FHA Loan: Basics and Requirements

What is 'FHA Loan: Basics and Requirements'

An FHA loan is a mortgage issued by federally qualified lenders and insured by the Federal Housing Administration (FHA). FHA loans are designed for low-to-moderate income borrowers who are unable to make a large down payment.

As of 2017, these loans allow the borrower to borrow up to 96.5% of the value of the home; the 3.5% down payment requirement can come from a gift or a grant, which makes FHA loans popular with first-time homebuyers.

BREAKING DOWN 'FHA Loans'

FHA loans were introduced after the Great Depression in the 1930s. During this time, defaults and foreclosures skyrocketed. In response, the government created federally insured loans that gave mortgage lenders peace of mind, reduced lender risk, and stimulated the housing market. By insuring mortgages, lenders were (and still are) more inclined to issue large mortgages in cases where they normally would not have approved the loan application.

Who are FHA Loans for?

FHA loans are offered to low-income individuals who have credit scores as low as 500. Individuals with a credit score between 500-579 can obtain an FHA loan with a down payment of 10%; individuals with a credit score higher than 580 can get an FHA loan with as little as 3.5% down. The Federal Housing Administration does not lend the borrower the money to take on a mortgage or to buy the house. Rather, the borrower pays a monthly or annual mortgage insurance premium to the FHA to insure the loan which the lending institution issues to him or her. In case of default, the lender’s financial risk is minimized since the FHA would step in to cover the payments.

Having no credit history is not a problem with an FHA loan. Instead of your credit report, the lender may look at other payment-history records, such as utility and rent payments.

Even people who have gone through bankruptcy and foreclosure may still qualify for an FHA loan. However, the lower the credit score and the lower the down payment, the higher the interest rate.

In addition to the traditional first mortgages, the FHA offers a reverse mortgage program known as Home Equity Conversion Mortgage (HECM). This program helps seniors convert the equity in their homes to cash while retaining the titles to their homes. FHA also offers a special product known as an FHA 203(k) loan, which factors in the cost of certain repairs and renovations into the loan. This one loan allows an individual to borrow money for both a home purchase and home improvement. That can make a big difference for a borrower who does not have a lot of cash on hand after making the down payment. The FHA’s Energy Efficient Mortgage program is a similar concept, but aimed at upgrades that lower the utility bill. The cost of newer, more efficient appliances, for example, becomes part of the loan.

How FHA Loans Work

In order for an FHA loan to be approved, the borrower has to have mortgage insurance. An FHA loan requires two types of mortgage insurance premium (MIP) to be made by the borrower – an Upfront Mortgage Insurance Premium (UFMIP) and an Annual MIP. The upfront MIP is equal to 1.75% of the loan amount (as of 2017) and is paid at the time of closing. A borrower who was issued a home loan for $350,000 will have to pay a UFMIP of 1.75% x $350,000 = $6,125. The payments are deposited into an escrow account set up by the US Treasury Department and the funds are used to make mortgage payments in case the borrower defaults.

The annual MIP payments is made every month by the borrower. The payments vary according to the loan amount, length of the loan, and the original loan-to-value ratio (LTV). The typical MIP cost is usually 0.85% of the loan amount. Following our example above, the borrower would have to make annual MIP payments of 0.85% x $350,000 = $2,975, or $247.92 monthly. This is to be paid in addition to the cost of UFMIP.

When you buy a home, you may be responsible for certain out-of-pocket expenses such as loan origination fees, attorney fees, and appraisal costs. One of the advantages of an FHA mortgage is that the seller, home builder, or lender is allowed to pay some of these closing costs on your behalf. If the seller is having a hard time finding a buyer, he or she might just offer to help you out at closing time as a deal sweetener.

Additional FHA Loan Requirements

While FHA loans give mortgage opportunities to people with low income or low credit and people who may be first-time homebuyers, there are specific lending requirements outlined by the Federal Housing Authority.

First, a borrower must have a steady history of employment or worked for the same employer for the past two years. This is important because the FHA requires a borrower's front-end ratio –  which is the summation of the monthly mortgage payment, HOA fees, property taxes, mortgage insurance, and homeowner’s insurance – be less than 31% of total gross income. However, it is possible to be approved with a 40% ratio. Additionally, a borrower's back-end ratio – which is the summation of the monthly mortgage payment and all other monthly consumer debts –  is required to be less than 43% of total gross income. However, it is possible to be approved with a ratio as high as 50%.

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.

Furthermore, borrowers must be at least two years out of bankruptcy, unless a borrower who has recently gone through bankruptcy has demonstrated that it was an uncontrollable circumstance. Borrowers must also be at least three years removed from any foreclosures and demonstrate that they are working toward re-establishing good credit. However, a borrower who is delinquent on his/her federal student loans or income taxes, won’t qualify for an FHA loan.

To be approved for an FHA loan, a borrower must be of legal age in the state where he is applying for a mortgage, have a valid Social Security Number, and be a lawful US resident.

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.

Finally, the lending institution that the borrower is using must be approved by the FHA board since the FHA is not a lender, but an insurer. In other words, 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 the borrower a very similar mortgage (or might turn the borrower down), since the FHA’s loan guidelines don't change based on who money can be borrowed 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 approve an FHA loan while another rejects it.

Are FHA Loans for you?

While an FHA loan may sound great, it is not for everybody. People with credit scores less than 500 will usually not be eligible for an FHA loan.

A borrower who can afford a large down payment may be better off going with a conventional mortgage as they could save more money in the long run through the lower interest rates and mortgage insurance premium that conventional lenders provide. 

Talk to an FHA advisor to determine whether this type of mortgage is right for you.