What Is An FHA Loan?
Katie Ziraldo5-minute read
June 30, 2021
An FHA loan can be an appealing mortgage option for home buyers due to its more lenient approval requirements. But what exactly is an FHA loan and how do you know if it's right for you?
In this article, we'll explore the basics of FHA loans, as well as the opportunities and obstacles you may face if you pursue this form of financing.
How Does An FHA Loan Work?
Like other types of mortgages, FHA loans are issued by banks, credit unions and private lenders for the purpose of borrowers buying a home – however these loans are backed by the Federal Housing Administration (FHA), a government agency that protects lenders if a borrower defaults on their mortgage.
Due to this guarantee, FHA loans typically come with less stringent approval criteria. With lower credit and down payment requirements, FHA loans are a popular option for first-time home buyers who may not be eligible for conventional mortgages.
Pros Of FHA Loans
When compared with conventional loans, the following are a few of the biggest advantages of FHA loans:
- FHA loans have fewer requirements for first-time home buyers, including low minimum down payment requirement
- Borrowers may qualify even if issues exist in their financial history.
- FHA loans have no income limits.
- Single or multifamily housing units can be financed with an FHA loan.
- FHA loan closing costs can be included in mortgage payments.
Cons Of FHA Loans
For all their perks, there are also a few disadvantages of FHA loans that must be considered, including:
- FHA loans typically have higher insurance premiums.
- There are usually lower loan limits for FHA loans.
- The FHA can have strict housing standards.
- The property must be the borrower's primary residence.
FHA Loan Requirements
A borrower applying for an FHA loan must meet certain requirements in order to qualify. Let’s take a look at some of those qualifications below.
Must Be A Primary Home Purchase
When choosing a mortgage type, one of the most important things to consider is the type of property being purchased. This is especially true with FHA loans, as they must be used toward a primary home purchase. An FHA loan will not work for you if you're planning to buy a second home or investment property. The buyer must also occupy the property within 60 days of the loan closing.
Minimum Credit Score Of 580
One of the biggest advantages of FHA loans is the lower credit score requirement, as most lenders only require a minimum score of 580 for approval. It's possible to be approved with a credit score as low as 500, but borrowers should remember that lower credit means more risk for the lender and therefore also means higher down payments and interest rates.
Proof Of Income And Employment
FHA loans require the borrower to prove their financial stability and ability to repay the lender, typically through proof of income and employment. Depending on the lender, borrowers may be asked to provide bank statements, pay stubs, tax returns, and W-2s from the past 2 years.
Your debt-to-income ratio (DTI) is the total of your monthly debt payments divided by your gross monthly income. Typically a lower DTI means a better chance of loan approval, but the exact DTI requirement will depend on other financial factors such as your credit score and the size of your down payment. In general, your DTI should not exceed 43% of your monthly income.
Minimum 3.5% Down Payment
The exact percentage needed for your down payment will depend on your credit history. Borrowers with a credit score of 580 or higher can be approved for FHA loans with as little as 3.5% down on the home, while borrowers with credit scores of 500 – 580 will need a down payment of at least 10%.
When you're deciding how much to put down on your home, it's important to remember that larger down payments mean lower monthly payments and vice versa. To find the best down payment for your needs, we recommend using a mortgage calculator to determine how much house you can afford.
FHA Appraisal And Inspection
Homes must meet certain requirements to qualify for FHA loans, which means you'll need an appraisal and home inspection through FHA-certified professionals to buy a home. These professionals consider the Department of Housing and Urban Development (HUD)'s minimum property requirements and examine the home's overall condition as well as any necessary repairs.
The results are reported back to HUD along with the approximate cost of fixing any necessary issues with the home. If the home is not compliant with FHA standards, these repairs must be made prior to closing. The seller is typically responsible for home repairs, but not all sellers are created equal, and some may not be willing to pay to bring the home up to FHA standards. In this case, the buyer must resume their search for an FHA-compliant property.
FHA Mortgage Insurance
Mortgage insurance is required regardless of the down payment. With conventional mortgages, mortgage insurance can be avoided by making a down payment of 20% or higher.
The mortgage insurance premium (MIP) protects lenders against damages when borrowers default on their mortgage and is made up of two parts: an upfront premium and an annual premium. The upfront premium is typically around 1.75% of your total loan amount and must be paid with the FHA closing costs. The annual premium is around 0.45% - 1.05% depending on your loan amount and down payment. If you put at least 10% down, you'll pay MIP for 11 years. If you put less than 10% down, you'll pay MIP for the life of the loan.
FHA Loan Limits
The FHA establishes loan limits by county, which means your maximum loan amount can vary depending on where you live. For 2022, FHA loan limits will range between $420,680 – $970,800 for single-family homes based on location.
To find out where your county falls in the range, we recommend using the search tool on the HUD website. Loan limits can change quickly, so be sure to check the website periodically to find the most up-to-date information.
How To Apply For An FHA Loan
The first and most important step in the mortgage process is comparing all loan types, including FHA loans and conventional mortgages. Be sure to consider your monthly budget and financial goals when choosing your loan type. If you decide FHA loans are right for you, the application process will begin with finding an FHA lender and providing the necessary information for approval, following the qualification requirements listed above.
As with any home loan, an FHA borrower should get preapproved for their FHA loan so that they can see if they qualify for the interest rates and loan terms they want.
Types Of FHA Loans
The FHA doesn’t only offer purchase mortgages. Let’s take a look at some of the other loan programs available through the FHA.
FHA Streamline Refinance
The FHA Streamline Refinance program offers a faster and simplified refinance process for homeowners with existing FHA loans. Borrowers could reduce their monthly payments and qualify with less required documentation.
Rocket Mortgage® offers FHA purchase loans and the FHA Streamline Refinance program, but as of this writing doesn’t offer the following FHA programs.
FHA 203(k) Loan
Also known as a renovation loan, the FHA 203(k) rehab loan allows borrowers to buy a home and pay for remodeling or repairs, all under one loan. An FHA 203(k) loan can come as either a Standard or a Limited loan, the latter requiring less paperwork for approval.
Home Equity Conversion Mortgage (HECM)
A HECM is an FHA-insured reverse mortgage that can help seniors over the age of 62 to convert the equity in their homes into cash and pay off their existing mortgage. The borrower can retain their name on the home’s title.
Energy-Efficient Mortgage (EEM)
An FHA EEM can help home buyers purchase energy-efficient homes or pay for energy-efficient upgrades that can lower the cost of utilities.
Conventional Loan Vs. FHA Loan
A conventional mortgage is a home loan that is not secured by the FHA. These loans differ from FHA loans in a few ways.
- Down payment and credit score requirements: With an FHA loan, you can qualify with a credit score of 580 and as little as 3.5% down. With conventional mortgages, most lenders require a credit score of 620 and at least 5% down on the home.
- Closing cost assistance: With seller concessions, sellers can cover part of your closing costs. Most conventional lenders cap the seller's contribution at 3% of the closing costs, but with FHA loans, sellers can pay up to 6%.
- Mortgage insurance requirements: Conventional mortgages only require mortgage insurance if the borrower puts less than 20% down. But with FHA loans, mortgage insurance is a guarantee, meaning you will be subject to pay an upfront MIP and annual premiums over the lifetime of the loan.
The Bottom Line: Is An FHA Loan Right For You?
FHA loans also come with a few downsides – from mandatory mortgage insurance premiums to lower loan limits. But, if you have less than perfect credit and lack the funds to commit to a large down payment, an FHA loan could be a great option to turn your dream of homeownership into a reality.
A great first step to getting an FHA loan is to get preapproved with an FHA lender. It’s typically a quick, easy process that will give you a clear picture of where you’ll stand with lenders and make any offer you make more attractive to sellers.
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