Understanding FHA Home Loans

For many first-time homebuyers, a Federal Housing Authority (FHA)-backed mortgage makes buying a home easier, or possible, thanks to less-rigid borrower requirements:

• A low minimum down payment (currently about 3%)
• Reasonable credit expectations
• More flexible income requirements

Perhaps more so than for conventional loans, providers of FHA loans are willing to look at the whole picture rather than dismissing a borrower for falling short on a particular criterion.

Still, not everyone can qualify for an FHA loan, and when applying for a mortgage, it can be frustrating not to understand how lenders determine your eligibility for a particular loan program. In this article, we'll discuss some of the basic requirements for FHA financing to help make the complex mortgage application and approval process less harrowing. (First-time shopper? Check out Financing Basics For First-Time Homebuyers.)

Background
The money for an FHA mortgage is not given to borrowers by the FHA; rather, borrowers receive the funds from an FHA-approved lender, and the FHA guarantees the loan. On one hand, this means that different lending institutions might offer you a very similar mortgage (or might turn you down), since the loan guidelines don't change based on who you borrow the money from.

On the other hand, the FHA offers lenders flexibility in determining loan eligibility based on a total picture of the applicant's situation, rather than requiring strict adherence to a list of requirements. This allows for different underwriters to interpret the guidelines differently; one institution may give you a loan while another adamantly refuses. Let's review the major components that determine borrower eligibility.

Dwellings Eligible For FHA Mortgages
In general, a property financed with an FHA loan must be the borrower's primary residence and must be owner-occupied. This loan program cannot be used for investment or rental properties. Detached and semi-detached houses, townhouses, row houses and condos within FHA-approved condo projects are all eligible for FHA financing. (Considering purchasing a condo? Read Does Condo Life Suit You? to find out if you're prepared.)

Maximum Mortgage Amount
The maximum mortgage a borrower can receive, assuming he or she has the required income, is the lesser of:

• The statutory limit for the geographic area in which the home is located.
• The maximum loan-to-value (LTV) ratio.

Limits are indexed to Freddie Mac-conforming loan limits. As of mid-2007, the limit is $417,000 in most areas and more in a few high-cost-of-living areas like Alaska and Hawaii. (To read more about Freddie Mac, check out Fannie Mae And Freddie Mac, Boon Or Boom?)

Credit Score
The FHA does not have minimum credit score requirements for its loans. That being said, borrowers with poor scores may be disqualified based on the activities that created those low scores, such as not paying bills on time.
Having no credit history is not a problem, however. Instead, the lender will to look at other payment-history records, such as utility and rent payments. Further, a previous foreclosure, short sale or bankruptcy will not disqualify the borrower, as long as enough time has passed (usually three years for a foreclosure or short sale and one to two years for bankruptcy) and the borrower has established a documented ability to manage his or her finances since the negative event. (For further reading, see Short Sell Your Home To Avoid Foreclosure.)

Also, consumers who participate in credit-counseling plans are eligible for FHA loans as long as they have been in the program for at least a year and have made all the required payments on time. Consumers who have successfully completed a credit-counseling plan should be prepared to provide documentation of successful program completion. (To learn more about these programs, check out How To Find A Credit Counselor.)

Income and Employment
Only stable and documentable income (called "effective income") can be considered for a borrower's mortgage eligibility. In general, lenders like to see two years of steady employment in the same line of work prior to the mortgage application, with no more than a one-month gap in employment. The job must be expected to continue for at least three years after obtaining the loan.

For this reason, part-time employment does not count unless it has been uninterrupted for the last two years. A full-time contract position that will end shortly also may not count, nor will the current salary of someone expecting to retire shortly. (Carrying a mortgage in retirement might negatively impact your finances. Read Burdening Your Retirement With A Mortgage to learn more.)

However, borrowers who have changed jobs frequently in order to move up in their fields and increase their income are looked upon positively. Also, there are allowances for those who work seasonally or have taken an extended leave of absence from the workforce, such as to raise kids or attend school. (Read Make Yourself A More Attractive Mortgage Candidate to learn more.)

Those who are self-employed will need two years of successful self-employment history, documented by tax returns and a current year-to-date balance sheet and profit and loss statement. Applicants who have been self-employed for less than two years but more than one year can be eligible if they have a solid work and income history for the two years preceding self-employment and the self-employment is in the same or a related occupation. (Self-employed individuals should read Secure A Mortgage - Even If You're Self-Employed to learn what they can do to increase their attractiveness to lenders.)

Debt-To-Income Ratios
The FHA does not set a maximum limit for the debt-to-income ratio, though exceeding a 45% back-end ratio takes special consideration and considerable cash reserves. This means that, as of mid-2008, the total of your debt obligations should not exceed 45% of your gross effective income. These obligations can include:

• Mortgage
• Interest
• Taxes
• Insurance
• Credit cards
• Student loans
• Car payments

So if you and your spouse together make $6,000 a month before taxes, your house payment plus your other monthly debt payments would need to be under $2,700.

Down Payment
FHA loans offer one of the most generously low down payments - just 3% of the purchase price, although this number is set to increase after December 2008, as a result of the signing of the Housing and Economic Recovery Act.

Gift funds may be contributed to the down payment if they come from an acceptable source (which must be verified), such as a relative or employer. If the gift was given in the distant past, generally three months or more for mortgage purposes, it will not need to be verified or even mentioned in the application. The reason the FHA wants documentation for gifts close to the time of purchase is to ensure that the money isn't from a new loan, which would throw off the borrower's previously approved debt-to-income ratio.

Closing Costs
FHA loans allow the seller to contribute up to 6% of the purchase price toward the buyer's closing costs. This feature of FHA loans makes it easier for cash-strapped buyers, or buyers who would simply prefer to hang on to their cash so they can invest it elsewhere or use it to remodel, to purchase a home. (To read more, check out Score A Cheap Mortgage.)

Mortgage Insurance
FHA loans require mortgage insurance because of their low down payments. Up-front mortgage insurance is due at the time the loan is taken out. This amount is equal to 1.5% of the loan amount and is typically rolled into the mortgage so the buyer doesn't have to come up with extra cash to close. This premium does not decrease the total loan a borrower is eligible for, but rolling it into the mortgage does increase the monthly payment slightly. The monthly payment will also include a monthly mortgage-insurance premium, which costs about 0.55% of the loan amount on an annual basis. This premium is generally lower than the private mortgage insurance (PMI) would cost on a non-FHA loan with the same down payment. (To learn more, check out Outsmart Private Mortgage Insurance.)

FHA Inspection and Appraisal Requirements
Even if you qualify for an FHA mortgage, that doesn't mean you'll be able to purchase the exact home you want. This is because the FHA requires all the mortgages it insures to be backed by homes of a particular caliber. Essentially, the home must be habitable, with running water, toilets, a stove and the other elements necessary to live in a safe and sanitary manner. Extreme fixer-uppers, while they can be a bargain, are not likely to qualify for FHA financing because of this requirement. (Read Five Mistakes That Make House Flipping A Flop to make sure you're not getting in over your head.)

Also, if the property does not appraise at or above the purchase price, it cannot be purchased with an FHA loan unless the purchaser/borrower can come up with enough cash to make up the difference between the appraisal amount and the sale price. (Read more in 10 Tips For Getting A Fair Price On A Home.)

Conclusion
The FHA-loan underwriting process offers a lot of flexibility in evaluating borrowers' ability to repay a mortgage. If your situation is not described above, that doesn't mean you won't be eligible for an FHA mortgage. This mortgage program looks at the borrower's big-picture situation, and financial strengths in some areas may compensate for weaknesses in others. If you want to know if you qualify for FHA financing, the best way to find out is to talk to an FHA-approved lender, which can be found through Fannie Mae's website, FannieMae.com.