Federal Housing Administration Loans
An FHA loan is a mortgage backed by the Federal Housing Administration. It is a government-backed loan that’s very popular with first-time buyers due to the relatively relaxed requirements when compared to other mortgage types.
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Homebuyers have multiple options at their disposal when looking for a mortgage loan, but for the majority, an FHA loan is the best option. In this guide, we’ll explore this mortgage in full and help you decide if it’s right for you.
What is a Federal Housing Authority Loan?
While an FHA mortgage loan is insured by the government, it’s actually provided by approved lenders. The lender is the one you will make your monthly payment to, not the government.
The credit score required to get a mortgage loan from an FHA-approved lender is generally much lower than that of a conventional loan. However, you still need to make your payments on time, and will still be charged a high-interest rate that sees you repay considerably more than the value of the home over the term.
Borrowers are also required to pay additional insurance premiums on top of their monthly payment. This includes:
- Upfront Mortgage Insurance Premium: Charged at 1.75% of the total loan amount. This cost can be added to the final balance.
- Annual Mortgage Insurance Premium: Charged at between 0.45% and 1.5%, depending on the length of the mortgage, loan-to-value ratio, and the total loan amount.
In most instances, these insurance premiums will remain and the only way to get rid of them is to sell your home or to refinance your mortgage into a non-FHA mortgage.
You will also be tasked with paying closing costs. These differ from lender to lender but should be no more than 5% of the total. Closing costs are charged on most mortgages and other big loans and are essentially the lender’s service fees.
Who is Eligible for an FHA Loan?
FHA loans are aimed at borrowers with low credit scores, and the requirements are much more forgiving than those required for conventional loans. However, they’re not available to everyone and you will need to meet the following terms:
- FICO credit score of at least 500.
- Proof of employment for at least 2 years.
- The mortgage will be used on a primary residence.
- Your debt-to-income ratio does not exceed 50%.
- The property has been appraised by an FHA-approved lender.
- You have not filed for bankruptcy within the last two years.
However, it’s not always that cut and dry and there are a few amendments to the criteria mentioned above. Keep reading to learn more.
Why Does the FHA Exist?
FHA loans were created out of necessity to end a housing crisis during the 1930s. After the Great Depression, fewer than half of all Americans were homeowners and the housing market was in decline.
Times were tough, and lenders weren’t making them any easier by insisting that borrowers paid at least 50% of the cost of the home up front and then hitting them with a balloon payment after just a few years.
The FHA was created in 1934 to help more Americans purchase their own homes, thus turning the US into a nation of homeowners and providing the economy with a much-needed boost.
Today, over 65% of Americans own their own homes, even though house prices are considerably higher than they were back in the 1930s, even when adjusting for inflation.
How Does the FHA Fund Loans?
Although the FHA is a government organization, it functions entirely through self-generated profits.
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The insurance premiums that you pay to your lender goes direct to the FHA and helps to fund the organization.
The organization also provides a massive annual boost for the economy, helping to stimulate growth in communities across the United States.
How do You Know if an FHA Mortgage is Right for you?
First-time homebuyers with low credit scores and a poor debt-to-income ratio can benefit from an FHA mortgage, simply because they may struggle to get a mortgage through any other means. It’s also a good option if you have a small down payment, as you can put down as little as 3.5% on one of these mortgage loans.
However, if your circumstances are not quite as bleak, there may be better options out there for you, as discussed below.
What Credit Score is Required?
You need a credit score of at least 500 to be considered for an FHA mortgage. However, if your score is between 500 and 579, a down payment of 10% is required. This is a lot of money for many homebuyers to find, but in the worst-case scenario you will only need to find an extra 79 points on your FICO score, so if you’re struggling to find the down payment then simply work on fixing your score.
Once you make it to 580, you can get a mortgage with a down payment of just 3.5%. To put this into perspective, 10% on a $250,000 mortgage is $25,000, while 3.5% is just $8,750. And even if you can scrape that 10% together, you’re still not in the clear as you’ll have to pay closing costs, appraisal fees, moving fees, and more.
Your debt-to-income score will also play a big role. We said that all Federal Housing Administration loans require you to have no more than 50%, which is true, but only in extreme situations. Many lenders will require a score that is less than 43%.
To calculate this ratio, simply compare your total debt payments to your gross income. The percentage of your income that is spent on debt is your debt-to-income ratio. For example, if you have a monthly income of $5,000 plus investments that earn $1,000 and debt that costs $3,000, your ratio will be 50%.
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For most lenders, this is too high, and even if you are accepted, it puts you on the brink and you should work on reducing it before the loan begins.
How Hard is it to Get FHA Approved?
It should be easier to get approved for an FHA loan than it is to get approved for a conventional loan, due to the credit score and other requirements. However, while these loans are technically available to individuals with scores between 500 and 579, in practice, it’s very difficult to process a successful application with a score in this range.
It’s also worth noting that these loans have changed a lot over the last few years and they are no longer as easy to get as they once were. The underwriting process for applicants with borderline debt-to-income scores and credit scores are incredibly strict. They’re also much stricter than they once were for anyone applying with a credit score that would be too low to get a conventional loan.
It would be a mistake to assume that you can get an FHA mortgage just because you’re ready to apply, can afford the 10% or 3.5% and are happy to cover the insurance premiums. There is no guarantee and you will still need to have your application signed off by the underwriters.
FHA Loans vs Conventional Loans
Conventional loans and FHA loans are the two most common mortgage types in the United States. Conventional loans are mortgages offered by private lenders and not backed by the government, while FHA loans are government-backed and offered by approved lenders.
There are several differences with regard to the requirements, advantages, and disadvantages of these mortgages.
How Do These Loans Differ?
It’s possible to get a conventional loan with as little as a 3% down payment, but only in the same way that it’s possible to get an FHA loan with as little as a 500 credit score. Technically, you can, but it’s far from easy or straightforward. In most cases, conventional loans require a 20% down payment while FHA loans are more forgiving, offering a down payment of just 3.5%.
FHA loans have terms of 15 or 30 years and insurance premiums; conventional loans have terms of between 10 and 30 years and, if the borrower doesn’t cover the full 20% down payment, they also charge additional insurance premiums. You need at least 620 on your credit score for a conventional loan, whereas anything above 500 can begin the application process with an FHA loan.
The FHA loans are fixed-rate loans with limits of $331,000 in most of the country and $765,000 in high-income areas (based on 2020 figures, but subject to annual changes). With a conventional loan, you can get both a fixed-rate mortgage and a variable rate mortgage. Conforming conventional loans have loan limits of $510,000 and $726,000 for general houses and high-income homes respectively.
Summary: Choosing a Mortgage
The FHA currently receives mortgage insurance payments from over 8 million residential properties across the United States and it welcomes countless others every single year. FHA-backed loans are one of the best options for first-time homebuyers and anyone with a low credit score and down payment.
However, it’s not the only option available and depending on your circumstances, you may be better off with something else. If you have a large down payment and credit score, for instance, look into a conventional loan; if you’re struggling to meet the terms of an FHA but are a military veteran, a VA Loan may be the right choice.