35% annual fee

Lenders are also prohibited from charging prepayment penalties, which means you may be able to pay off your mortgage early. 

Because USDA loans don’t require any down payment, they’re often a solid choice for first-time homebuyers. But before you commit to this loan program, you’ll want to examine its strengths and weaknesses. 

A USDA loan offers many distinct advantages, including: 

• No need for a down payment 
• Low, fixed interest rate 
• Flexible options for purchasing, refinancing, or construction 
• Sellers may pay closing costs 
• No prepayment penalty 

USDA loans are ideal for homebuyers looking to avoid the down payment associated with other loan types like FHA loans or conventional loans.

USDA loans aren’t without some drawbacks, including: 

• Restrictions to homes in qualifying rural/suburban areas 
• Mortgage insurance premiums that are part of the monthly payment 
• Household income limits

The following USDA loans can be used to buy, build, or renovate a home. 

The Section 502 Single Family Housing Guaranteed Loan Program, more commonly referred to as a “guaranteed loan,” represents the majority of USDA loans issued in the United States. These loans come through partner lenders such as your local bank and provide lump-sum financing of your home with no money down. 

Like the Guaranteed Loan Program, the USDA Construction Loan Program provides financing for homebuyers looking to build a new home in a qualifying area. But because you’re financing new construction, you must use a USDA-approved contractor, and the builder must supply a new construction warranty. 

Admittedly, this can be more challenging than finding other types of contractors, but buyers can still build a home with no down payment. 

Refinancing means replacing your existing USDA loan with an entirely new one, ideally one with better rates and terms. 

You must have had your existing loan for at least one full year to refinance. The USDA offers several refinancing options that can be tailored to your ultimate financial goals, including the USDA streamline refinance loan.  

To qualify for a USDA loan, you must meet the following requirements: 

• Be a U.S. citizen or permanent resident 
• The home must be your primary permanent residence 
• The home must be in a qualifying rural or suburban area

Income eligibility and other financial requirements vary between lenders and can also differ based on your location and household size. However, to qualify for a guaranteed loan, your income cannot exceed 115% of the median income for your area.

Typically, borrowers should expect to meet the following financial requirements: 

• A credit score of 640 or higher 
• A debt-to-income ratio of 41% or less 
• A documented history of reliable income  

It may also be possible to qualify for a USDA loan through the direct program (see above), which requires you to go through the USDA’s manual underwriting process. The direct program can help you secure a loan even if your credit score is below 640.

The USDA makes it easy to find qualifying homes. Simply visit the USDA website to use the interactive map. You can choose your loan type and enter your address to find eligible homes in your area. You’ll also receive information on income and other eligibility requirements for qualifying homes. 

First-time homebuyers have several loan options to consider. How does a USDA loan compare to other mortgage options? 

While most other loan programs don’t place restrictions on where you can purchase your home, they do present other factors that can impact qualification. Consider the following examples. 

The actual loan process looks much like other mortgage products, with a few slight variations that account for the government backing. Here are the steps you’ll need to take: 

1. Locate a USDA-approved lender 
2. Get pre-qualified to determine your budget 
3. Apply for pre-approval 
4. Locate a USDA-approved home 
5. Sign a purchase agreement 
6. Go through the underwriting process 
7. Close on your new home