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FHA Loan – Complete Guide for Beginners

If you’re looking to buy your first home and you’re considering an FHA loan, but you’re new to the concept, in this article I will go over the most important things to know about these loans including requirements, interest rates, limits, and how you can get an FHA loan.

I’ll also help you understand how these loans operate and what are the benefits of opting for such a loan construction, but also the drawbacks of accessing an FHA loan.

Compared to many conventional loans, FHA loans require a lower minimum down payment and a lower credit score, but there are other strict requirements to be met that I’m going to detail in this article.

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What is an FHA Loan?

What is an FHA Loan?

Simply put, and FHA loan is a mortgage insured by the Federal Housing Administration (FHA). Borrowers in this loan system must pay mortgage insurance premiums, designed to protect the lender from borrower defaults.

FHA loans have especially garnered much attention from first-time home buyers, because it allows them to access these loans even with a down payment as low as 3.5% with a credit score of 580+ and borrow up to 96.5% of the value of a home with an FHA loan.

A lower credit score (between 500-579) can also qualify you for an FHA loan provided that you make a 10% down payment, however, the lower the credit score, the higher the interest rate.

The FHA loan program was introduced as a result of the hasty foreclosures and defaults that predominated the 1930s with the aim to provide better protections to lenders all the while stimulating the housing market by making loans accessible even for those with lower credit scores and a lower down payment.

As the FHA puts it, this loan type is designed for ‘low- and moderate-income home buyers,’ especially when it comes to buyers that only have a small down payment saved.

Through this program, the Federal Housing Administration lenders that are approved by the administration will have the insurance protection of the federal government against borrower defaults.

What are the Requirements of an FHA Loan?

FHA Loan Requirements
FHA Loan Requirements

The credit score and down payment amount are just two of the requirements that borrowers must meet to qualify for an FHA loan.

As I wrote above, applicants with a FICO score of 580 and above and a 3.5% down payment are eligible for a FHA loan, but even those with a credit score below 580 aren’t excluded from accessing this loan provided they can make a 10% down payment.

As for the other eligibility requirements of FHA loans, these are established by the Federal Housing Authority as follows:

  • Steady employment history or employment at the same employer for the past two years;
  • Lawful U.S. residency, holder of a valid Social Security Number, and applicant must be of legal age to sign a mortgage;
  • Property appraisal by an FHA-approved appraiser;
  • New FHA loans can be requested only for primary residence occupancy;
  • The mortgage payment plus HOA fees, property taxes, mortgage insurance, homeowners insurance (front-end ratio of borrower) must be less than 31% of their gross income, although a higher percentage can also be approved (up to 40%) if the lender can provide justification of why a higher risk mortgage is acceptable;
  • The back-end ratio of the applicant (mortgage + all other monthly debt) mustn’t be higher than 43%, although a higher percentage of up to 50% can be approved in justified cases;
  • Borrowers must be 2 years out of bankruptcy and 3 years out of foreclosure and have re-established good credit although exceptions can be made if there are extenuating circumstances for the foreclosure or bankruptcy and the borrowed has managed their money responsibly or have improved their credit;
  • Property must meet minimal standards at appraisal;
  • Applicants must have a minimum credit score of 580 and minimum down payment of 3.5%, the down payment can be gifted by a family member, or a minimum credit score of 500-579 and a down payment of 10%.

Although there is a fair number of requirements that must be met for eligibility, this type of loan is still one of the most accessible ones, especially when it comes to applicants with a credit score that isn’t perfect.

What are the Benefits of FHA Loans?

FHA Loan Benefits
FHA Loan Benefits

From the above, you may draw your own conclusions about the benefits of this type of loan.

In a nutshell, these benefits can be summed up as follows:

1.  Low Down Payments

Applicants who can’t afford higher down payments can apply for FHA loans even with a down payment as low as 3.5% and even if that down payment is offered as a gift from a family member, provided that the borrower meets the credit score and the other requirements of FHA loans.

2.  Lower Credit Score Requirements

Without near-perfect-credit, some loan options are not accessible to borrowers and so the lower credit score requirements makes these loans accessible to more people.

Therefore, even if you have a credit score between 500-579, you can still apply for an FHA loan provided that you have a 10% down payment.

3.  Past Bankruptcy or Foreclosure isn’t a Disqualifying Factor

You can access an FHA loan even if you’ve filed for bankruptcy or foreclosure in the past, provided that enough time has passed since those events (2 years for bankruptcy and 3 years for foreclosure) and you’ve improved your credit since.

4.  Assumable Mortgage

A further benefit of applying for an FHA loan is that this type of loan is an assumable mortgage, which means you can sell your home and the buyer can assume your mortgage releasing your obligation to pay.

Therefore, even if you’ve undergone bankruptcy, foreclosure, or you don’t have a perfect credit, you can apply for an FHA loan if you meet all other requirements established by the Federal Housing Authority.

What’s the Downside of FHA Loans?

Of course, since the requirements of an FHA loan aren’t as strict as those of conventional loans, there are a few downsides to consider, and these are two kinds of mortgage insurance premiums, which are payable as follows:

  1. Upfront mortgage insurance premium (UFMIP): This insurance premium is payable regardless of the borrower’s credit score and it’s 1.75% of the home loan. You can choose to pay this amount upfront at closing or you can decide to roll it into the mortgage.
  2. Annual mortgage insurance premium (AMIP): This premium is calculated as a percentage of the loan amount depending on the applicant’s loan-to-value (LTV) ratio, length and size of loan. The AMIP is charged monthly and it’s rolled into your mortgage payment.

To exemplify the two types of premiums, let’s look at an example:

For a loan of $300,000 the payable UFMIP premium would be $300,000 loan x 1.75% = $5,250.

The AMIP, on the other hand, is calculated a bit differently, because more factors come into play. But let’s stick to an example of a loan of $300,000 that’s borrowed for 15 years or less.

If the LTV ratio is 90% or less, the annual insurance premium is 0.45%, if the LTV ratio is over 90%, the AMIP is 0.70%.

Applying this to our example of a loan of 300,000, the monthly insurance premium would be as follows: $300,000 x 0.45 = $1,350 divided by 12 months = $112.5

The AMIP can go as high as 1.05% if the loan term is over 15 years, the loan amount is over $625 000 and the LTV ratio is over 95%.

The table below summarizes the different annual insurance premium percentages based on the term, amount and LTV ratio:

Loan Term Loan Amount LTV Ratio Annual Insurance Premium
Over 15 years $625,000 or less 95% or less 0.80%
Over 15 years $625,000 or less Over 95% 0.85%
Over 15 years Over $625,000 95% or less 1%
Over 15 years Over $625,000 Over 95% 1.05%
15 years or less $625,000 or less 90% or less 0.45%
15 years or less $625,000 or less Over 90% 0.70%
15 years or less Over $625,000 90% or less 0.70%
15 years or less Over $625,000 Over 90% 0.95%

How Long are the Mortgage Insurance Premiums Payable For?

The term for which borrowers are obliged to pay the mortgage insurance premiums depends on the amortization period and the LTV ratio and the loan origination date.

For loans with FHA case number assigned on or after June 3, 2013 the mortgage insurance is payable for the entire loan term if the LTV is greater than 90% at the time the loan was originated.

If the LTV is 90% or lower at the time the loan was originated the mortgage insurance is payable for the mortgage term of 11 years, whichever comes first.

What are the Loan Limits for FHA Loans?

The mortgage limits are set by the Federal Housing Authority and it varies by state and county.  There are low-cost areas, where there is a lower limit than the usual FHA loan and high-cost areas having a higher limit.

Then there are special exception areas (e.g. Hawaii, Alaska, Guam, Virgin Islands), which have even higher limits due to the very high cost of construction.

If you access the FHA website, there is a page that allows you to look up the FHA loan limits applicable in your county.

How to Get an FHA Loan?

How to Get an FHA Loan?
How to Get an FHA Loan?

First, to apply for an FHA loan, the lender must be approved by the Federal Housing Authority. There are marketplaces created, where you can submit loan requests anonymously and get custom quotes from various different lenders.

Once you find a quote that interests you, you can contact the lender directly to work out the details of your loan.

The advantage of these marketplaces is that you can literally shop around for mortgage quotes and receive hundreds of quotes without paying for these and without offering up any personal information.

What are the FHA Loan Interest Rates?

Loan marketplace websites like Zillow can be used to see the various FHA loan interest rates that would apply to your situation.

To see the applicable interest rates, you must provide concrete information related to credit score, monthly income, and monthly debts.

FHA vs Conventional Loans

To qualify for a conventional mortgage, you typically need a credit score of 620 and a down payment between 3 to 20%. With an FHA loan, you can have a credit score of 580 and a down payment of 3.5% and still qualify for a loan.

Another notable difference is that with FHA loans as much as 100% of the down payment can be a gift, while in the case of conventional loans only part can be a gift when the down payment is less than 20%.

Mortgage insurance premiums are also different in the sense that conventional loans have lower mortgage insurance premium costs compared to FHA loans. Interest rates can also be higher in the case of FHA loans.

FHA loans, however, can the benefit of qualifying the borrower for a loan relief program should they encounter a legitimate financial hardship while they’re paying off their loan.

This loan relief program works with the borrower to permanently lowering their monthly mortgage payment to an affordable level after successful completion of a trail payment plan.

While FHA loans do sound great when it comes to aspects related to credit score and down payment percentage, they’re not for everybody.

Those with credit scores below 500 or those shopping for higher priced properties will not benefit from  FHA loans, nor is the loan intended to benefit these borrowers.

Conclusion

FHA loans are useful for those that don’t otherwise qualify for conventional loans, either because of a bad credit score, lack of a sizeable down payment or past event of bankruptcy or foreclosure.

If all other requirements are met by the borrower, FHA loans can be accessible even for those that don’t have perfect credit score, can’t make a down payment that’s larger than 3.5% or have failed for bankruptcy or foreclosure in the past.

Of course FHA loans have a catch too, and that’s the mortgage insurance premiums that must be paid either upfront or rolled into the monthly mortgage.

Those that don’t qualify for conventional loans should analyze the pros and cons of FHA loans if they’re planning on buying a home.

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