What is an FHA Loan?
An FHA loan is a type of government-backed mortgage loan insured by the Federal Housing Administration. The Federal Housing Administration is an agency under the jurisdiction of the Department of Housing and Urban Development.
FHA Loan is insured by the government means that if the borrower is unable to repay the loan for any reason, the FHA will take steps to protect the lender. Banks, credit unions and non-banking institutions provide these types of loans.
Since the down payment and credit score of FHA Loan is much lower than conventional loans, the demand and popularity of this loan is also high, especially for those who are buying a house for the first time. In this case the down payment amount will be minimum 3.5% and the credit score will be 580 or more. However, even if FHA loan requires low down and credit score, you will have to pay mortgage insurance.
FHA Loans Requirements
- Whether you buy a house, condo or multi-family home, you must comply with the minimum property requirements set by the FHA. The home you want to buy must be appraised by an FHA approved appraiser. An inspection will be carried out to observe the quality of the property. If you apply for FHA 203 (k) renovation loan then these appraisals will be occurred twice. First time appraisal that assesses the present condition of the property and second time appraisal observe the quality after the house is repaired.
- FHA loans are only approved for those who purchase a home for primary housing. If you want to buy more than one house, you will not get this loan.
- You must take possession of the home within 60 days of loan approval,
- To be eligible for an FHA loan, you need to have a FICO score of 500 to 579 with 10 percent down payment. Or the FICO score should be 580 or higher with 3.5 percent down payment. But because of the Covid-19 situation and the economic downturn, many FHA lenders have raised the minimum credit score limit, many lenders now seeking at least 620 credit scores.
- Those with a credit score of 580 or higher will receive a loan with a 3.5% down payment. Those with a credit score of between 500 and 579 will have to pay at least 10% down payment.
- Borrower must have verified employment history of last two years.
- The front-end debt ratio (monthly mortgage payments) cannot exceed 31% of the gross monthly income.
- The back-end debt ratio (mortgage plus all monthly debt payments) cannot exceed 43% of the gross monthly income. However, some lenders can consider up to 50 percent.
- If you are bankrupt, apply after one to two years. And in case of foreclosure, apply after three years.
Related Article: What is a Mortgage? How Does a Mortgage Work?
How Does FHA Loan Work
FHA loans are granted for 15 and 30 years and interest rates are fixed. Lenders charge between 3 and 5 percent of the total loan amount in closing costs, it is called the Debt Originating Fee.
FHA loans are given to those who are buying a home for the first time. This loan requires low down payment and low credit score. However, borrower must pay FHA mortgage insurance. This will protect the lender from potential losses for loan default.
FHA mortgage insurance is usually required when the down payment amount is less than 20%. There are two mortgage insurance premiums that borrower has to pay:
Upfront mortgage insurance premium: 1.75% of the loan amount you get will have to be paid to the lender. Suppose you borrow $100,000, then the upfront mortgage insurance premium will be $1750.
Annual mortgage insurance premium: Annual mortgage insurance premium ranges from 0.45 to 1.05 percent. The annual mortgage insurance premium will depend on the term of the loan, the loan amount and the initial loan-to-value ratio. The total premium is divided by 12 and is paid every month. If you borrow $100,000, you will need to pay between $450 ($37.5 per month) and $1050 (87.5 per month) depending on the terms of the loan.
In most cases, FHA mortgage insurance premiums are canceled after 11 years if the borrower finances 90 percent of the home value or less and continues to pay mortgage payments every month.
If your LTV ratio is more than 90 percent, you will have to pay insurance until all the loans are repaid.
FHA loans vs. Conventional Mortgages
Conventional mortgages are not insured by the government, but FHA loan is insured by the Government. There are some differences between FHA loans and conventional mortgages. E.g.
The minimum credit score for FHA loans is 500. On the other hand, the lowest credit score for conventional mortgages is 620.
FHA loans are available with 3.5% to 10% down payment. Conventional mortgages require a 3% to 20% down payment.
The term of FHA loan is 15 and 30 years. The term of conventional mortgages is 8 to 30 years.
FHA loan interest rates are fixed but conventional mortgages interest rates are fixed or adjustable.
Advantages and Disadvantages of FHA Loans
The biggest advantage of FHA Loans is that borrower can get a loan with a low credit score. For example, if your credit score is 500 plus, then you can apply for FHA Loans. However, if the credit score is low, the down payment is high.
Down payment is a big factor in borrowing. While other private loans require a down payment of 20% or more, FHA loans require down 3.5% to 10%.
Main disadvantage of FHA loans is that the borrower must pay mortgage insurance. This is because if borrower has a low credit score and pay down low amount, it becomes a big risk for the lender. Mortgage insurance helps reduce the risk to the lender. If the borrower has made a down payment less than 10%, he will have to go through mortgage insurance till the loan is repaid in full.
You must meet certain conditions when you apply for an FHA loan. The most necessary condition is price. You cannot purchase a home that exceed certain amounts set by the FHA. You have to stay in this house and this should be your initial abode.
FHA loan limits
No matter which type of FHA loan you are applying for, there is a limit on the amount of mortgage. In 2021, FHA loans are limited to $356,362 to $822,375. However, depending on the county, the FHA loan limit varies.
The maximum limit for a small family in a less expensive area is $356,362. Again in expensive areas like New York, San Francisco the maximum limit for FHA loans is $822,375. The limit is determined based on the value of the county’s property.
Through the FHA mortgage limits page you can look up the mortgage limits of different areas. You can also find out the median sale price of each area through this page.
How to apply for FHA loans
Borrower needs to apply to a lender to get an FHA loan. At this time borrower has to submit different types of documents, e.g.
- A valid Social Security number.
- Proof of US nationality, permanent address or proof of working in the United States.
- Bank transaction statements for the last two months.
- Credit score, tax return and employment records etc.
Types of FHA loans
There are different types of loan options that FHA offers. These are discussed in the below:
203 (k) loan is also called Rehab Loan or FHA Construction Loan. With a 203 (k) loan you can buy a house as well as repair it. However, repairs or improvements must be $35,000 or less.
It is often seen that a borrower wants to buy a house that needs major repairs. But most lenders are reluctant to lend money to buy this type of home. 203 (k) loan solves this problem.
203 (k) loan requires a minimum credit score of 580. However, some lenders consider the borrower for a 203 (k) loan if borrower has a credit score of 620-640.
203 (k) loan requires 3.5 percent down payment. The borrower will be able to borrow up to 110 percent of the future value of the property or the value of the house plus the cost of repairs, whichever is less.
Home Equity Conversion Mortgage (HECM)
Those aged 62 or over may consider HECM. This will allow you to convert some of your home equity into cash and it is not required to sell the house or pay any additional monthly bills. However, this type of mortgage can be complicated for you. Because it will increase the amount of equity usage in your home. This will curb your rights to your property.
The amount you can withdraw depends on the age of your inheritance, the current interest rate and the lesser of the home’s appraised value.
Energy Efficient Mortgage
FHA Energy allows Efficient Mortgage. Under Energy Efficient Mortgage, the borrower can purchase an energy-efficient home.
FHA Growing Equity Mortgages
FHA growing equity mortgages are offered to first time home buyers and small families. Growing Equity Mortgages are available with low down payments and low credit scores.
The FHA Section 245(a) states that those whose current income is low but expected to increase in the future will be able to purchase a home through growing equity mortgages. Payments will start here in small amounts and increase gradually over time. However, borrowers will be able to reduce the loan term by increasing the amount of monthly payment according to their ability.