What Is An FHA Loan?
Katie Ziraldo5-minute read
June 30, 2021
Conventional, fixed-rate and adjustable – oh my! With so many types of mortgages available, it can be challenging for home buyers to know precisely which loan will best suit their needs.
One of these loan types is an FHA loan, which can be appealing to 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 and both 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 – however these loans are backed by the Federal Housing Administration, 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.
Advantages Of FHA Loans
When compared with conventional mortgages, the following are a few of the biggest advantages of FHA loans:
- Fewer requirements for first-time home buyers, including low minimum down payment requirement
- Borrowers may qualify even if issues exist in their financial history
- No income limits
- Single or multifamily housing units can be financed
- Closing costs can be included in mortgage payments
Disadvantages Of FHA Loans
For all their perks, there are also a few disadvantages of FHA loans that must be considered, including:
- Higher mortgage insurance costs
- Lower loan limits
- Strict housing standards
- Property must be the borrower’s primary residence
FHA Loan Requirements
To help you determine your likelihood of approval, we’ve compiled the following list of requirements for FHA loans.
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, so this 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 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, borrower’s 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, however the exact DTI requirement will depend on other financial factors such as your credit score and the size of your down payment – but 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 between 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 Loan Limits
So how much money can you borrow? The FHA establishes loan limits by county, which means lending limits will vary depending on where you live. In 2020, FHA loan limits ranged between $356,362 – $822,375 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.
FHA Mortgage Insurance
Mortgage insurance is required when the borrower has less than 20% equity in the home. With conventional mortgages, mortgage insurance can be avoided by making a down payment of 20% or higher. But with FHA loans requiring smaller down payments, mortgage insurance is a guarantee.
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 closing costs. The annual premium is around 0.85%, although this rate can be lower if you put more than the minimum 3.5% down. These annual payments usually continue for the lifetime of the loan but can be removed when the borrower reaches 20% equity.
FHA Loans Vs. Conventional Mortgages
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: Did you know 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 mortgage insurance premium and annual mortgage insurance premiums over the lifetime of the loan.
The Bottom Line: Is An FHA Loan Right For You?
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. But for all of their advantages, FHA loans also come with a few downsides – from mandatory mortgage insurance premiums to lower loan limits.
If you’re unsure which home loan type is right for you, explore our Home Buying Learning Center for tips on finding the best loan!
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