An FHA loan is a mortgage backed by the Fair Housing Administration, a department of the federal Department of Housing and Urban Development. FHA loans are designed to allow individuals with poor credit to purchase qualifying homes with lower down payments and more flexible income requirements.
What You Should Know:
- The term “FHA Loan” really means “FHA-backed loan.” The FHA doesn’t lend you the money, it only insures the mortgage you get through an FHA-approved lender and is responsible for settling the debt if you don’t pay.
- To apply for an FHA-backed mortgage, you must have a credit score of at least 580 for a 3.5% down payment or 500 to 579 for a 10% down payment.
When most people talk about FHA loans, they’re referring to the Basic Home Mortgage 203(b) Loan, which is usually a fixed-rate, 15-year or 30-year mortgage for purchasing a residential property. Unlike conventional mortgages, which have very strict credit and income requirements, FHA loans are more flexible in their underwriting and offer additional benefits to borrowers. This flexibility means you don’t necessarily have to be a high earner to buy the house you want.
“Federal Housing Administration loans assist those who have a lesser amount of down payment available, have slightly lower credit scores, those who only have enough money to cover their down payment and closing costs, and those who are stretching their debt load compared to their income,” says Matthew Posey, a residential mortgage loan originator and certified mortgage planning specialist with Axia Home Loans.
|FHA Mortgage vs. Conventional Mortgage|
|FHA Mortgage||Conventional Mortgage|
|Min. credit score of 580 and 3.5% down payment, or 500–579 with 10% down||Min. credit score of 620 for most lenders and 3%–20% down payment|
|Can use gift funds for the entire down payment||Limits gift funds for the down payment|
|Sellers can contribute up to 6% for closing costs||Sellers can only contribute up to 3% for closing costs|
|DTI can be as high as 50%||DTI cannot exceed 36%|
|Only for the purchase of a primary residence||Can be used to purchase a second (or third) residence|
|Mortgage insurance is mandatory||You don’t need mortgage insurance with a 20% down payment or 20% in equity|
|The property must be FHA approved||You can purchase any property|
|FHA loan limits are set by HUD and vary by location||Conventional loan limit depends on your lender, income, creditworthiness, and other factors|
Benefits of FHA loans include:
Loans are eligible for a lower down payment. To get the most favorable interest rate (and avoid paying mortgage insurance) on a conventional mortgage, you’ll need to put at least 20% down. FHA loans, on the other hand, set the minimum down payment at 3.5% if your credit score is 580 or higher and 10% if it’s 500–579.
Buyers can use borrowed or gifted funds for the down payment. With a traditional mortgage, banks require that most of the money for the down payment comes from your own savings, investments, and bank accounts. With an FHA loan, however, 100% of the down payment can come from a gift from a relative, a friend, or a charity. You can also participate in local down payment grants and loan assistance programs that are often only offered to FHA borrowers.
These loans allow a higher debt-to-income ratio. DTI is the measure of how much of your monthly income you will be using to pay off debts, including your new mortgage. The higher the ratio, the riskier the loan appears to a lender. Many lenders say the “ideal” DTI is around 36% and federal guidelines suggest staying below 43%. However, that’s not realistic for some people, and many FHA borrowers are able to exceed those limits and still be approved.
The seller can cover closing costs. Closing costs range from 2% to 5% of the home price, and since they can’t be folded into the loan amount most of the time, that is additional money you need to have on hand. FHA loans allow sellers to contribute up to 6% of the purchase price to the closing costs, contrary to conventional loans which cap the seller concessions at 3% if your down payment is less than 10%. If the seller is eager to sell or wants to help you purchase the home, this is a great opportunity.
Taking out an FHA-backed mortgage also means you have certain limits and responsibilities.
FHA loan limits are strict. The FHA also restricts the loan amount, which depends on your location and the size of the home. To check the loan limits in your area, enter the home’s county into the FHA database. For 2020, the limit for a one-family home in a low-cost area is $331,760 while the ceiling in high-cost areas is $765,600. “If the needed loan amount exceeds the FHA loan limit for the area then you will not be able to go FHA without a higher down payment to stay at or below that limit,” says Posey.
Mortgage insurance is mandatory. With a conventional mortgage, you can avoid paying mortgage insurance if you make a down payment of at least 20%. You can also ask your lender to cancel the private mortgage insurance once you build 20% equity. With an FHA loan, you are required to pay mortgage insurance for the life of the loan. If your loan is under $625,000, the annual Mortgage Insurance Premium is 0.87% of the loan amount, which you pay monthly. Additionally, there is a one-time mortgage insurance fee for 1.75% of the loan amount that you can pay upfront or add to the loan amount.
FHA loans are only for primary residences. Since these loans are intended to help individuals have access to secure housing, you can’t use an FHA loan for a second home, flip or rental property. You need to live in the home for at least one year before selling. That also means you can’t use an FHA loan to flip a property unless it’s your primary residence for at least one year. The occupancy requirement also states that you must move into the property within 60 days of finalizing the loan.
The property must be FHA-approved. The FHA requires that the home meet its safety, security, and soundness regulations. To find out if the property meets these requirements, you’re required to have an appraiser review the property. If the house suffers from “defective conditions” like termites, leakage, and decay, among others, the appraiser will provide a cost estimate to get the house up to regulation. Before 2019, if you wanted to buy a condo, it had to be in an FHA-approved complex. Luckily, nowadays you can request a “spot approval” to have the individual unit inspected and approved.
There are other FHA-insured loans, such as adjustable-rate mortgages, refinance mortgages, loans for disaster victims who wish to rebuild or replace their destroyed property, and loans for making improvements to a home. All of these loans are offered by private lenders but insured by the Federal Housing Administration and offer incentives to lower-income homeowners.
To find a HUD-approved lender that offers FHA loans, you can head to the agency’s Lender List and search for qualified institutions in your area.
Let’s Break it Down:
When it comes to your monthly payment, the big difference between an FHA loan and a conventional mortgage is the fact that you must pay mortgage insurance. With a conventional mortgage, if you put at least 20% down, you’ll be able to skip the PMI. That means your monthly payment will consist of your principal plus interest, and any other taxes and fees for which you may be responsible.
With an FHA loan, you will always be required to pay two portions of mortgage insurance. As we explained above, there is an upfront 1.75% MIP. For a house costing $250,000, after the 3.5% down payment, this amounts to a payment of $4,222. You can choose to add the upfront MIP to the closing costs or add it to the loan amount and pay it as you go. Additionally, every month you must pay a 0.87% MIP, which in our example is $175 per month or $2,099 annually.
On its face, these additional costs may mean that an FHA loan is more costly than a conventional mortgage, and this may very well be true for borrowers with higher credit scores. However, consider that lenders will usually reject conventional mortgage applicants with credit scores below 620. Even if your credit score is higher than 620, you may be subject to a higher interest rate, whereas if you apply for an FHA loan with a lower credit score, you are less likely to be denied and, in some cases, more likely to be given a lower interest rate than you would have gotten for a conventional loan.
In the end, if you have poor credit and can’t afford a 20% down payment, an FHA loan will probably be the best option for you.
What can I do if the property I want to buy doesn’t pass the inspection?
“This actually ended up happening to one of my clients,” says Heather Wilson, a real estate agent based in Milwaukee. After the inspector hired to review the property found out that the plumbing system was on the fritz, the seller agreed to pay for the repairs based on a word-of-mouth agreement that the buyer wouldn’t pull out of the transaction at the last minute.
“This type of agreement isn’t too common and it requires a lot of trust between homeowner and homebuyer that no one will back out once the issue is resolved. Talking with the homeowner and negotiating with them to fix any issues the appraiser finds that prevents you from using an FHA loan is one way to get it resolved.”
Another solution is to apply for a 203(k) Rehab mortgage instead. “203(k) loans are for fixer-upper homes that provide a loan for the purchase of the property plus repairs,” says Randall Yates, CEO of The Lenders Network. Additional requirements apply here, such as that the repairs must cost at least $5,000, but 203(k) mortgages follow the general parameters of the more common 203(b) mortgage that we’ve discussed in this article.
How long do I have to wait to request an FHA loan if I have had a foreclosure?
“If a borrower has had a major credit blemish, such as a foreclosure, the time frame to get an FHA loan is significantly less than a conventional mortgage,” explains Thomas B. Trott, Jr., branch manager at Embrace Home Loans in Frederick, MD.
For a conventional mortgage, this waiting period is usually seven years from the date the foreclosure proceedings end, which is usually the date the foreclosed property is sold. For FHA loans, however, you only have to wait three years.
What is the 90-day rule?
We already discussed the occupancy requirement, which states that you must live in the property you purchase with an FHA loan for at least one year. There is also a 90-day rule that says that the house you buy must have been owned by the seller for at least 90 days. This period of time is also called “title seasoning,” and the purpose of this requirement is to limit fraudulent house flippers’ access to FHA loans.
Once the 90-day period passes, you’ll likely be able to request and close on the loan, unless one of these two conditions are present within 180 days of the seller’s original purchase:
(1) The purchase price you are being offered is at least twice as high as the price the seller paid for the property; or (2) your loan is classified as a high-priced mortgage loan or HPML, meaning that the interest rate is significantly higher than the market rate, and the purchase price is at least 20% higher than what the seller bought the house for.
In this case, you’ll need to have a second appraisal done, which ensures that the flipped house is actually valued at the purchase price and that FHA loan funds aren’t being used in a fraudulent scheme.