Understanding FHA Home Loans

By Amy Fontinelle AAA

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 3.5%)
  • Reasonable credit expectations
  • More flexible income requirements

Compared with providers of 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. 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 home 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 FHA’s loan guidelines don't change based on whom you borrow the money from. 

On the other hand, the FHA offers lenders flexibility in setting their own standards for determining loan eligibility, and many lenders’ minimum requirements are higher than those set by the FHA. As a result, one institution may give you an FHA 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 principal 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 where the home is located. 
  • The maximum loan-to-value (LTV) ratio for a specific property.

Limits are indexed to Freddie Mac conforming loan limits and change as often as once a year on January 1. In 2014, the limit is $ $271,050 in most areas and up to $625,550 in a few high-cost-of-living areas, such as Alaska and Hawaii. (To read more about Freddie Mac, check out Fannie Mae and Freddie Mac, Boon Or Boom?)

Credit Score
The FHA has a minimum credit score requirement of 500 for its loans, which is very low. Anything below 620 is considered subprime. 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. Also, lenders typically require a higher minimum credit score. The typical FHA borrower who got approved in January, according to data analyst Ellie Mae, had a score of 688, while the typical rejected applicant’s score was 667. But the typical conventional borrower had a score of 755, so FHA loans are in fact easier to get for borrowers with credit problems.

 
Having no credit history is not a problem with an FHA loan. Instead of your credit report, the lender will look at other payment-history records, such as utility and rent payments. Further, a previous foreclosureshort 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/her finances since the negative event. But if you’re delinquent on your federal student loans or income taxes, you won’t qualify. (For further reading, see Short Sell Your Home To Avoid Foreclosure.)

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. 

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 affect your finances. Read Burdening Your Retirement With A Mortgage to learn more.)

However, lenders look positively upon borrowers who have changed jobs in order to move up in their fields and increase their incomes. Also, there are allowances for those who work seasonally or have taken an extended leave of absence from the workforce for reasons such as to raise kids or attend school. (Read 5 Steps to Scoring A Mortgage 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 fewer 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 Self-Employed? 5 Steps to Scoring A Mortgage to learn how to increase their attractiveness to lenders.)

Debt-to-Income Ratios
The FHA lets borrowers have a maximum back-end ratio of 50% if they have what are called “strong compensating factors,” such as at least three months of cash reserves or a history over the last 1–2 years of making housing payments greater than or equal to the proposed monthly mortgage payments.

This means that the total of your debt obligations must not exceed 50% of your gross effective income.These obligations 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 $3,000.

If you have a credit score of less than 580, your debt-to-income ratio must be 43% or lower. (L6) Also, as with credit scores, lenders can and often do require lower debt-to-income ratios than the FHA does.

Down Payment
FHA loans offer one of the lowest down payment requirements – just 3.5% of the purchase price. Here again, however, you’ll have to make up for a credit score lower than 580 by coming up with a down payment of at least 10%.

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, 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 loan amount toward the buyer's closing costs, compared with 3% for conventional loans.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 1.75% 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 1.35% of the loan amount on an annual basis if you’re putting 3.5% down on a 30-year loan. It’s divided by 12 and added to your monthly payment. You’ll pay these premiums for the life of the loan, which makes FHA loans significantly more expensive than conventional loans. In addition, this premium is generally at least as much as private mortgage insurance (PMI) would cost on a non-FHA loan. (To learn more, check out How to 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. 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 The FHA's Minimum Property Standards to learn more.)

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 appraised value 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. To find out if you qualify for FHA financing, talk to an FHA-approved lender. Check http://www.hud.gov/ll/code/llslcrit.cfm for names.

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