FHA mortgages -- long the financing of choice for many buyers -- will be easier to get beginning April 21st, 2014. In some cases, borrowers will be able to get FHA loans with as much as 50 percent of their income devoted to housing costs.
FHA: The "F" Stands for "Flexibility"
Borrowers have often preferred FHA financing because the program has more liberal underwriting standards than conventional mortgages. This means borrowers who might not qualify for a conventional loan can often get financing through the FHA program.
To see what's going on, we have to start with what are known as "front" and "back" ratios. The front ratio is the percent of monthly income which lenders allow for housing costs such as mortgage principal, mortgage interest, property tax and property insurance -- expenses generally known as PITI. For instance, with a conventional mortgage, the maximum front ratio might be 28 percent. This means if your household income is $75,000 a year ($6,250 per month before taxes), 28 percent of your income (your PITI) equals $1,750.
The back ratio includes PITI plus all your other recurring monthly expenses such as student loan payments, car payments, credit card bills, etc. (not utilities, food or other living expenses). Conventional (non-government) lenders have traditionally allowed about 36 percent of gross monthly income for the back ratio of $2,250 for a household with a $6,250 monthly income.
Lenders would usually describe conventional loan ratios as 28/36, but most are willing to be more generous for applicants with exceptional credit or sizable down payments. This willingness to "stretch" ratios is reflected in two changes coming into the marketplace.
First, with Wall Street reforms, lenders can make qualifying mortgages with back ratios as high as 43 percent. For this reason we may see lenders with more liberal "official" back ratios starting this year.
Second, the FHA has announced that it will make its qualifying ratios more liberal starting April 21st.
FHA Mortgages with New Standards
The FHA announcement is important because FHA qualifying standards have been more loose than conventional financing for many years. The front and back ratios for most FHA mortgages have been officially 31/43 (33/45 with an energy efficient mortgage). This means our model household with a $6,250 monthly income could spend $1,937.50 on PITI versus $1,750 for a conventional borrower. It also means our sample household could have monthly costs of $2,687.50 and qualify for FHA financing instead of the $2,250 allowed under conventional guidelines.
40 Is the New 50
Beginning in April, however, FHA mortgages will be available to qualified borrowers with even more flexible standards -- 37/47. However, such front and back ratios will not be available to all borrowers.
Instead, a set of qualifying standards must be met, including at least one of the following requirements:
___ The borrower must have verified cash reserves. For a one-to-two unit property, the borrower must have cash reserves equal to at least three total monthly payments. For a borrower financing a three-to-four unit property, the reserve requirement is cash on hand for at least six monthly payments.
___ The total new mortgage payment cannot be more than $100 or five percent higher than the previous total monthly housing payment, whichever is less. Also, the borrower cannot have had more than one 30-day late payment during the past 12 months. In a cash-out transaction, the borrower must have made all payments on time and in full during the previous 12 months.
___ The borrower must have a suitable level of "residual income." The idea of residual income was developed by the Veterans Administration for VA loans. It defines residual income as "the amount of net income remaining (after deduction of debts and obligations and monthly shelter expenses) to cover family living expenses such as food, health care, clothing, and gasoline." In other words, regardless of ratios no borrower should be house-poor, spending so much money on housing that they cannot afford a reasonable standard of living.
Here's the really big deal: Borrowers who meet one of the qualifications above may be able to qualify for 37/47 ratios; however, borrowers who can meet two of the compensating factors may qualify for 40/50 ratios.
New FHA Mortgages: Bottom Line
First, the more liberal standards will help marginal borrowers who today qualify for less financing or do not qualify at all.
Second, we may see more liberal conventional loan ratios because of the new standards under Dodd-Frank. As a result, borrowers should also ask about conventional financing when considering FHA mortgages.
Third, it's good that the FHA is pushing qualifying ratios higher, however every borrower has to look at their own circumstances and preferences. In some cases borrowers will be happy to know that they qualify for a large loan amount but will elect to borrow less, to find a loan amount which is more comfortable.
For more information, shop around and ask lenders how the new FHA standards might help in your situation.