What Is a Federal Housing Administration Loan (FHA Loan)?
An FHA loan is a mortgage issued by an FHA-approved lender and insured by the Federal Housing Administration (FHA). Designed for low-to-moderate income borrowers, FHA loans require lower minimum down payments and credit scores than many conventional loans.
As of 2019, you can borrow up to 96.5% of the value of a home with an FHA loan (meaning you'll need to make a down payment of only 3.5%). You’ll need a credit score of at least 580 to qualify. If your credit score falls between 500 and 579, you can still get an FHA loan provided you can make a 10% down payment. With FHA loans, your down payment can come from savings, a financial gift from a family member or a grant for down-payment assistance.
All these factors make FHA loans popular with first-time homebuyers.
How FHA Loans Work
It’s important to note that the Federal Housing Administration doesn’t actually lend you money for a mortgage. Instead, you get a loan from an FHA-approved lender, like a bank, and the FHA guarantees the loan. You pay for that guarantee through mortgage insurance premium payments to the FHA. Your lender bears less risk because the FHA will pay a claim to the lender if you default on the loan.
An FHA loan requires that you pay two types of mortgage insurance premiums – an Upfront Mortgage Insurance Premium (UFMIP) and an Annual MIP (charged monthly). The Upfront MIP is equal to 1.75% of the base loan amount (as of 2018). You pay this at the time of closing, or it can be rolled into the loan. If you’re issued a home loan for $350,000, for example, you’ll pay an UFMIP of 1.75% x $350,000 = $6,125. The payments are deposited into an escrow account set up by the U.S. Treasury Department, and the funds are used to make mortgage payments in case you default on the loan.
Despite the name, you make Annual MIP payments every month. The payments range from 0.45% to 1.05% of the base loan amount, depending on 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. If you have a $350,000 loan, for example, you will make annual MIP payments of 0.85% x $350,000 = $2,975, or $247.92 monthly. This is paid in addition to the cost of UFMIP.
You will make Annual MIP payments for either 11 years or the life of the loan, depending on the length of the loan and the LTV.
|How Long You Pay the Annual Mortgage Insurance Premium (MIP)|
|TERM||LTV%||HOW LONG YOU PAY
THE ANNUAL MIP
|≤ 15 years||≤ 78%||11 years|
|≤ 15 years||78.01% to 90%||11 years|
|≤ 15 years||> 90%||Loan term|
|> 15 years||≤ 78%||11 years|
|> 15 years||78.01% to 90%||11 years|
|> 15 years||> 90%||Loan term|
You may be able to deduct the amount you pay in premiums; however, you have to itemize your deductions – rather than take the standard deduction (as much as $24,000 in 2019 if you’re married filing jointly) – to do so.
[Important: While Federal Federal Housing Administration Loans (FHA Loans) demand lower down payments and credit scores than conventional loans, they do carry other stringent requirements.]
Lenders Consider Work History
Your lender will evaluate your qualifications, too, as it would any mortgage applicant's. But Instead of using your credit report, a lender may look at your work history for the past two years as well as other payment-history records, such as utility and rent payments. You can qualify for an FHA loan if you’ve gone through bankruptcy or foreclosure, provided you’ve re-established good credit. In general, the lower your credit score and down payment, the higher the interest rate you’ll pay on the mortgage.
Keep in mind, 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 can pay some of these closing costs on your behalf. If the seller is having a hard time finding a buyer, they might just offer to help you out at closing time as a deal sweetener.
Types of FHA Loans
In addition to traditional first mortgages, the FHA offers several other loans programs, including:
- Home Equity Conversion Mortgage (HECM) program – a reverse mortgage program that helps seniors aged 62 and older convert the equity in their homes to cash while retaining title to the home. You choose how to withdraw the funds, either as a fixed monthly amount or a line of credit (or a combination of both).
- FHA 203k improvement loan, which factors in the cost of certain repairs and renovations into the loan. This one loan allows you to borrow money for both home purchase and home improvements, which can make a big difference if you don’t have a lot of cash on hand after making a down payment.
- FHA’s Energy Efficient Mortgage program is a similar concept, but it’s aimed at upgrades that can lower your utility bills, such as new insulation or the installation of new solar or wind energy systems. The idea is that energy-efficient homes have lower operating costs, which lower bills and make more income available for mortgage payments.
- Section 245 (a) loan – a program for borrowers who expect their incomes to increase. Under the Section 245(a) program, the Graduated Payment Mortgage starts with lower initial monthly payments that gradually increase over time, and the Growing Equity Mortgage has scheduled increases in monthly principal payments that result in shorter loan terms.
|The 5 Types of FHA Loan|
|FHA LOAN TYPE||WHAT IT IS|
|Traditional Mortgage||A mortgage used to finance a primary residence|
|A reverse mortgage that allows homeowners aged 62+ to exchange home equity for cash|
|A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills|
|A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills|
|Section 245(a) Loan||A Graduated Payment Mortgage (GPM) with lower initial monthly payments that gradually increase (used when income is expected to rise), and a Growing Equity Mortgage (GEM) where scheduled increases in monthly principal payments result in shorter loan terms|
FHA Loans vs. Conventional Loans
To recap the numbers: FHA loans are available to individuals with credit scores as low as 500. If your credit score is between 500 and 579, you can get an FHA loan with a down payment of 10%. If your credit score is 580 or higher, you can get an FHA loan with as little as 3.5% down. By comparison, you’ll typically need a credit score of at least 620, and a down payment between 3% and 20%, to qualify for a conventional mortgage.
|FHA Loans vs. Conventional Loans|
|FHA LOAN||CONVENTIONAL LOAN|
|Minimum Credit Score||500||620|
|Down Payment||3.5% with credit score of 580+ and 10% for credit score of 500 to 579||3% to 20%|
|Loan Terms||15 or 30 years||10, 15, 20, or 30 years|
|Mortgage Insurance||Upfront MIP + Annual MIP for either 11 years or the life of the loan, depending on LTV and length of loan||None with down payment of at least 20% or after loan is paid down to 78% LTV|
|Mortgage Insurance Premiums||Upfront: 1.75% of the loan + Annual: 0.45% to 1.05%||PMI: 0.5% to 1% of the loan amount per year|
|Down Payment Gifts||100% of down payment can be a gift||Only part can be a gift if down payment is less than 20%|
|Down Payment Assistance Programs||Yes||No|
Special Considerations for FHA Loans
Along with the credit score and down payment criteria, there are specific lending requirements outlined by the FHA for these loans. Among them:
- Your lender must be an FHA-approved lender.
- You must have a steady employment history or have worked for the same employer for the past two years.
- If you’re self-employed, you 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. If you’ve been self-employed for less than two years but more than one year, you may still be eligible if you 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.
- You must have a valid Social Security number, reside lawfully in the U.S. and be of legal age in your state to sign a mortgage.
- Usually, the property being financed must be your 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.
- Your front-end ratio (your mortgage payment, HOA fees, property taxes, mortgage insurance and homeowner’s insurance) needs to be less than 31% of your gross income. In some cases, you may be approved with a 40% ratio.
- Your back-end ratio (your mortgage payment and all other monthly consumer debts) must be less than 43% of your gross income. However, it is possible to be approved with a ratio as high as 50%.
- You need a property appraisal from an FHA-approved appraiser, and the home must meet certain minimum standards. If the home doesn’t meet these standards and the seller won’t agree to the required repairs, you must pay for the repairs at closing (the funds are held in escrow until the repairs are made).
- You must be at least two years out of bankruptcy unless you can demonstrate the bankruptcy was due to an uncontrollable circumstance.
- You must be at least three years removed from any foreclosures and demonstrate you are working toward re-establishing good credit.
- If you’re delinquent on your federal student loans or income taxes, you won’t qualify.
Background of the FHA Loan
Congress created the Federal Housing Administration in 1934, amid the Great Depression. At that time, the housing industry was in trouble: Default and foreclosure rates had skyrocketed, loans were limited to 50% of a property’s market value and mortgage terms – including short repayment schedules coupled with balloon payments – were difficult for many homebuyers to meet. As a result, the U.S. was primarily a nation of renters, and only 40% of households owned their homes.
To stimulate the housing market, the government created a federally insured loan program that reduced lender risk and made it easier for borrowers to qualify for home loans. The homeownership rate in the U.S. steadily climbed, reaching an all-time high of 69.2% in 2004, according to research from the Federal Reserve Bank of St. Louis. (As of the third quarter of 2018, it's at 64.4%.)
Pros and Cons of FHA Loans
There are some differences between FHA and conventional loans.
Con: Loan Limits
One limitation of FHA loans is that they have outside limits on how much you can borrow. These are set by the region in which you live, with low-cost areas having a lower limit (the "floor") than the usual FHA loan and high-cost areas having a higher figure (the "ceiling"). Then there are "special exception" areas – including Alaska, Hawaii, Guam and the U.S. Virgin Islands – where very high construction costs make the limits even higher. Everywhere else, the limit is set at 115% of the median home price for the county, as determined by the U.S. Dept. of Housing and Urban Development. The chart below lists the 2019 loan limits:
|2019 FHA Loan Limits|
|PROPERTY TYPE||LOW-COST AREA
Curious about how much money the FHA in your area would let you borrow? The FHA website provides a page where you can look up your county's loan limit.
Pro: Loan Relief
FHA loans are not without their pluses: Once you have one, you may be eligible for loan relief if you’ve experienced a legitimate financial hardship – such as a loss of income or increase in living expenses – or are having a hard time making your monthly mortgage payments. The FHA-HAMP program, for example, can help you avoid foreclosure by permanently lowering your monthly mortgage payment to an affordable level. To become a full participant in the program, you must successfully complete a trial payment plan in which you make three scheduled payments – on time – at the lower, modified amount.
Decide What's Best for You
While an FHA loan may sound great, it’s not for everybody. It won't help those with credit scores less than 500. On the opposite end, aspiring homeowners 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.
As the Federal Housing Administration puts it, an FHA loan "won’t accommodate those who are shopping on the higher end of the price spectrum – nor is it intended to. The FHA loan program was created to support 'low- and moderate-income home buyers,' particularly those with limited cash saved for a down payment."