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What Is an FHA Loan?
Financing a house with a damaged credit history or a down payment of less than 20% can be challenging. Still, while difficult, it is possible to obtain a mortgage with less than ideal circumstances thanks to governmental guaranteed financing programs like FHA mortgages, which can transform the dream of homeownership into a reality.
The FHA loan guarantor is the Federal Housing Authority and it is the largest mortgage issuer in the world. It helps fund single and multi family properties as well as healthcare facilities. When applying for an FHA loan, your credit history counts, as it would with all lenders, but the FHA’s guidelines are more lenient in some ways and less in others. It’s important to note, though, that while the FHA guarantees a loan, the funds for FHA loans come from mortgage lenders.
To decide whether an FHA loan is right for you, it’s important to understand what an FHA loan actually is, how much it differs from conventional loans and what the alternatives might be.
What is an FHA loan?
An FHA loan is a home loan designed especially for individuals who have a less than stellar credit history. Many lenders require an average FICO score of 684, but having a score below this doesn’t negate your chances of owning a home. With an FHA home loan, the minimum FICO score you need is 500, but it will require 10% down. However, if you boost your credit score to 580, then the required minimum down payment drops to 3.5%. There are other requirements for an FHA home loan as well, but overall, it’s designed to help those with fair and sometimes poor credit buy a home.
What does FHA stand for?
The Federal Housing Administration (FHA) is a part of the U.S. Department of Housing and Urban Development, which is a cabinet-level department in the federal government. The FHA works to help more Americans get access to affordable housing through homeownership. The main way that the FHA does this is by providing mortgage insurance to private lenders so they can extend financing to a wider range of American homebuyers. Since the FHA’s inception in 1934, over 46 million mortgages have been backed by this federal department.
COVID-19’s impact on FHA loans
While the Federal Housing Administration’s requirements for borrowers are set quite low, private lenders still have the final say on approval. Meeting the FHA’s loan requirements doesn’t mean automatic approval. Private lenders still weigh the risks and can decide whether they want to approve you for a loan or not.
The economic damage caused by COVID-19 has greatly increased the concern over lending and potential foreclosures, which has injected a lot of uncertainty into the housing market. When foreclosures increase, mortgage rates and lending requirements also increase. Some lenders have tightened approval restrictions for new loans across the board, including FHA loans.
FHA loans vs. conventional loans
When you look at what an FHA loan is on the surface, it looks similar to a conventional loan — but you only need to put down 3.5%. There are some differences between the two products to be aware of, though.
Conventional loans only require private mortgage insurance (PMI) until you have 22% equity built up in your home. With an FHA loan, you’re required to pay mortgage insurance for at least 11 years to help the lender recoup losses if you default on the loan. The MIP paid on FHA loans can last for anywhere from 11 years to the life of the loan.
There’s an upfront insurance premium of 1.75% that also must be paid on FHA loans. However, many lenders will allow you to roll the cost of this fee into the total loan to limit the upfront costs. This doesn’t mean you’re not paying the fee — it’s just spread out over the life of your loan with interest in that case.
The other major difference between the two products is that FHA loans have a geographically-determined limit on the amount you can borrow. The maximums change each year, but the max loan amount ranges from $331,760 and $765,600 for 2020 depending on where you live.
|Loan Type||Min. FICO Score||Min. Down Payment||Insurance requirement||Debt-to-Income Ratio|
|Conventional||640||usually 10%-20%||MIP requirement varies||45% — maximum 50% in rare exceptions|
*Sometimes a lower FICO score for conventional loans might be used, but this depends on the lender’s underwriting policies and the borrower’s available liquid assets.
Types of FHA loans
When most people think about home loans, three options come to mind: fixed-rate mortgages, ARM loans and refinance loans. However, FHA loan options go beyond this.
- Fixed-rate mortgage — The most popular FHA loan available is a fixed-rate mortgage. With this loan type, your mortgage payments and interest rate are fixed for the life of the loan. This helps borrowers know exactly what they’ll need to pay from month to month with no chance of surprises down the road.
- Adjustable-rate mortgage (ARM) — ARM loans come with a low introductory interest rate that is in place for a fixed period of time. Once that period is over, the rate can adjust to be higher or lower once per year based on the economic climate. While this type of loan may seem attractive due to the low intro rate, it can create problems if the interest rate increases because your payment size could drastically change.
- 203(k) mortgage — This type of FHA loan gives homebuyers the ability to purchase a home that needs renovations. In addition to covering the cost of the home, the loan gives you access to the cash you need to make the renovations to the home. The terms of this loan are particularly nuanced, so make sure you fully understand the stipulations and requirements before choosing to go this route.
- Section 245(a) loan — Known as the graduated payment mortgage, a section 245(a) loan is designed for borrowers who expect their income to rise over time. The plans start with low monthly payments that slowly increase with time to match your growth in income.
- Reverse mortgages — Reverse mortgages are designed for homeowners aged 62 and older who could use a bump in income. They convert your home’s equity into income or a line of credit, but consumer counseling is a requirement. The mortgage is not repaid until the house is sold and if the sale doesn’t yield enough to repay the full loan, the FHA insurance covers what’s left.
FHA loan requirements
Ideally, you need a FICO score of at least 580 and a 3.5% down payment to qualify for an FHA home loan. However, some lenders may give special consideration to those with a 500 FICO score if you have at least 10% to put down.
All FHA loans require a mortgage insurance premium. It is a kind of insurance policy for the lender in case you default on the loan later. The debt-to-income ratio should be no higher than 43%. If you’re uncertain of what your debt-to-income ratio is, you can calculate it with an online tool.
Finally, the home you’re considering needs to be your intended primary residence and you’ll need to provide proof of steady income and employment to meet the requirements.
Best FHA lenders
Quicken Loans is one online lender for FHA loans. It might be a good choice for someone looking for a fast, easy certification process. It has an online application that’s a breeze to use and current FHA rates start at 3.625% for a 30-year fixed loan.
Navy Federal Credit Union is another option. Rates start at 4.125% for a 15-year mortgage and 4.000% for a 30-year mortgage for members. However, membership is limited to veterans, active military members, their families and the Department of Defense.
FHA loan alternatives
There are a few alternatives to FHA home loans to consider: VA, USDA and conventional mortgages.
- VA loans are guaranteed by the Veteran’s Association, but the loans are originated by approved lenders, which means your funds will be paid directly from a lender and not the VA. These loans are designed for veterans, active military members and their families. To qualify, you’ll need satisfactory credit, a solid income and a valid certificate of eligibility.
- USDA loans are issued for rural home purchases and 90% guaranteed by the United States Department of Agriculture. Approved lending institutions originate the loans. The home needs to be for your primary residence and the property must meet all program requirements.
- Conventional home loans offer another option, but they depend greatly on your income, credit history and other things. So, if you have a higher FICO score, or can afford to take the time to work on your credit history, then you may be able to save on interest and possibly mortgage insurance premiums with conventional loans.
Pros and cons of FHA loans
- Requires a smaller down payment
- Potential approval for lower credit scores
- Can, in some circumstances, roll closing costs into the loan to limit upfront cash needed
- Maximum loan limits
- MIP for the life of the loan (or at least 11 years)
- Upfront mortgage premium
How to apply for an FHA loan
- Gather your documents. The first step to applying for an FHA loan is to gather the necessary documents. This includes income verification, proof of assets, bank statements and other information required by your lender.
- Shop lenders. You should shop around for different lenders to see what rates and repayment terms you can get. Remember, even a fractional difference in your rate can mean tens of thousands of dollars over the life of the loan.
- Complete your application. After you’ve selected the private lender you want to work with, it’s time to fill out your application. Make sure that you stay on top of your paperwork and get it in as quickly as possible. If the lender asks you for anything, quick compliance can help increase your approval chances and speed up the process.