Home ownership can be difficult to achieve in today’s market, but it remains an “American Dream” not an “Impossible Dream.” Though requirements have been tightened in the wake of the home mortgage crisis, FHA loans continue to offer a way for persons of modest means to purchase a home. This guide outlines the types of, as well as the necessary qualifications for, FHA loans.
|What is an FHA Loan?|
|Types of FHA Loans|
|FHA vs Conventional Loans|
|FHA Refinance Guidelines|
|FHA Home Inspection Checklist|
|Are FHA loans assumable?|
|How to apply for an FHA loan?|
|Who pays FHA closing costs?|
The FHA, a unit of the Department of Housing and Urban Development, was created in 1934 specifically to help low- and moderate-income families obtain financing for home ownership. The FHA doesn’t actually lend any money. Instead, the agency guarantees repayment to lenders if a borrower defaults, so that the lenders know they won’t lose money on the deal, thus allowing them to offer competitive mortgage rates on loans that are easier to qualify for than conventional home loans.
FHA lending guidelines are different from those of the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac) simply because they’re designed specifically to help low-income prospective home buyers. For example, unlike with a traditional home loan, lenders must either pay part of an FHA loan’s closing costs or roll them into the loan amount, so as to minimize the out-of-pocket burden on borrowers.
To be clear, there are a number of different FHA loans, from traditional fixed rate mortgages, to adjustable mortgages, mortgage refinance products, and equity loans. While each type of loan has specific rules and guidelines, many FHA loans share common requirements, which we examine below. These requirements are current as of February 2013:
|Name||Current FHA Requirement|
|Minimum Credit Score||500|
|Debt to Income Ratio||41%|
|Interest Rates||Higher than Conventional Loans|
|Home Inspection Guidelines||Strict|
1. Credit Requirements
Credit Score: FHA loans feature very lenient credit requirements; the following score ranges should give you an idea of what you can qualify for:
- 500 and below: likely cannot get an FHA mortgage
- 500 – 620: must meet certain requirements such as having a consistent payment history for last least 1 year or be willing to make a larger down payment.
- 620 and above: Usually will have their pick of FHA mortgage products and lenders.
Bankruptcy: You can qualify for FHA loans one year after Chapter 13 bankruptcy, two years after Chapter 7 and three years after a foreclosure, provided you’ve had no negative credit events since.
Income: FHA mortgage loans require a steady source of income and consistent employment for at least two years. You’ll be required to list all of your assets such as:
- Personal property
- Cash in the bank
- Investment account totals
Most borrowers can get an FHA loan with only 3.5% down. Compared to the national average (near 12%), FHA loans are a bargain. Since the 2008 financial crisis did away with most zero down mortgages, FHA loans have become the go-to choice for borrowers who cannot afford to put down large sums of money. For the same reason, FHA mortgages have become one of the most popular mortgage products of any type, over the same time span.
The FHA also will allow you to accept a “gift” of money from a loved one as a down payment, provided you have a “gift letter” confirming that the funds are indeed a gift and do not have to be repaid. As with other mortgages, borrowers are allowed to work with state and local programs that provide help with down payments, closing costs and low-rate loans. Your lender will be glad to explain how these work.
The FHA allows a maximum housing ratio of 30% on their home loans. Housing ratio, which stands for the percentage of your gross income that you spend on your mortgage payment, plays a major role in any type of mortgage loan. As a rule, conventional mortgage lenders usually allow a housing ratio of up to only 28%.
To get an idea how housing ratio works, if your gross monthly income equals $5,000, you can get an FHA mortgage with a payment up to $1,500, while with a conventional loan you’d only be able to get a loan with a $1,400 monthly payment.
The FHA allows a debt-to-income (DTI) ratio of 41% on their mortgages (most conventional loans allow only 36%). DTI, which represents the percentage of your gross monthly income that you spend on debt payments, will also be considered by any mortgage lender who is determining your mortgage eligibility.
One of the few downsides of an FHA loan is its requirement that you purchase mortgage insurance and pay for it for at least 5 years, even if you obtain the amount of equity (78%) that is usually necessary to remove mortgage insurance. FHA mortgage insurance is charged both as a fee at closing as well as each month as part of your regular loan payment.
All FHA borrowers, regardless of the term of their loan or the size of the down payment they make, must pay a 1.75% upfront mortgage insurance premium at closing. That means that you’ll pay a $1,750 insurance premium on every $100,000. While the premium can be added to your loan amount, it’s still an extra charge.
FHA loans also carry an ongoing mortgage insurance payment in addition to the upfront fee. For loans with less than a 5% down payment, an annual charge of 1.25% of the loan amount is required.
Interest rates on FHA mortgages tend to be higher than other loan types because most FHA loans are taken out by riskier borrowers. This doesn’t mean you’ll always have to pay more interest to get an FHA mortgage, but it does mean if you have several mortgage options, the FHA loan’s interest rate will likely be the highest of the bunch.
Because mortgage rates vary by lender, shop around and compare different mortgage loan companies. Mortgage shopping is a bit time-consuming, but it can save you a ton of money on interest. Start with your personal bank and acquire a free rate quote, and then talk with at least two or three other lenders.
FHA loan limits for single-family homes range from $417,000 in most parts of the country to as high as $729,750 in high-cost regions such as New York and San Francisco. On average, most FHA loans are for lower than the maximum limits.
The FHA has unique inspection guidelines that a home must meet before the loan can be guaranteed. The inspector (usually hired at the buyer’s expense) looks for issues that can impact the health and safety of the potential homeowner.
Some common areas of emphasis for an inspection:
- Lead-based paint
- Noise hazards
- Location of gas and petroleum lines
- Proximity to electrical lines and television towers
- Stationary tanks with more than 1,000 gallons of explosive material
- Insects, that can eat wood, such as termites
- Property’s roof to make sure that the home has at least three years of remaining life and at least three layers of qualified material
- Heating and electrical systems
In general, the FHA home inspection guidelines are far stricter than those you will find on a conventional loan. It is a common occurrence for a potential home purchase to fall apart due to the property failing an FHA home inspection.
A wide variety of loans are available under the FHA’s umbrella in today’s mortgage market. You’ll find a brief description of each of the most common types below, along with links to more detailed information:
|Fixed Rate Mortgages||Traditional mortgages with a set interest rate and a fixed time frame.|
|Adjustable Rate Mortgages||Mortgages with a varying interest rate that moves up or down based on market conditions.|
|Hybrid Mortgages||A combination mortgage that begins with a fixed interest rate for a set term then becomes an adjustable rate mortgage.|
|Jumbo Mortgages||Loans that exceed the conforming loan limit of $417,000 in most areas.|
|Balloon Mortgages||A mortgage that is structured to provide a low payment until near its completion date when payment in full is expected.|
|Relocation / Bridge Mortgages||A mortgage that allows a borrower to purchase a new home, while their previous home remains on the market.|
|Home Equity Loans||Loans secured by your home that provide the borrower with a lump sum or a new line of credit.|
While FHA loans have increasingly become the mortgage of last resort, many borrowers continue to favor them over a variety of other mortgage options at their disposal. Deciding between a conventional mortgage loan and an FHA loan usually comes down to a few important factors:
|Mortgage Insurance||Monthly||Monthly and Upfront|
|Interest Rates||Average||On average higher|
In the past, FHA loans were unique among mortgage programs because they allowed the home seller to contribute up to 6% of the total home sale price towards the buyer’s down payment. To convince a seller to comply, a home buyer would negotiate a higher price for the house, and the seller would pocket the difference between the sale price and down payment. In effect, a home buyer was borrowing their down payment from their lender. However, this practice was officially banned in 2008, and potential home owners are now required to use only their own funds.
The FHA offers borrowers three different mortgage refinancing options.
- FHA Replacement Loan – For borrowers with a conventional mortgage, the FHA Replacement Loan allows them to refinance into the FHA mortgage system. The Replacement Loan program uses the same mortgage requirements as a regular FHA mortgage.
- FHA Cash-Out refinance – For borrowers with a current FHA mortgage, a FHA Cash-Out refinance will allow them to refinance while taking out money from the equity in their home. Qualifying for a cash-out refinance depends on the borrower’s credit score and equity:
- 580 and above: A borrower needs to have at least 3.5% equity to qualify.
- Below 580: A borrower needs to have at least 10% equity to qualify for a cash-out refinance.
- FHA Streamline refinance – Only for borrowers with a current FHA mortgage, the Streamline program is a fast and cheap way for a homeowner to refinance their mortgage. With no credit or income requirements, almost any borrower who has an FHA mortgage can qualify for a Streamline refinance, which is why they have become one of the FHA’s most popular programs.
An FHA Home Inspection can be a very difficult process, especially when you are trying to sell your home. The FHA Inspection checklist itself is quite lengthy and covers areas that might be left out during a conventional home inspection.
FHA loans are assumable, meaning you can transfer your loan to the new owner if you sell your house. That allows the new owner to take over your FHA loan without the additional cost of obtaining a new loan. To assume the loan, the buyer has to meet the credit standards for the loan, but this can make it easier to sell your home.
Applying for an FHA loan is largely similar to applying for a conventional mortgage, but you might need more extensive financial documentation, depending on your credit history. We’ve drawn up an exhaustive list of what you’ll need and good practices to follow before applying for an FHA mortgage.
For home buyers, one of the best features of an FHA mortgage is the requirement for the home seller or mortgage lender to cover many parts of the home’s closing costs. We have created a detailed list of who pays which closing costs that can help you figure out your potential FHA loan.