Mortgage 101: What Is An FHA Loan?
What Are FHA Loans?
For the first-time homebuyer, qualifying for a mortgage loan can be harder than it would be for someone who has already bought a home in the past. But there is hope! Certain types of loans are geared towards first-time home buyers, such as loans insured by the Federal Housing Administration, also known as FHA loans.
In the 1930s, the U.S. economy and housing market were in crisis and the result was a spike in the number of foreclosures and mortgage defaults. To help combat the growing problem, the FHA created a program to provide mortgage lenders the adequate insurance they needed to boost their confidence in the borrower’s ability to pay. This program enabled loans to be more accessible and affordable for Americans who had less than stellar credit and/or couldn’t afford higher down payments. To this day, lenders are more comfortable issuing FHA loans because the federal government is the one that insures the loans, which reduces the lender’s risk of loss should a borrower default on their loan.
Benefits of FHA Loans
FHA loans aren’t just for first-time homebuyers– they’re among the most popular types of loans for all home buyers, as the qualification requirements tend to be less strict than conventional loans. Conventional loans often require the borrower to put as much as 20% down on their home, whereas most borrowers can qualify for an FHA loan with a down payment as low as 3.5%. FHA loans are also more forgiving when it comes to credit rating. For instance, an applicant with a credit score of 580 or higher can qualify for an FHA loan with the lowest down payment required. But, if the borrower’s credit score is somewhere between 500 and 579, they can still qualify–they will just have to pay a larger down payment. Typically that down payment is still a much lower down payment than what’s often required with a conventional loan. Also, a lesser-known advantage of FHA loans is that they are “assumable.” This means that if you sell your home, the buyer can “assume” your current loan. Ultimately, FHA loans give people who have low or bad credit, have undergone a bankruptcy, or have been foreclosed upon in the past, the best opportunity to qualify for a mortgage.
FHA Loan Requirements
Even though FHA loans are easier to obtain than conventional loans, there are still certain requirements that need to be met:
- Borrowers must have a steady employment history or have worked for the same employer for the past two years.
- Borrowers must have a valid Social Security number, lawful residency in the U.S. and be of legal age to sign a mortgage in your state.
- Borrowers must pay a minimum down payment of 3.5 percent; the money can be gifted by a family member.
- New FHA loans are only available for primary residence occupancy.
- Borrowers must have a property appraisal from an FHA-approved appraiser.
- Borrowers’ front-end ratio (mortgage payment plus HOA fees, property taxes, mortgage insurance, homeowners insurance) needs to be less than 31 percent of their gross income, typically. You may be able to get approved with as high a percentage as 46.99 percent, but your lender will be required to provide justification as to why they believe the mortgage presents an acceptable risk. The lender must include any compensating factors used for loan approval.
- Borrowers’ back-end ratio (mortgage plus all your monthly debt, i.e., credit card payment, car payment, student loans, etc.) needs to be less than 43 percent of their gross income, typically. You may be able to get approved with as high a percentage as 56.99 percent, but your lender will be required to provide justification as to why they believe the mortgage presents an acceptable risk. The lender must include any compensating factors used for loan approval.
- Borrowers must have a minimum credit score of 580 for maximum financing, with a minimum down payment of 3.5 percent.
- Borrowers must have a minimum credit score of 500-579 for maximum LTV of 90 percent with a minimum down payment of 10 percent. FHA-qualified lenders will use a case-by-case basis to determine an applicant’s creditworthiness.
- Typically borrowers must be two years out of bankruptcy and have reestablished good credit. Exceptions can be made if you have been out of bankruptcy for more than one year, if there were extenuating circumstances beyond your control that caused the bankruptcy, or if you’ve managed your money in a responsible manner.
- Typically borrowers must be three years out of foreclosure and have reestablished good credit. Exceptions can be made if there were extenuating circumstances and if you’ve improved your credit. If you were unable to sell your home because you had to move to a new area, this does not qualify as an exception to the three-year foreclosure guideline.
- The property must meet certain minimum standards at appraisal. If the home you are purchasing does not meet these standards, and a seller will not agree to the required repairs, your only option is to pay for the required repairs at closing (to be held in escrow until the repairs are complete).
How Can a New Home Buyer Obtain an FHA Loan?
In order to obtain an FHA-backed mortgage loan, the borrower needs to use a lender that is approved by the Federal Housing Authority.
Is Mortgage Insurance Required With an FHA Loan?
Loans that are backed by the FHA don’t have the same standards as those for a conventional loan. Therefore, FHA loans require two different types of mortgage insurance premiums. One is paid in full at closing (or it can be financed into the mortgage), while the other is included within the monthly mortgage payment.
Additional Considerations With FHA Loans
While conventional loans can be issued for any home sale price, FHA loans have limits, with the maximum limits varying by state and/or county. Also, FHA loans require that the house is inspected to ensure it meets certain conditions and appraised by an FHA-approved appraiser. Lastly, it’s important to remember that if you’re applying for an FHA loan and you have a lower credit rating, you will be subjected to higher interest rates.
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