FHA Loans – The Basics
Buyers that may have a hard time getting approved by traditional lenders may still have a chance at home ownership courtesy of FHA loans. FHA loans might not be everyone’s cup of tea, but they have several features that make them appealing:
- Make a down payment as little as 3.5%
- Get approved to borrow with issues in your credit history or thin credit
- Buy FHA-backed manufactured homes, multi-unit properties, condos, or single-family homes
- Receive more funding (above and beyond the purchase loan) for repairs and renovations courtesy of the FHA 201k program
- Fund the down payment with help from the seller or gift money
All the details will be covered below. To get your FHA loan, talk to an online or local lender and inquire about FHA programs
What’s an FHA Loan?
FHA loans are home loans guaranteed by the United States Federal Housing Administration. Private lenders such as credit unions and banks provide the loans while the FHA backs them: If you fail to repay the loan, it is will be up to the FHA to pay the lender.
Due to that guarantee, lenders are ready to make significant mortgage loans in situations where they would otherwise not be willing to approve loan applications.
The FHA was created in 1934 during the Great Depression and it is a government agency whose role is providing lenders with mortgage insurance. Before the introduction of the FHA, the housing markets were in turmoil. Just 4 in 10 households actually owned homes and loans were a burden for buyers. For instance, borrowers were only able to finance about 50 percent of the purchase price of the home (rather than putting 3.5 percent down), and loans required a balloon payment after 3 to 5 years.
Today, the FHA insures over 14,000 multifamily properties and 7.95 million single-family homes. The program has, in part, helped grow homeownership rates in the United States to a high of 69.2 percent just prior to the mortgage crisis of 2008, even though this figure has dropped marginally as the housing markets recover.
FHA Loan Benefits
FHA loans might not be the right option for everyone, but they are the best one in some situations. The main appeal of these loans is that they make it easier to own property. However, it is worth keeping in mind that the benefits always come with tradeoffs. The most attractive features of FHA loans include:
Minimal down payment: FHA loans let you purchase a property with a down payment as little as 3.5 percent. Traditional loan programs may require higher income and credit scores or larger down payments to get approved with a small down payment.
If you have more than 3.5 available, it would be better to simply make a more substantial down payment. If you do that, you will have more borrowing options available to you and you will save money on interest costs over the loan’s life.
Other people’s money: It is easier to use gifts for the closing costs and down payments in you opt for FHA financing.
Sellers can also pay up to 6 percent of the loan towards the closing costs of the buyer. It is in a buyer’s market that you are most likely to benefit from this, but you can potentially adjust your offer price enough to attract sellers even in in strong markets.
Assumable loans: If you have an assumable FHA loan, a buyer can “take over”. The seller will then pick up where you left off, benefiting from lower interest costs (since you will have already gone through high interest years, which you can see with an amortization table.) Depending on whether rates change or not by selling time, the buyer may even enjoy a low interest rate that’s not available in the current environment.
How Can One Qualify for an FHA Loan?
FHA loans are typically easier to qualify for compared to conventional loans.
The FHA has made it easier for people at all income levels to have access to home ownership. The government guarantees the loan, which means that lenders are more willing to approve applications.
Income limits: No minimum income is actually required. All you need is enough income to show that you are capable of repaying the loan. However, FHA loans are targeted towards lower-income borrowers. If you have a high income, you won’t necessarily be disqualified, as you could be with some first-time home buyer programs.
Debt to income ratios: You need a reasonable debt-to-income ratio to qualify for an FHA loan. The amount that you spend on loan payments every month should be considerably low compared to your monthly income. It is advisable to be lower than 31/43. However, you can get approved with debt-to-income ratios closer to 55 percent in some situations.
Example: Assume that you earn $3,500 each month.
To meet the standard requirements, you need to keep the monthly housing payments under $1,225 since it is 31 percent of $3,500.
If you have other forms of debt such as credit card debt, all the monthly payments combined should be below $1,505.
To determine how much you might spend on payments, use an online loan calculator to model your payments.
Credit Scores: Low credit score borrowers have a higher chance of being approved for FHA loans. If you wish to make a down payment of 3.5 percent, your score can be as low as 580. If you are ready to make a more substantial down payment, your credit score can be potentially lower still (a down payment of 10 percent is typical for FICO scores ranging from 500 to 580).
Lenders may choose to set limits more restrictive than the FHA requirements. If you have no credit history at all or have a low score, you may be required to find a lender who does underwriting manually. That process allows lenders to determine how creditworthy you are by checking “alternative” credit information, including utility and rent payments.
Loan Amount: The FHA places a cap on the amount you can borrow. You are generally limited to modest loan amounts relative to the home prices in your area. To find the local maximums, visit HUD’s website. You can consider jumbo loans if you need more money, but note that you must first have a strong income and credit to qualify.
Worth trying: Even if you believe that you might not be approved, talk with an FHA-approved lender to find out for a fact. If you don’t meet the standard approval criteria, the compensating factors such as a massive down payment that offsets your credit history can actually help you qualify.
How Do FHA Loans Work?
FHA loans are issued by private lenders and the FHA provides lenders with a guarantee to lower the risk to the lender. To get a loan, start with a online mortgage broker, local loan originator, or loan officer at your financial institution. Discuss the options available to you, including FHA loans and its alternatives and settle on the best option for your needs.
Mortgage insurance: The FHA promises to repay lenders in case borrowers ever default on FHA loans. The FHA charges borrowers (you) a fee to fund that obligation.
Home buyers that use FHA loans are required to pay an upfront mortgage insurance premium (MIP) of 1.75%.
Borrowers are also required to pay a modest ongoing fee with every monthly payment depending on the risk the FHA takes with the loan. Larger down payments, smaller balances, and shorter-term loans result in lower monthly insurance costs. The charges range between 0.45 and 1.05 percent annually. The majority of borrowers with small down payments and 30-year loans pay 0.85 percent or 85 basis points on average.
FHA loans are available for multiple property types. Besides standard single-family homes, you can buy manufactured homes, duplexes, and properties of other types.
How FHA Loans Compare: Terms & Rates
FHA loans might come with attractive features, but it is still worth it compare them to conventional loans.
Mortgage insurance: The upfront mortgage insurance premiums may increase the loan balance with FHA loans while the monthly FHA premiums can cost more than private mortgage insurance. Furthermore, in many instances, it is not possible to cancel the mortgage insurance on FHA loans. However, it is far easier to cancel PMI on traditional loans as you build equity.
Interest rates: FHA loans should theoretically have lower interest rates since lenders take less risk. However, the difference is usually minimal (0.17 percent in recent years), and FHA rates might actually come in higher. Ellie Mae reported in early 2018 that conventional loan interest rates were just 4 basis points (0.04 percent) higher than the average FHA rate.
Low down payment: FHA loans allow most people with very little down to buy property. However, you might also be able to buy a property with a traditional loan and small down payment. If you have good credit, it is possible to find competitive offers that actually beat FHA loans including loans that would require even less than 3.5 down payment. With such programs, you can eliminate any mortgage insurance by building equity in the home.
Loan limits: The FHA sometimes doesn’t provide sufficient funding when you require a large loan. FHA might not work for you if you are looking to buy in a hot market or buying a particularly expensive property.