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What Is an FHA Loan and How Does It Work?

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An FHA loan is a mortgage that’s backed by the Federal Housing Administration (FHA). FHA loans come with flexible borrowing guidelines, making them a popular choice for first-time buyers with credit issues and little cash savings who can’t otherwise qualify for conventional financing.

Since 1934, the FHA loan program has helped make homeownership possible for millions of Americans by insuring mortgages offered by approved lenders. In turn, lenders can recoup financial losses if a borrower doesn’t repay their loan.

What is an FHA loan?

An FHA loan is a government-backed mortgage offered by an FHA-approved lender and insured by the FHA.

With an FHA loan you can:

  • Buy a home with a 3.5% down payment and a credit score as low as 580
  • Buy a home with a 10% down payment and a credit score as low as 500
  • Buy a two- to four-unit home with a 3.5% down payment and use the rental income to qualify
  • Buy a home and use the income of someone who doesn’t live there to help you qualify
  • Buy a fixer-upper home and roll renovation costs into the loan amount

How does an FHA loan work?

The FHA was created at a time when America was mostly a nation of renters. If you couldn’t afford a 50% down payment or the payment on a three- to five-year mortgage, you couldn’t afford a home.

Today, FHA lenders are able to offer FHA borrowers low down payment loans that can be paid over 30 years. In exchange for that flexibility, borrowers pay FHA mortgage insurance premiums to help protect lenders against financial losses if the homeowner defaults. First-time homebuyers often choose FHA home loans because they’re easier to qualify for than conventional loans and require a low down payment.

FHA loan requirements

Although FHA loan guidelines offer flexibility, there are some restrictions and added costs to be aware of before filling out an FHA loan application.

  • Credit score. The minimum credit score for an FHA loan is 580 with a 3.5% FHA loan down payment. Your FHA loan credit score can be as low as 500 to 579 with a 10% down payment.
  • Credit history. One key advantage of an FHA loan is the ability to apply for a loan just two years after a Chapter 7 bankruptcy; the wait is four years for conventional loans.
  • Income. FHA loan income requirements include verification of a two-year history of employment to qualify. However, there are no income limits.
  • Debt-to-income (DTI) ratio. The FHA recommends that your DTI ratio, a measure of total debt divided by your income, not exceed 43%. However, exceptions may be made for a higher DTI if you have strong credit and significant cash reserves.
  • FHA loan down payment. The minimum FHA loan down payment is 3.5% and the funds can come from a gift.
  • Payment reserves. If your DTI ratio is high, you may need a few months’ worth of mortgage payments in the bank, also known as cash or mortgage reserves.
  • Occupancy. You must live in the home you are buying for at least the first year with FHA financing.
  • Home appraisal. The property you buy must meet FHA safety and livability requirements. The FHA does not offer appraisal waivers for purchase loans.
  • Mortgage insurance. You’ll pay two types of FHA mortgage insurance premiums to cover the extra risk FHA-approved lenders take on. The first type of mortgage insurance is an upfront mortgage insurance premium (UFMIP) equal to 1.75% of your loan amount, which is typically rolled into your loan amount. The second is an annual mortgage insurance premium (MIP) ranging from 0.45% to 1.05% of your loan amount, which is divided by 12 and added to your monthly mortgage payment. FHA mortgage insurance premiums are the same regardless of your credit score.

FHA loan limits

When you buy a home using FHA financing, the home’s purchase price must fall within FHA loan limits for your area. For 2020, FHA’s “floor,” or maximum loan limit in a low-cost area, for a single-family home is $331,760 in most parts of the country. The FHA “ceiling,” or maximum loan amount in high-cost areas, is $765,600.

FHA loan limits are higher if you’re buying a two- to four-unit multifamily home. For example, in much of the country, you can buy a four-unit property up to $638,100. An added bonus: As long as you live in one of the units as your main home, you only need a 3.5% FHA down payment.

FHA 2020 Loan Limits
FHA low-cost area limit FHA high-cost area limit
One unit $331,760 $765,600
Two units $424,800 $980,325
Three units $513,450 $1,184,925
Four units $638,100 $1,472,550

 

Different types of FHA loans

Current and aspiring homeowners have a variety of FHA programs to choose from to accomplish different financial goals. Here’s a rundown of FHA home loans:

FHA purchase loans

Qualified buyers can purchase a home with as little as 3.5% down and a 580 credit score. FHA-approved lenders often participate in down payment assistance (DPA) programs that vary by state.

FHA rate-and-term refinance loans

Homeowners can refinance up to 97.75% of their home’s value with low credit scores, and roll closing costs into the loan.

FHA cash-out refinance loans

A good option for homeowners who want to tap their home equity but don’t meet the tougher conventional refinance loan standards. You can tap up to 80% of your home’s value and a credit score as low as 580 with an FHA cash-out refi.

FHA streamline refinance loans

Exclusively for homeowners with a current FHA loan, the FHA streamline loan doesn’t require any income verification or a home appraisal.

FHA 203(k) loans

If you want to buy or refinance a fixer-upper home and roll renovation costs into the loan amount, the FHA 203(k) loan is worth a look.

FHA Energy Efficient mortgages

You may be able to offset higher mortgage insurance costs with a lower utility bill if you opt for FHA’s Energy Efficient Mortgage program (EEM). You can finance up to $3,500 into your loan amount to pay for everything from thermostats and insulation to solar and wind technology.

FHA construction-to-permanent loans

If you need the credit flexibility of FHA loans to build a home, the FHA construction loan may allow you to buy land and finance the cost of a home build all with one loan. You’ll pay just one set of closing costs, and the construction loan automatically converts to a permanent loan once construction is complete.

Home Equity Conversion Mortgage (HECM) loans

If you’re 62 or older, you may be eligible for a HECM. Backed by the FHA, HECMs are the only reverse mortgage product insured by the federal government. Instead of a “forward” mortgage in which you make monthly payments to your lender, your lender makes payments to you using your home’s equity. You can receive reverse loan funds through a lump-sum payment, line of credit or even as monthly income. To qualify for a reverse mortgage, you’ll need significant equity and must agree to pay ongoing costs, such as property taxes, homeowners insurance, homeowners association dues and maintenance expenses.

Pros and cons of FHA loans

Pros

You can still make a low down payment even if you have lower credit scores
You may qualify with a higher DTI ratio than other loan programs
You can buy a multifamily home with just a 3.5% down payment
You’ll pay lower mortgage insurance premiums with lower credit scores

Cons

You’ll pay higher mortgage insurance costs overall, usually for the life of the loan
Your home will face tougher appraisal scrutiny if it’s a fixer-upper
You’ll have less borrowing power in expensive neighborhoods due to FHA loan limits
You can’t use an FHA loan to buy a rental or vacation home

Comparing a conventional loan vs. an FHA loan

Conventional loans are not backed by the federal government, which means they follow stricter guidelines set by government-sponsored enterprises Fannie Mae and Freddie Mac. However, conventional loans don’t require any mortgage insurance to protect the lender against default if you make a 20% down payment. The table below shows FHA versus conventional loan differences side by side.

Loan feature FHA loan Conventional loan
Minimum down payment
  • 3.5% with a 580 credit score
  • 3%
Minimum credit score
  • 500-579 with a 10% down payment
  • 620
DTI ratio
  • 43% with exceptions above 50%
  • 45% with exceptions up to 50%
Maximum loan limits
  • Lower loan maximums than conventional loans
  • Higher loan maximums than FHA loan limits
Appraisal requirement
  • Required on all purchase loans
  • Waived on streamline refinance programs
  • Can be waived on eligible purchases and refinance programs
Mortgage insurance
  • 1.75% UFMIP
  • 0.45 to 1.05% MIP
  • Required regardless of down payment
  • Same premiums regardless of credit score
  • Cannot cancel MIP with 3.5% minimum down payment; can be canceled after 11 years with 10% down
  • Typically no upfront mortgage insurance
  • 0.15% to 2.5% annual PMI paid monthly
  • Waived with a 20% down payment
  • The lower the credit score, the higher the MI premium
  • Can request PMI cancellation after reaching 20% equity

How to apply for an FHA loan

The process for applying for FHA financing is similar to applying for any other type of home loan.

You’ll need to:

  • Shop around with FHA-approved lenders to compare FHA loan rates and terms
  • Fill out an FHA loan application
  • Agree to a credit report pull so lenders can confirm your credit scores and credit history
  • Verify your employment and income history for the last two years by providing a list of employers’ contact information and federal tax returns
  • Provide two months’ worth of bank statements or other documentation to show you can afford a down payment and closing costs

Additionally, your lender will need to:

  • Verify you aren’t in default on any federal loans using the Credit Alert Interactive Verification Reporting System (CAIVRS)
  • Obtain a case number for your loan that is tied to the home you’re buying
  • Order an FHA appraisal to confirm the value of your home and ensure that it meets FHA safety and habitability standards
  • Order a title search to verify the title to your home is clear of any liens or issues with previous owners
 

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