What is an FHA Loan?
An FHA loan is a kind of mortgage loan insured by the Federal Housing Administration (FHA), a branch of the U.S. Department of Housing and Urban Development (HUD). FHA loans are created to accommodate individuals with low to moderate income. They also help those who are not able to establish a good credit score. This type of loan is popular among first-time home buyers, such as newlyweds or college graduates, who do not have time to save for a bigger amount of down payment or do not have an impressive credit history. It is ideal for those who do not have enough savings left to buy the house they want because FHA loans require only a minimum cash investment. At the same time, individuals who have been denied of a conventional loan application or unable to apply due to a bankruptcy or foreclosure record can opt for an FHA loan. Compared to conventional loans, FHA does not require a large amount of down payment. Individuals with credit scores of 500-579 can buy a home for as little as 10% down payment. Meanwhile, those who have a credit score of 580 and above can get an FHA loan with 3.5% down payment.
How to Qualify for an FHA Loan?
FHA loans are easier to qualify for compared to conventional loans. This type of loan helps anyone, regardless of their income level, to be able to have their own home. Because FHA loans are guaranteed by the government, more mortgage lenders are willing to approve applications. FHA-approved lenders may have different standards, so it’s better to shop around to land the one that is most suitable for you. Aside from having a certain good credit score, anyone who is interested to apply for an FHA loan should be able to meet certain requirements such as:
- Provide proof of identification – One should have a valid Social Security number, possess lawful residency in the U.S. and must meet the legal age required to sign a mortgage in the state where he/she lives.
- Reliable income stream – No minimum income required. However, the applicant should be able to demonstrate a stable employment history or at least have the same employer for the past two years.
- Must have plans in living in the home – Those who are planning to rent the home out are not qualified for an FHA loan.
- Must have reasonable debt-to-income ratio –The front-end ratio of a borrower, like property taxes, mortgage insurance and homeowners’ insurance, must be at least below 31% of their gross income.
- Must be regularly paying income taxes or federal student loan taxes.
- Have not gone through home foreclosure for at least three years and have re-established good credit
- Must be out of bankruptcy for at least two years and have re-established good credit
- Must be able to find an FHA-approved lender
FHA Loans Pros
After the Great Depression in 1929, families in the USA had difficulties in purchasing their own homes. Back then, loans were available to 50% of the property’s market value. In addition, mortgage loans were difficult to meet. FHA was then established in 1934 to make mortgages become more accessible to many people. Aside from lowering the down payment requirements, FHA helped qualify borrowers based on their capacity to repay a loan. A loan amortization schedule is also created which allows both principal and interest payments made each month. Furthermore, FHA introduced borrowers to longer loan terms.
Today, FHA offers single-family and multi-family homes with mortgage loans through FHA-approved lenders in the USA. FHA is not a mortgage lender but only a mortgage insurer. It insures loans so lenders can provide better deals. Here are some of the benefits that come with FHA loan application:
- Lower down payments
Unlike other conventional loans, FHA loans have a low down payment requirement. That is why if you haven’t been able to save money for a down payment, this type of mortgage loan can be your best option. FHA requires only 3.5% of the home’s price as a down payment. For down payment assistance, individuals can apply for a government grant, use a financial gift from a family member or use what’s left of their own savings.
- Good credit history is not a requirement
A credit score helps lenders identify whether or not a person is worthy of lending money to. It can help estimate how risky it is to extend credit to a certain individual. There are major credit reporting agencies. However, the most widely used credit score is the FICO score. An individual’s FICO score is based on five factors, including new credit and recently opened accounts, types of credit used, length of credit history, amounts owed and most importantly, payment history. To receive maximum financing, a credit score of at least 580 is required. Those who have a credit score of 500-579 can still be approved but may have to make a larger down payment.
- Closing costs may be covered
Closing costs are expenses included with your home purchase and are paid at the closing of a real estate transaction. “Closing” means when the title of the property is then transferred from the seller to the buyer. Depending on the contract and kind of fee, closing costs can either be paid by you, the seller or the lender.
With an FHA loan, borrowers can get help paying closing costs. Most of the time, mortgage lenders, home sellers and builders agree to pay part of the amount of the closing costs to be able to close a deal and build a good relationship with the FHA administrators. If a lender agrees to pay closing costs, the lender may charge more interest. That is why it is best for borrowers to compare loan estimates among FHA-approved lenders in the market. Closing costs depend on the state you live in, the size of your loan and if you use points to reduce the interest rate. By policy, FHA money lenders can charge 3% to 5% of the loan amount for closing costs.
- Home improvement and repairs
Some FHA loans can be used to pay for any repairs necessary. If the borrower is planning to buy a house that requires an upgrade, they can apply for an FHA loan called 203(k). The loan amount is based on the projected value of the property after the necessary improvements are completed. This type of FHA loan can cover bath and kitchen remodels, decks and patios, heating and air conditioning, flooring and plumbing needs. Not all properties qualify for the 203(k) loan. A more detailed home improvement proposal with cost estimates is required for the loan application to be approved.
FHA Loans Cons
While applying for an FHA loan seems to be promising, it still has some restrictions and requirements that may prevent borrowers from getting the most from it.
- Mortgage insurance
FHA loans come with two kinds of insurance that a borrower will be required to pay during the entire lifespan of the loan. A borrower is required to pay a private mortgage insurance (PMI). This serves as a protection for the lender in case the borrower fails to pay the mortgage loan. The Upfront mortgage insurance premium (UFMIP) is a one-time premium payment. It costs 1.75% of the home loan. Borrowers have the option to pay this upfront or roll them into the mortgage. The other type of payment required from the borrowers is a monthly mortgage insurance premium (MIP). It can range between 0.80% and 1.05% of the loan balance or can go down to 0.45% if the borrower availed of a 15-year FHA loan.
- Higher interest rates
Since an FHA loan has a low down payment offer, borrowers can end up paying higher interest rates than going for a conventional loan with a 20% down payment. Borrowers can save more by choosing a 15-year fixed rate mortgage than a 30-year fixed rate mortgage.
- Property restrictions
Because the FHA loan program is managed by HUD, there are specific rules as to what type of properties are eligible for purchase. Limits have been lowered in some of the most expensive locations in the country to live. If you want to buy a vacation home, FHA loan is not the answer. An HUD-approved appraiser will also drop by the property you plan to purchase to check if it meets all the program requirements. If a condominium is what you are eyeing for, then the condominium project must be included in the approved condo list of HUD.
Indeed, FHA loans are the easiest mortgage loans you can get. They offer a convenient solution for those individuals or families with low income, low credit score and lesser budget to make large amount of down payments to buy a house of their own. Going for an FHA loan still depends on your personal situation. If you can afford to make a big down payment, conventional loans are still recommended as they offer fewer interest rates and less mortgage insurance premiums.
However, if you are fully decided to apply for an FHA loan, here are the steps you need to go through:
- Get your mortgage loan pre-approved by an FHA-approved lender
- Fill out Form 1003 after you have found the home you want to buy
- Let a professional home appraiser inspect your chosen property. If the estimate matches the amount you have requested, you move forward to the next step. On the other hand, if the appraisal is lower than the mortgage loan amount, your FHA loan application can be denied.
- Wait for the mortgage lender underwriter to evaluate your application. Should there be any issue, you can send a formal letter of explanation to the lender.
- Once everything is clear with the underwriting process, your FHA loan can now be approved.