Everything You Need to Know About FHA Loans

The Federal Housing Administration (FHA) loan is a mortgage loan designed to help low- to moderate-income families buy homes. FHA loans are prevalent among first-time homebuyers, as these borrowers often have the most difficulty qualifying for traditional mortgages. 

When compared to conventional loans, FHA loans have more lenient requirements, such as lower down payment requirements and higher debt-to-income ratios. This makes them an attractive option for borrowers with less-than-perfect credit scores or other financial constraints. 

In this article, we’ll discuss everything you need to know about FHA loans including who qualifies for FHA loans, how they work, and how you can apply for one. 

What is an FHA Loan?

FHA loans are insured by the Federal Housing Administration (FHA), which is a sub-department of the Department of Housing and Urban Development (HUD). Since the federal government guarantees the loan, it’s less risky for lenders to offer this type of loan to borrowers with lower credit scores or higher debt-to-income ratios. As a result, FHA loans are easier to qualify for than conventional mortgages.

Benefits of an FHA Loan

FHA borrowers enjoy a number of benefits that make the path to homeownership much easier. There are key selling points to FHA loans:

• You can have a lower credit score: If your credit history is limited or you have a poor credit history achieving a credit score of 620, which is the typical requirement for a conventional mortgage, may be difficult. FHA loans only require a 580 credit score.
• You can make a lower down payment: Homebuyers typically have to make a down payment of 20% on their mortgage loan. With an FHA loan, borrowers with a credit score of at least 580 can make a down payment of just 3.5 percent. Even if your credit score falls between 500 and 579 you could still be eligible for an FHA-backed loan, you’ll just have to pay a higher down payment of 10 percent to secure the loan. 
• You can own a home sooner: Instead of continuing to rent while trying to save more money or improve your credit score, you can become a homeowner sooner through an FHA loan, allowing you to start building equity through your property. This provides new homeowners with a valuable asset contributing toward greater financial stability and security.

What are the FHA loan requirements?

As with any loan, borrowers must meet certain requirements to qualify for an FHA loan. Homebuyers must demonstrate steady employment history by providing pay stubs, W-2s, federal tax returns, and bank statements. They must also meet the following requirements:

• Have a credit score of at least 500
• Have a debt-to-income ratio of no more than 50%
• Make a down payment of at least 3.5%
• Purchase a home that meets FHA requirements
• The home has to be a primary residence.
• The borrower must occupy the property within 60 days of closing.

How does an FHA loan work?

In addition to having more lenient restrictions than a traditional mortgage, FHA loans come with fixed interest rates applied to either 15- or 30-year mortgages. Since interest rates are fixed and the risk of default is slightly higher, lenders implement an extra layer of protection for themselves by requiring FHA borrowers to pay a mortgage insurance premium (MIP) on their FHA loans. 

This upfront mortgage insurance premium is usually mandatory on most loans when the borrower puts down less than 20 percent. For all FHA loans, two types of mortgage insurance premiums are required: 

• Initial mortgage insurance premium which amounts to 1.75 percent of the loan amount. Borrowers are required to pay this premium when they receive the loan. It cannot be rolled into the financed loan amount.
• Annual mortgage insurance premium which ranges from 0.45 percent to 1.05 percent. This annual premium is divided by 12 and paid throughout the loan term along with your monthly mortgage payment.

Given that these insurance premiums are an added expense to borrowers, FHA restrictions cap closing costs at 3%-5% of the loan amount. Additionally, up to 6% of the borrower’s closing costs may be covered by sellers, builders, or lenders. These limitations are intended to offer borrowers some flexibility when managing their upfront FHA loan expenses.

What kind of FHA loans exist?

Not all borrowers know that FHA loans don’t just replace traditional mortgages, but they can also replace other types of home loans such as:

1. Home Equity Conversion Mortgage (HECM): An HECM is a type of FHA loan that works like a reverse mortgage. HECMs allow homeowners aged 62 and older to convert the equity in their homes to cash without selling their homes. The homeowner can receive the funds in a lump sum, monthly payments, or a line of credit. The loan is repaid when the homeowner sells the home or dies.
2. FHA 203(k) Improvement Loan: A 203(k) loan is a kind of FHA loan that is especially beneficial for borrowers interested in purchasing a fixer-upper, allowing them to invest their efforts and skills in enhancing the property's value.
3. FHA Energy Efficient Mortgage: This type of mortgage operates similarly to a 203(k) loan but with a focus on upgrades that contribute to reduced utility expenses, such as insulation installations or the integration of solar or wind energy systems. 
4. Section 245(a) Loans: This program is specifically designed for borrowers who anticipate an increase in their incomes and would like to pay off their mortgage sooner. 245(a) loans can come in two forms: the Graduated Payment Mortgage (GPM) and the Growing-Equity Mortgage (GEM). With the GPM, borrowers begin with lower monthly payments that gradually rise over time, while the GEM involves scheduled increases in monthly principal payments. 

How do you apply for an FHA loan?

After considering the benefits of an FHA loan, the types of FHA loans that exist, and whether or not you qualify for one, it’s important to know how to apply for one.

1. Establish a reasonable budget.

Once you’ve confirmed your eligibility for an FHA loan, the first thing you want to do is establish a reasonable budget. Although you’ll be saving money on a down payment, you still need to consider closing costs, home inspections, and other home-buying expenses. Make sure you have enough money to cover all of these costs as well as some left over to move into your new home. 

2. Look for FHA lenders willing to work with your credit score.

Not all lenders work with FHA loans. As an FHA borrower, you’ll need to secure your home loan through an FHA-approved lender. These lenders have the flexibility to establish their own rates, costs, and underwriting standards as long as they adhere to the minimum requirements set by the FHA. Approved lenders include national banks, credit unions, community banks, and independent mortgage companies. 

3. Compile your documents and apply for your loan.

Once you’ve settled a list of qualifying lenders, you’ll want to put together the documents you’ll need for your application. Before applying for an FHA loan, have the following ready:

• Two years of tax returns
• Two recent pay stubs
• Your driver’s license
• Full statements of your assets (checking account, savings account, 401(k), and any other places where you hold money)

FHA loans: Key considerations

While FHA loans certainly come with a number of benefits, there are a few drawbacks to taking one out. Consider the following before moving forward with an FHA loan:

FHA loan limits are set by the government.

The Federal Housing Administration (FHA) sets loan limits for FHA loans based on location and population. The limits are higher in expensive areas and lower in low-cost areas. In Los Angeles County, California the loan limit is $970,000 for a single-family home. However, in El Paso County, Texas the loan limit is just $420,680. There are also special exception limits for Alaska, Hawaii, Guam, and the U.S. Virgin Islands. The loan limits are updated every year.

You'll need to pay FHA mortgage insurance as well as other fees.

When comparing mortgage rates an FHA mortgage and a conventional loan, you’ll notice that the interest rates on FHA loans are generally lower. However, it’s important to consider the APR (Annual Percentage Rate) as a more comprehensive comparison point, because it represents the total borrowing cost, encompassing both the interest rate and other associated fees.

In some cases, the APR on FHA loans can turn out to be higher than that of conventional loans, despite the initially lower interest rates. Borrowers should evaluate both the interest rates and the APR to determine the full cost of borrowing for both FHA and conventional loans, and then make an informed decision on which type of loan makes sense for them.

Unlocking homeownership: The power of FHA loans for first-time buyers

The FHA loan is a valuable tool for low- to moderate-income families aspiring to become homeowners. With its lenient requirements, including lower down payments and credit score flexibility, it opens doors for first-time buyers who may have struggled with traditional mortgages. The benefits of an FHA loan, such as the ability to own a home sooner and build equity, make it an appealing option. Prospective borrowers must meet certain qualifications, but the FHA loan provides a pathway to homeownership for those who may not have otherwise had the opportunity.

An FHA loan functions similarly to conventional mortgages but offers added security for lenders, thanks to its government-backed guarantee. FHA loans come with fixed interest rates, making budgeting predictable for borrowers. However, they also involve mortgage insurance premiums to protect lenders, which borrowers must consider when evaluating the overall cost of the loan. Various types of FHA loans, like the FHA 203(k) Improvement Loan and the Energy Efficient Mortgage, cater to different needs, allowing borrowers to explore different options based on their circumstances.

When applying for an FHA loan, potential buyers should establish a reasonable budget, considering all associated costs. They should seek FHA-approved lenders willing to work with their credit score and compile the necessary documents for a smooth application process. While FHA loans have many advantages, it's essential to be aware of the government-set loan limits and the additional fees that may be incurred.

In summary, the FHA loan is an excellent opportunity for first-time homebuyers and those with lower credit scores to achieve the dream of homeownership. By meeting the requirements and working with FHA-approved lenders, aspiring homeowners can make their dream a reality and embark on a journey to build wealth through real estate.