Created in the wake of the Great Depression to stimulate the housing market, FHA loans protect lenders and provide opportunities for homeownership to borrowers who may have trouble qualifying for a traditional loan. FHA loans are insured by the Federal Housing Administration, have less stringent qualification requirements and are quite affordable, making them an attractive option for many borrowers, especially first-time home buyers.
Key Differences Versus a Traditional Home Loan
FHA loans have two major differences that can benefit many buyers who may otherwise not be able to get into the housing market. A typical home loan requires a minimum credit score of 620 and a 20 percent down payment. In this scenario, depending on the cost of the home, a home buyer might need funds in the upper five figures immediately on hand before they could even start home shopping. Contrast this with the minimums for an FHA loan. FHA loans allow down payments of 3.5 percent for buyers with a minimum credit score of 580. For lower scores, the requirement is 10 percent. This is higher but still preferable to 20 percent. Also, the down payment amount can be gifted by a member of the borrower’s family. On the credit score front, as you may have already inferred, FHA loans have a lower bar to pass. FHA loan borrowers can qualify with scores as low as 500 as opposed to traditional loans’ 620 minimum.
One difference between FHA and traditional loans that is a slight drawback is that FHA loans require mortgage insurance. This, along with these loans’ government-backed feature, give some incentive and reassurance to lenders. This insurance, known as PMI (Private Mortgage Insurance), is paid partially up front and then in installments. 1.75 percent of the loan amount is required immediately, and then the annual premium is rolled into the borrower’s monthly mortgage payment, amounting to between 0.45 and 1.05 percent annually depending on the loan terms. This can make FHA loans slightly more expensive than a traditional loan, long-term. The good news is that PMI can be discharged to minimize this additional cost. Once loan-to-value ratio (LTV) reaches 80 percent, a buyer can request PMI be removed. LTV can be lowered both by paying the mortgage monthly and by adding value to the home.
We’ve gone over the down payment and credit score requirements for FHA loans. Here are the other requirements mandated by the Federal Housing Administration:
[*] Employment: FHA loan borrowers need to have a stable employment history or must have spent the past two years working for the same employer.
[*] Residency: borrowers must have lawful United States residency, be of legal age to sign a mortgage in their state and must have a valid Social Security number.
[*] Appraisal: an appraiser approved by the FHA must evaluate the property. The property must meet certain standards or the seller must agree to repoairs to get the home up to standard.
[*] Occupancy: the borrower must be the primary occupant. FHA loans will not cover rental property.
[*] Front-End Ratio: the combined monthly payment – loan plus homeowner’s insurance, taxes, PMI, HOA fees and other expenses) — must be less than 31 percent of the borrower’s gross income. Lenders may be able to go as high as 40 percent if they can provide adequate justification to the FHA.
[*] Back-End Ratio: the borrower’s total monthly debt payments – the mortgage plus all other debt like credit cards, car payments and student loans – must be less than 43 percent of their gross. As with the front-end ratio, a lender could go higher, as much as 50 percent, with adequate backing information
[*] Bankruptcies and Foreclosures: borrowers must be three years out of foreclosure, two years out of bankruptcy, and need to have re-established good credit. Some exceptions can be made depending on the circumstances of the foreclosure and/or bankruptcy.
[*] Loan Limits: the FHA sets limits on loan amounts, which vary by county and by whether an area is considered high- or low-cost. Borrowers need to check the limits in their own area, available from lenders.
How Do I Get an FHA Loan?
If an FHA loan looks attractive to you, the first step is to find an FHA-approved lender. A simple online search can find lenders approved by the FHA in your area, and listings are also available through hud.gov. Once a lender has been chosen, the borrower should gather the following:
[*] W2 forms for the past two years
[*] Two years’ worth of addresses and employers
[*] Proof of gross monthly salary – typically two paystubs is sufficient
[*] Down payment, including documentation if the down payment is the result of a gift
[*] Loan application
After meeting with the lender and getting the loan approved, it’s time to start house shopping.