A lot of us dream of owning a starter home, either to shelter our growing families or as an early investment in our futures. A home, however, is the most expensive thing most of us will ever buy, so saving the money to purchase your very first one can be a challenge.
This is where an FHA loan can help.
An FHA loan can open the door for people who otherwise couldn’t afford to buy a house. These loans are issued by banks, but unlike conventional loans, FHA loans are backed by the federal government.
FHA stands for Federal Housing Administration. In the acronym jungle that is our nation’s capital (think DOJ, DOD and, everybody’s favorite – IRS) the FHA stands out as an example of government working for the consumer.
The consumer in this case is usually someone who’s had the door slammed in his/her face when applying for a conventional loan and there are a lot of them out there. In 2019, one in five homebuyers financed a home with an FHA loan.
But FHA loans have their drawbacks, otherwise 100% of homebuyers would use them. Here are some questions to ponder that will help you determine if one is right for you.
What Is an FHA loan?
An FHA loan is a loan that is guaranteed by the U.S. government. That makes it attractive to lenders, who know that if the home buyer defaults, Washington D.C. can print all the cash it wants to back them up.
FHA loans are used to purchase or refinance homes. You can even use FHA loans to renovate or repair your home, thus increasing its value.
FHA loans are great for first-time home buyers, especially those who haven’t been working long enough to secure the funds for a large down payment on a house.
The loans are issued by private lenders, but they have looser qualifications than conventional loans and require smaller down payments and closing costs.
That’s the upside. The downside is if you don’t have a 20% down payment, you’ll have to pay mortgage insurance for the life of the loan, and that can run up a hefty bill, especially if you have to take out a 30-year mortgage.
When shopping for a loan, beware of loan scams, or any lender offering a deal that sounds too good to be true. Don’t let a lender pressure you into making a decision before you’ve had a chance to reflect on what’s best for you and your family.
If you happen to jump the gun and agree to loan terms you can’t handle, remember you still have a three-day rescission period, where you can refuse the loan, no questions asked.
What Are the FHA Mortgage Qualification Requirements?
The FHA program is designed for low and middle-income Americans, but you don’t have to be eating ramen noodles five nights a week to qualify. There are no minimum or maximum salary requirements.
You must, however, have at least two established credit accounts like a car loan or credit cards. And you can’t have any outstanding debts to the federal government.
Applicants also must have a FICO credit score of at least 580 if they want to qualify for the lowest down payment, which hovers around 3.5%. The average FICO score for a first-time homebuyer using an FHA loan was 668, in 2019. For repeat buyers it was 673.
You are not out of luck if your score is less than 580. It just means you’ll have to put down a 10% down payment if you want a loan.
If your FICO score is below 500, you probably are out of luck and need to enroll in a debt management program before attempting to buy a cheeseburger, much less a house.
FHA loans also have a debt-to-income (DTI) requirement. That is determined by taking your monthly bills (mortgage, credit cards, student loans, etc.) and dividing that by your gross monthly income.
For instance, if your monthly bills are $2,000 and your monthly pay is $5,000, your DTI is 40% (2.,000 ÷ 5000 = .40). To qualify for an FHA loan, your DTI cannot be above 50%.
How Much Can You Borrow With an FHA Loan?
That depends on where you live and fluctuates based on housing prices in the area.
In 2020, consumers can borrow $331,760 for single-family homes in low-cost regions, and $765,600 in high-cost areas. Alaska, Hawaii, Guam and the Virgin Islands have a limit of $1,148,400.
How Much Is FHA Mortgage Insurance?
Conventional mortgages require at least a 20% down payment, or the buyer has to pay mortgage insurance. If you have that much for a down payment, chances are you’ll be better off pursuing a conventional loan.
With the FHA, there is a one-time upfront premium of 1.75% of the amount of the loan. If you are borrowing $200,000, you’ll get whacked with an extra $3,500 bill when you close your loan.
Then there’s an ongoing mortgage insurance premium (MIP) that is collected every month. That amount differs for every loan and depends on the amount and length of the loan, and your loan-to-value (LTV) ratio. The LTV is calculated by taking the amount of the mortgage lien and dividing it by the appraised value of the house. For instance, if you borrow $100,000 to buy a $110,000 house, the LTV is 91.6% (100000 ÷ 110000).
Determining the exact MIP payment gets pretty complicated. Fortunately, there are plenty of MIP calculators available on the Internet. For example, if a buyer’s down payment is less than 5%, the premium is .85%. So, if a person bought a $200,000 house and put down a 3.5% down payment, the LTV is 96.5%. Their mortgage insurance would cost about $1,700 a year.
That’s not chicken feed. And here’s the real rub:
With conventional mortgages, you don’t have to pay mortgage insurance once your LTV reaches 78%. In other words, once your balance (on the above example) is down to $156,000 on that $200,000 house, you’re off the MIP hook.
With FHA loans you are almost never off the hook.
Only those who had an LTV of 90% or lower when they got a loan get to stop paying. And they have to wait at least 11 years, even if the LTV reaches 78% long before that.
All these numbers are based on the ever-changing machinations of Washington D.C., of course. The FHA was set to cut premiums 25% in 2017 based on an executive order under the Obama Administration.
That was cancelled when Donald Trump was sworn in as president, since Republicans said the reduction would have left the FHA without enough money to cover mortgage defaults.
Taxpayers and FHA loan applicants should stay tuned. Washington D.C. is not known for stability, so things could change.
How Do You Apply for an FHA Mortgage?
Applying for an FHA loan is like any other mortgage application process, meaning get ready for a lot of paperwork. The only difference is the mortgage broker must be authorized to make FHA loans.
Most are, and you can check with FHA Lender finder on the internet to find a list of brokers. Consider getting a mortgage pre-approval before going out home shopping, so your offer carries more weight with sellers.
FHA vs. Conventional Loan
There are far more similarities than differences, but the differences are important. To recap:
The down payment and credit score requirements are lower with an FHA loan. That’s the upside. The downside is an FHA borrower has to pay a hefty premium for mortgage insurance and that charge never goes away.
|Down Payment||2.5% – 10%||3% – 20%|
|Private Mortgage Insurance||1.75% upfront; .45% – 1.05% monthly||.55% – 2.25% monthly (waived if down payment exceeds 20% or LTV drops below 78%|
|Credit Score||500 – 580 (10% down); 580+ (3.5% down)||620+|
|Interest Rates||As low as 3.5%, generally lower than conventional loans, but you may pay more in the long run thanks to PMI.||As low as 3%, but generally higher than FHA loans.|
Who Is a Good Candidate for an FHA Loan?
Anyone who wants a home but doesn’t have a lot of money for a down payment and/or has a poor credit score.
The FHA has health and safety requirements for houses. If you find a broken-down house at a low price and see it as a bargain, the FHA will probably see it as a dump and not give you the loan.
FHA mortgages are often ideal for first-time home buyers. Their income and credit histories might improve, at which time they could refinance with a conventional loan and get out from under the mortgage insurance premium.
Even if their financial situation doesn’t improve, an FHA mortgage is often the best way for somebody to get their foot in the door of a new house. That sure beats having it slammed in their face.