FHA Mortgage Loans: A Comprehensive Guide
When you make a plan to purchase your first home, seeing the costs can be discouraging. Homeownership is much more than paying a monthly mortgage; it can also include utilities, insurance, homeowner association fees, and a host of other hidden costs. Plus, down payments are expected on the mortgage, which can cost as much as a brand new car, and closing costs are another few thousand dollars.
For someone that doesn’t have a lot in savings but is eager to take the leap into homeownership, what can you do? Or what if you do have the savings, but your credit score is too low? Are there financial options available that can help you with your first ever home purchase?
Luckily, there are, and some government-backed mortgages may be just the ticket you need to obtain your first home. VA loans are reserved for those who have served in the military, and USDA loans are for those who work in farming and live in rural areas. That leaves FHA loans, or mortgages that are insured by the Federal Housing Administration (FHA).
But what all does an FHA loan entail, how can you qualify, and how can you apply?
Table of Contents
What Is an FHA Loan?
The Federal Housing Administration (FHA) — a division of the US Department of Housing and Urban Development (HUD) — is the largest insurer of mortgages in the world, with about 47.5 million properties being insured by the FHA since it was created in 1934. The purpose of FHA is to “provide mortgage insurance on loans made by FHA-approved lenders” in the United States and its territories.
This insurance provides protection for lenders in case the homeowner defaults on their mortgage loan, and so borrowers are seen as less risky to these approved lenders. In the event that a borrower defaults on their mortgage, the FHA will pay the lender in their stead. The FHA was created to help stimulate the housing market and provide accessible home loans to those that have poor (or are lacking any) credit history and who don’t have the money for a large down payment.
Overall mortgage limits and interest rates vary from state to state, but the average limit is about $630,000. Annual percentage rates (APR) tend to be between 4.99% to 5.98%, depending on the age limit of the mortgage (10-30 years) and your overall credit history. You can find FHA-approved lenders on the HUD’s website.
Benefits of FHA Home Loans
FHA loans are easier than conventional mortgages to afford and qualify for. Lenders are more likely to approve a borrower, even if they don’t have much to put down or have a low credit score. Overall FHA loans only require a 3.5% down payment (whereas normal mortgages require anywhere from 10-20%), and borrowers can have a credit score as low as 580.
With the protection of mortgage insurance and the insurance of the FHA, lenders are more likely to allow “risky” borrowers to take out a mortgage on a new home. For first time home buyers or low-income families, this is a major benefit, as they may be able to finally purchase the home of their dreams without having to worry too much about the approval process. Even those that have struggled with bankruptcy, past foreclosures, or other financial hardships could apply for a FHA loan.
FHA loans are some of the easiest loans to qualify for, and are a valuable resource that can help stimulate the local housing market. Plus, a final additional advantage to FHA loans is the ability to have an “assumable mortgage.” If, after buying a home, you decide to sell it again down the road, but your FHA-approved mortgage is still not paid off, the new buyer can “assume” the terms and remainder of your mortgage when they buy your home. This passes some of the benefits on to the next purchaser, who may not even need to get their own mortgage if they have enough money to cover the difference between the home’s value and the remainder of the mortgage.
FHA Construction Loan
Although fairly rare, FHA construction loans do exist, but they are reserved specifically for financing the building of brand new homes or for financing an extensive remodel of an existing home. Unlike traditional FHA loans, construction loans are a little bit harder to obtain as lenders don’t particularly like doing them, and they do require a higher credit score of at least 680 or above.
Construction loans work differently from typical loans, as the mortgage amount that you get must be “closed on” or approved before you can break ground on construction. The money is then put into an escrow account, which you can withdraw from only after passing certain inspections at various stages of the house build. Before the last funds can be withdrawn, the house then has to meet the standards of the FHA before it can be approved and finalized.
FHA Loan Requirements
Once you’ve received pre-approval of an FHA loan, applicants need to be sure that they meet specific requirements in order to secure the loan. Additionally, there are more qualifications that you need to meet in order to be able to apply in the first place, and those are listed in the next section.
3.5 Percent Down Payment
All FHA loans require a down payment of at least 3.5% of the home’s overall value. You can be pre-approved for an FHA loan prior to deciding on a home, but when you do choose a house, you must have 3.5% of the price ready in cash in order to be fully approved.
Another deciding factor is your credit score, which can be relatively low compared to most loan requirements. FHA loans require a minimum credit score of 580 or more.
However, they do also offer special considerations for those that have a credit score of only 500 or above. If your credit score is 500 or more, you can make a down payment of 10% of the home’s value to qualify for an FHA loan.
Debt to Income Ratio
As with any loan application, lenders also want to ensure that you make enough money to not only be able to pay mortgage bills, but also to ensure you can afford all your other debts and monthly expenses. You will have to meet the specific debt-to-income ratio set by the lender and the FHA.
All of your monthly home expenses — mortgage PITI payments, mortgage insurance, and any other charges such as homeowners association fees — must be less than or equal to 31% of your overall gross income. Some lenders may allow a ratio of about 40% of your overall income, but this depends on the lender and what your level of risk appears to be to them. The lender should further explain these specific factors in your loan application.
Additionally, all your other debts (credit cards, car loans, student loans, etc) must be below 43% of your gross overall income. Some lenders may allow a ratio as high as 50%, but this, again, depends on the lender and what your level of risk appears to them. The lender may have to provide justification for this if they approve you with a high ratio of 50%, and they must also list further factors or issues in your loan application.
Finally, FHA loan holders are required to pay for private mortgage insurance (PMI), which is created to protect the lender in case of default. PMI does not protect a home, only the mortgage, but PMI’s are helpful for borrowers that may appear “risky” to lenders. Without a PMI, the lender simply wouldn’t allow you to take out a loan.
FHA Loan Qualifications: Complete List
Besides the credit score, PMI, and down payment requirements needed for an FHA loan, you must also meet these specific qualifications in order to apply for pre-approval of an FHA-insured loan:
- You must have proof of at least 2 years of steady employment, including proof of income (in the form of a W-2) that shows your wages have remained the same or increased over that time.
- Your credit report has to show that you’ve had no more than two 30-day late payments within the past year, and no more than a single 60-day/90-day/any other late payment within the same time frame.
- If you have experienced a bankruptcy, your discharge date cannot be within two years of applying for the FHA loan, and you cannot have had a home foreclosure within the past three years. If your previous home that was foreclosed on was also an FHA-insured loan, then you may have to wait longer than three years, and you may no longer qualify for an FHA loan.
- You have to be the primary resident of the home in which the FHA loan is being used to purchase. You also have to be intending to live on that property.
How To Apply for an FHA Loan
Now that you know all the qualifications and requirements needed for an FHA loan, you can start the process of finding and applying for your very own. Ensuring that you qualify is the first step, but what should you do next?
Here’s how you can apply for an FHA loan in your area:
- Find an FHA-approved lender in your area: Search for an FHA-approved mortgage provider in your area by going to the HUD’s website and filling out your search criteria. Once you’ve found some lenders that work with the FHA, you can start comparing their services online and decide which one is the best for you. Keep in mind that some lenders charge additional fees for their services, or loan origination fees of 1% of the value of the loan. If you are unable to afford an origination fee, then find a lender that is willing to waive those fees.
- Collect and supply the necessary documents: Once you’ve decided on a lender, you will need to collect your proof of employment, provide proof of savings (or proof of the 3.5% down payment that you would like to make if you’ve decided on a home), credit score (the lender will also do their own credit search), and personal identification. Here are some of the items that you may need to bring with you:
- Job records: proof of employment for the past two years, including information on your gross monthly salary, W-2 forms, income tax forms, and the name of your employer(s) from the past two years.
- Personal records: provide the addresses where you’ve lived for the past two years and your personal identification.
- Complete the loan application: Once you’ve met with your lender and discussed your options with them, they will be able to get you the proper paperwork needed in order to apply for an FHA loan. Fill it out completely, and be sure that everything in the document is true and factual; as incorrect information on a federal document can create criminal charges (perjury). If you’re unsure of something in the application, speak with your lender before filling it out or research the question online to get a better idea of what the application is asking. Additionally, you may be able to get pre-approval for the loan if your credit score and financial situation are in good order. Speak with your lender about pre-approval.
- Appraise the property: At this point, you should have an idea of what home you’re interested in buying. However, even if you receive pre-approval of an FHA loan, you can still have it denied if the property you’re interested in doesn’t pass a proper appraisal and inspection from your lender or an FHA-approved appraiser. Additionally, if the lender believes you’re unable to afford the monthly payments of that house, then they may reject your loan. Your lender should order the appraisal on your behalf, and they will check that the home complies with health and safety regulations in your area, as well as compare the value of the home or property to the asking price. If they find the asking price is more than the value of the home, then they may reject the loan or ask you to negotiate the price. These steps often take place during the escrow process.
- Sign and complete closing papers: The closing process is rather complex, so be sure to do your research before closing day arrives. The lender and the seller will have some paperwork that they will need you to sign, and you may have to pay additional closing costs (about 3-5% of the cost of the home, on average), but you should be aware of this information when your lender provides you a “good faith estimate” when you first go into escrow. Be sure to review every charge so that if something new comes up on closing day, you can contest it or ask for clarification. Additionally, you will want to make sure you’ve chosen a PMI at this point, and will need to pay some of the front-end costs for that service. Once the closing process has been completed, and you’ve paid all the closing costs, then the home is yours!
Purchasing your first home is a huge milestone, and luckily with the help of the FHA that process is a bit more accessible. Whether you’re buying the house of your dreams, or you’re just taking your first steps into homeownership, FHA-insured mortgages can be an essential service to help you get there.
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Katie McBeth is a researcher and writer out of Boise, ID, with experience in marketing for small businesses and management. Her favorite subject of study is millennials, and she has been featured on Fortune Magazine and the Quiet Revolution. She researches SEO strategies during the day, and freelances at night. You can follow her writing adventures on Instagram or Twitter: @ktmcbeth
This post was updated December 18, 2018. It was originally published December 5, 2018.