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A Federal Housing Administration (FHA) loan is a type of home mortgage that is backed by the government and provided by a bank or other approved lender. These loans typically require a lower minimum down payment than many conventional loans and may allow applicants with lower credit scores than is normally required.
The primary purpose of the FHA loan is to assist low- to moderate-income families in achieving homeownership. These loans are especially favored by first-time homebuyers.
How Does an FHA Loan Work?
As of 2022, if your credit score is at least 580, you may qualify for an FHA loan that allows you to borrow up to 96.5% of a home's value. This means that the minimum down payment required is only 3.5%.
In the event that your credit score is between 500 and 579, you may still be eligible for an FHA loan. However, you would be required to make a 10% down payment in order to qualify.
An individual may source their down payment for FHA loans from various means, including personal savings, a financial gift from a family member, or a grant specifically for down payment assistance.
The Bank's Role in an FHA Loan
The FHA does not directly provide mortgage loans to borrowers. Instead, these loans are issued by banks or other financial institutions that have been approved by the FHA.
However, the FHA guarantees the loan, which means that the bank is not solely responsible for the risk of default. This guarantee makes it easier for borrowers to obtain bank approval, and is why some people refer to it as an FHA-insured loan.
Individuals who qualify for an FHA loan are required to purchase mortgage insurance, with the premiums going to the FHA.
Read More: Loan: How Does It Work, Types, and Tips on Getting One
History of the FHA Loan
During the Great Depression in 1934, Congress established the Federal Housing Administration (FHA). This was in response to a housing industry in crisis, with high default and foreclosure rates, common 50% down payment requirements, and mortgage terms that ordinary wage earners could not meet. At the time, only one in 10 households in the U.S. owned their homes, with the majority of the population being renters.
The government created the FHA to help reduce the risk to lenders and make it easier for borrowers to qualify for home loans.
Over time, the homeownership rate in the U.S. steadily increased, reaching an all-time high of 69.2% in 2004 according to research from the Federal Reserve Bank of St. Louis. As of the first quarter of 2022, the rate stood at 65.4%.
Types of FHA Loans
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Apart from traditional mortgages, the FHA provides a range of other home loan options.
- Home Equity Conversion Mortgage (HECM): This reverse mortgage program helps seniors aged 62 and older convert their home equity into cash while retaining ownership of the property. The homeowner can choose to withdraw the funds in a fixed monthly amount, a line of credit, or a combination of both.
- FHA 203(k) Improvement Loan: This loan incorporates the cost of certain repairs and renovations into the total amount borrowed. It's ideal for individuals looking to purchase a fixer-upper and put some sweat equity into their home.
- FHA Energy Efficient Mortgage: This program is comparable to the FHA 203(k) improvement loan, but focuses on energy-efficient upgrades that can help reduce utility bills, such as new insulation or solar or wind energy systems.
- Section 245(a) Loan: The Section 245(a) loan is a program designed for borrowers who anticipate an increase in their income over time. It offers two types of mortgages:
- Graduated Payment Mortgage (GPM) - This option provides borrowers with lower initial monthly payments that gradually increase over time. This can be an excellent choice for those who expect their income to grow.
- Growing Equity Mortgage (GEM) - This option includes scheduled increases in monthly principal payments, resulting in shorter loan terms. This is another good option for those who anticipate an increase in their income in the future.
| The 5 Types of FHA Loan | |
|---|---|
| FHA LOAN TYPE | WHAT IT IS |
| Traditional Mortgage | A mortgage that finances a primary residence. |
| Home Equity Conversion Mortgage | A reverse mortgage that allows homeowners ages 62+ to exchange home equity for cash. |
| 203(k) Mortgage Program | A mortgage that includes extra funds to cover the cost of repairs, renovations, and home improvements. |
| Energy Efficient Mortgage Program | A mortgage that includes extra funds to pay for energy-efficient home improvements. |
| Section 245(a) Loan | A Graduated Payment Mortgage (GPM) has a low initial monthly payment that increases over time. A Growing Equity Mortgage (GEM) has scheduled increases in monthly principal payments to shorten the loan term. |
What Are FHA Loan Requirements?
When applying for an FHA loan, your lender will evaluate your qualifications just as they would for any other mortgage applicant. This will start with verifying that you have a valid Social Security number, lawful U.S. residency, and are of legal age according to your state's laws.
While FHA loan criteria are more flexible in some ways than those of a traditional bank loan, there are still some stricter requirements that you must meet.
Regardless of whether it is an FHA-guaranteed loan or not, your financial history will be reviewed during the mortgage application process.
Credit Scores and Down Payments
FHA loans are accessible to individuals with credit scores as low as 500, which falls within the "very poor" range on the FICO score scale.
If your credit score is between 500 and 579, you may still qualify for an FHA loan, but you will need to make a down payment of at least 10%. On the other hand, if your credit score is 580 or higher, you can obtain an FHA loan with a down payment as low as 3.5%.
In contrast to FHA loans, conventional mortgages usually require a minimum credit score of 620 for applicants to qualify. The down payment required by banks for a conventional mortgage can range from 3% to 20%, depending on market conditions at the time of application.
Typically, a higher interest rate will be charged on mortgages with lower credit scores and down payments.
History of Honoring Debts
Lenders will assess your payment history for bills like rent and utilities over the past two years, as well as your work history.
Applicants who have fallen behind on federal student loan payments or income tax payments may not be approved unless they have a satisfactory repayment plan in place. A history of bankruptcy or foreclosure can also pose problems for approval.
In general, to be eligible for an FHA loan or any other type of mortgage, a borrower must have waited at least two to three years after experiencing bankruptcy or foreclosure. However, there may be some exceptions if the borrower can show that they have taken steps to improve their credit and manage their finances responsibly.
Proof of Steady Employment
To ensure that the borrower is able to fulfill their obligation to repay the mortgage, the FHA-approved lender requires proof of stable employment. Recent and consistent employment history is essential in assessing the borrower's capacity to meet their financial obligations.
The borrower can demonstrate stable employment by providing tax returns, a current year-to-date balance sheet, and a profit-and-loss statement. If the borrower has been self-employed for at least one year but less than two years, they may still qualify if they have a reliable work and income history in the same or a related field for the two years before becoming self-employed.
Sufficient Income
To be eligible for a mortgage, it's important that you have enough income to support your mortgage payment, property taxes, HOA fees, mortgage insurance, and homeowners insurance. Banks typically use two ratios to determine if your income is sufficient.
The first ratio is called the front-end ratio, and it refers to the percentage of your gross income that your mortgage payment and related expenses should not exceed. For an FHA loan, this should be less than 31%.
The second ratio is called the back-end ratio and includes your mortgage payment along with other monthly consumer debts. This ratio should be less than 43% of your gross income.
| FHA Loans vs. Conventional Loans | ||
|---|---|---|
| FHA LOAN | CONVENTIONAL LOAN | |
| Minimum Credit Score | 500 | 620 |
| Down Payment | 3.5% with a credit score of 580+ and 10% for a 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 the loan | None with a down payment of at least 20% or after the 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 the down payment can be a gift | Only part can be a gift if the down payment is less than 20% |
| Down Payment Assistance Programs | Yes | No |
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Assuming you have an annual MIP rate of 0.85%, a $350,000 loan would require annual MIP payments of 0.85% x $350,000 = $2,975 (or $247.92 per month). These monthly premiums are separate from the upfront MIP payment and will continue to be paid for either 11 years or the life of the loan, depending on the loan length and LTV.
It's possible to claim a tax deduction for the premium payments you make, but you must itemize your deductions instead of taking the standard deduction.
| How Long You Will 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 | ≤ 90% | 11 years |
| > 15 years | > 90% | Loan term |
The FHA loan program requires that the property being financed is the borrower's primary residence and must be owner-occupied. This means that the program is not meant for rental or investment properties.
FHA-approved condo projects, as well as detached and semi-detached houses, townhouses, and rowhouses are all eligible for FHA financing.
Additionally, to qualify for an FHA loan, you must obtain a property appraisal conducted by an appraiser approved by the FHA, and the property must meet certain minimum standards set by the FHA. If the property fails to meet these standards and the seller is unwilling to make the necessary repairs, you must cover the cost of the repairs at closing. In such cases, the funds are held in escrow until the repairs are completed.
What Are the Federal Housing Administration Loan Limits?
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FHA loans have borrowing limits that vary by region. In areas with lower costs, the limit, also known as the "floor," is lower than the typical FHA loan, while high-cost areas have a higher limit, known as the "ceiling." However, some regions, such as Alaska, Hawaii, Guam, and the U.S. Virgin Islands, have even higher limits due to their exceptionally high construction costs. In other regions, the limit is set at 115% of the median home price in the county, as determined by the U.S. Department of Housing and Urban Development (HUD).
The chart below lists the 2022 loan limits:
| 2022 FHA Loan Limits | |||
|---|---|---|---|
| PROPERTY TYPE | LOW-COST AREA 'FLOOR' | HIGH-COST AREA 'CEILING' | SPECIAL EXCEPTION AREAS |
| One-Unit | $420,680 | $970,800 | $1,456,200 |
| Two-Unit | $538,650 | $1,243,050 | $1,864,575 |
| Three-Unit | $651,050 | $1,502,475 | $2,253,700 |
| Four-Unit | $809,150 | $1,867,275 | $2,800,900 |
If you have experienced a genuine financial hardship such as a decrease in income or an increase in living expenses, you may qualify for loan relief when you obtain an FHA loan. The FHA Home Affordable Modification Program (HAMP), for instance, can reduce your monthly mortgage payment to a sustainable level on a permanent basis.
To be considered for the program, you must complete a trial payment plan in which you make three timely payments at the modified lower amount. Once you have completed this plan, you will become a full participant in the program.
Advantages and Disadvantages of FHA Loans
FHA loans can be a valuable option for borrowers who may not qualify for traditional financing from private lenders. Individuals with lower credit scores, higher amounts of debt, and greater debt-to-income ratios may be eligible for an FHA loan.
However, due to the higher risk associated with FHA borrowers, interest rates on these loans tend to be somewhat higher, and private mortgage insurance (PMI) is required. Additionally, FHA loans are only available for primary residences and are subject to specific borrowing limits.
Pros and Cons of FHA Loans
The amount you can borrow depends on both your location and your ability to pay back the loan. Your financial situation will determine the maximum amount that you can borrow.
The maximum amount that can be borrowed from the FHA varies based on the region you live in. As of 2022, the loan limits range from $420,680 for a single-unit property in a less expensive area to $2,800,900 for a four-unit home in the most expensive cities in the country.
How Much Does FHA Mortgage Insurance Cost?
FHA loans come with two types of fees: an upfront premium fee and a monthly charge. The upfront fee can be included in your mortgage and is equal to 1.75% of the loan amount. The monthly fee is added to your mortgage payment and is paid directly to the FHA. It is calculated based on the value of your home.
If you want to estimate the costs of an FHA loan, you can use an FHA Loan Calculator by entering the relevant numbers. For instance, the calculator can provide an estimate for a 30-year FHA loan with an interest rate of 3.955% on a property worth $250,000, which would result in a monthly loan payment of $1,166 plus a monthly mortgage insurance payment of $174.
In most cases, lenders require borrowers to have mortgage insurance if they make a down payment of less than 20% of the loan amount. Once the borrower has paid off enough of the loan to reach 20% ownership, the insurance can be cancelled.
What are the disadvantages of FHA loans?
FHA loans typically come with higher interest rates than conventional mortgages and require borrowers to buy mortgage insurance. They are also less flexible than conventional loans and have specific loan limits.
In Conclusion
The FHA loan provides a pathway to homeownership for individuals who may not qualify for conventional loans due to factors such as a low down payment or poor credit score. The government guarantee ensures that the bank will recover its money even if the borrower defaults.
However, those who have the means to make a significant down payment may find a conventional mortgage to be a better option. By doing so, they may be able to avoid monthly mortgage insurance payments and secure a lower interest rate on the loan.
FHA loans were not designed to assist prospective homeowners seeking to purchase high-priced properties. Instead, the purpose of the FHA loan program is to aid low- and moderate-income homebuyers, particularly those with minimal savings for a down payment.
Read More: How to Get a Personal Loan in 8 Steps
Source: https://www.investopedia.com
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