A Comprehensive Guide to FHA Mortgage Loans
One Of The Most Versatile Home Loans For Buying and Refinancing Your Home
Saving up for a large down payment on a residential home can be a financial challenge that prevents first-time homebuyers with minimal savings from ever becoming homeowners. Fortunately, government-backed Federal Housing Administration (FHA) loans can help potential homebuyers who want a home but struggle to save or source a large down payment. In 2018, more than 80% of FHA loans made were to first-time homebuyers, according to the U.S. Department of Housing and Urban Development.
This guide will cover the advantages and disadvantages of using an FHA loan to purchase a home, how homebuyers can begin the process of researching and getting approved for these loans, and how you may be able to utilize and FHA loan for refinance purposes.
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What is an FHA Loan?
An FHA loan is a home mortgage insured by the government - specifically, by the Federal Housing Administration. The term “FHA loan” is actually somewhat of a misnomer because the FHA doesn’t actually lend money to would-be homeowners. Rather, it ensures the loans made by private lenders. So while we’ll use the term “FHA loan” for simplicity, an “FHA-backed or insured loan” is more accurate.
An FHA loan aims to put homeownership within reach for many Americans who wouldn’t otherwise qualify for a conventional, non-FHA-backed mortgage. You may be able to get an FHA loan with a lower credit score, lower down payment, and a higher debt-to-income ratio than you could have for a conventional mortgage.
Types of FHA Loans
FHA mortgage loans come in several different configurations depending on your age, assets, income, current home equity, needs, and circumstances.
Fixed-Rate Purchase Loan.
Also known as a 203b mortgage loan, this is the most popular type of FHA purchase loan. Terms can vary, but 15 and 30 years are the most common. Interest rates tend to be lower than comparable conventional mortgages. 203b mortgage loans can be used on one to four-family residential homes.
Adjustable-Rate Purchase Loan (ARM).
Under the Section 251 Adjustable Rate Mortgage Program, the FHA insures ARMs whose interest rates can rise by no more than one percentage point per year and no more than five percentage points over the full term. Borrowers receive notice of pending rate increases at least 25 days prior to the increase.
Known as Section 234c loans, FHA-insured condominium loans are 30-year fixed-rate products that finance the purchase of individual condominium units within developments larger than four units. There’s no strict occupancy requirement, so borrowers can use FHA-backed condo loans to earn rental income. However, in any given development, at least 80% of FHA-insured loans must be made to owner-occupants.
Secure Refinance Loan.
FHA Secure Refinance loans are designed to help borrowers with conventional mortgage loans refinance into fixed-rate, FHA-backed mortgages. Delinquency is not necessarily disqualifying, though it must result from higher monthly payments on a conventional ARM. Non-delinquent borrowers can refinance any type of conventional loan. Standard qualification requirements apply, including steady income, acceptable credit rating, and reasonable debt-to-income ratios.
FHA Streamline Refinance Loan.
An FHA Streamline is a refinance option for homeowners with existing FHA mortgages. This program is “streamlined” because it doesn’t have many of the income and appraisal requirements that are included with standard refinance programs. As a result, the streamlined program provides homeowners with a quick, simple way to make their mortgage more affordable.
The FHA guidelines state that a streamline refinance must provide a benefit to the borrower by either lowering the interest rate or converting the loan from an adjustable-rate mortgage (ARM) to a fixed-rate. The program also allows for higher loan-to-value ratios than many refinance programs, so borrowers who have little or no equity in their home are still eligible.
Home Equity Conversion Mortgages (HECM or Reverse Mortgage).
Popularly known as a reverse mortgage, a HECM enables owner-occupant seniors aged 62 or older to tap their home equity and pay off the remainder of their existing mortgages without making monthly mortgage payments or moving away. For seniors with limited savings and fixed incomes, HECMs are excellent sources of tax-free cash, though they do have an important legal and financial consequence for homeowners and their heirs.
Graduated Payment Loan.
Known as Section 245 loans, graduated payment loans are designed for owner-occupants who expect their incomes to grow substantially in the medium term – for example, aspiring professionals or engineers in the later stages of training. Graduated payment loans’ monthly payments can increase over the course of 5 or 10 years, after which they remain constant for the remaining term. Annual increases range from 2.5% to 7.5% on 5-year plans, and 2% to 3% on 10-year plans.
Growing Equity Loan – Section 245a.
The Growing Equity Loan program’s intent is similar to the Graduated Payment Loan program, except more versatile: They can be applied to purchases of owner-occupied one- to four-family homes, condominiums, shares in cooperative housing, and housing destined for renovation or rehabilitation. Monthly payments are subject to annual increases between 1% to 5%, and loan terms cannot exceed 22 years.
Energy Efficient Mortgages
The FHA’s Energy Efficient Mortgage (EEM) program is designed to help homeowners save on utility bills by financing energy-efficient improvements with an FHA loan. The program is available as part of a home purchase or by refinancing the current mortgage.
To qualify for an EEM, the borrower must first get a Home Energy Rating Systems Report performed by a professional rater. The rater inspects everything in the home, from insulation to appliances and windows. Once the property’s current energy efficiency is calculated, the inspector makes recommendations for energy-efficient upgrades.
EEMs are available for $4,000 or 5% of the property value up to $8,000. If the EEM is included in the initial home purchase, you do not need to come up with a larger down payment.
Standard 203k loan
A standard 203k loan can be used by homeowners or homebuyers who would like to finance a property that requires major renovations. With the standard 203k loan, you have the ability to get just one loan for the cost of your mortgage, along with the required repairs. There are no limitations on the repair funds that you are able to receive, however, there are limits to FHA loans.
Repair types allowed:
- Major rehabilitation and/or structural repair
- Renovations that require detailed architectural drawings
- Major landscape work and site improvements *restrictions apply
- Elimination of safety or health hazards
- New addition construction
- Site amenity improvements, such as landscaping *restrictions apply
- Repair work that will require longer than 3 months or more than 2 payments per specialized contractor
- More intensive paperwork is required for a standard 203k loan and you could live in the home anytime unless the municipality places restrictions as part of the permit. Although, you will be permitted to add up to 6 months of mortgage payments to the loan amount.
Streamline 203k loan
A streamline 203k loan requires less paperwork than a standard 203k loan. You are still able to refinance your home or buy a new one and borrow the money you need for renovations while having just one monthly payment. When obtaining a streamline refinance loan, you will get a list of recommended repairs along with a bid from a contractor. There will be a timeframe in which all repairs must be completed for your final appraisal. Homeowners can finance up to $35,000 into their mortgage to repair, improve, or upgrade their home. Repair types allowed:
- Replace or repair existing HVAC systems
- Replace or repair roofs, including gutters and downspouts
- Replace or repair plumbing systems
- Update floor and/or flooring treatments
- Interior and/or exterior painting
- Update appliances
- Waterproof basement
- Home weatherization
- Door and/or window replacement
- Enhancing home accessibility
- Update home’s electrical wiring
- Replace/repair home’s exterior
- Make energy efficient improvements
- Installing a septic system or a well
- When dealing with a property that is in need of modernization or repairs, homeowners often have to take out high-interest home improvement loans. A streamline 203k loan allows the borrower a fixed or adjustable rate loan with straightforward terms.
FHA Loan Requirements
FHA loan down payment
With the FHA, the minimum down payment depends on your credit score. With a credit score of 580 or higher, the minimum down payment is 3.5%. With a score of 500 to 579, the minimum down payment is 10%.
FHA debt-to-income requirements
Lenders pay attention to your debt-to-income ratio, regardless of the type of mortgage you get. The debt-to-income ratio, known as DTI, measures the percentage of your pretax income that you spend on monthly debt payments, including mortgage, credit cards, student loans, and other obligations. You can use a debt-to-income ratio calculator to figure out where you stand.
The FHA requires a debt-to-income ratio of 50% or less, according to Brian Sullivan, public affairs specialist for the U.S. Department of Housing and Urban Development, which runs the FHA.
FHA loan income requirements
There is no minimum or maximum salary you can earn that will qualify you for or prohibit you from getting an FHA-insured mortgage. However, you must:
Have at least two established credit accounts. Examples: a credit card and a car loan.
Not have delinquent federal debt or judgments tax-related or otherwise or debt associated with past FHA-insured mortgages.
Account for cash gifts that help with the down payment. These gifts must be verified in writing, signed and dated by the donor.
Checklist of Required FHA Loan Documents
Individual mortgage lenders have different paperwork requirements. After all, they are different companies with different business models and procedures. But when it comes to FHA loans, there are certain documents borrowers must provide regardless of which mortgage company they are working with.
According to the Department of Housing and Urban Development (HUD), the government agency that manages this program: “The mortgage loan application package must contain all documentation that supports the lender’s decision to approve the loan.” This includes a wide variety of documents relating to the borrower’s financial situation, as well as those pertaining to the property being purchased.
Common FHA documents include, but are not limited to, the following:
- Loan Application
- Form HUD-92900-A
- SSN Verification
- Credit Report
- Verification of Employment
- Tax Returns
- Sales Contract
- FHA Amendatory Clause
- Real Estate Certification
- Appraisal Report
It’s also worth noting that mortgage lenders cannot have borrowers sign blank documents to be “filled in later.” This is a violation of FHA documentation requirements and guidelines. The HUD handbook states this clearly enough: “Lenders may not have borrowers sign incomplete documents … or blank sheets of paper.” These reasons for this rule are fairly obvious — you need to know what you’re signing!
Pros and Cons of FHA Loans
What are the advantages of an FHA loan?
One of the main advantages is that you don't need to make a very big down-payment (which can be as low as 3.5% of the purchase price) for an FHA-insured loan. Most traditional loans require an initial payment of 20% of the property cost. College graduates, newlyweds, first-time homeowners and people with low income generally cannot afford a 20% down-payment.
Since an FHA-insured loan requires only a minimum cash investment, it is ideal for people who haven't been able to save enough money for the purchase. First-time home buyers and people who may have been denied for a conventional loan will definitely benefit from an FHA-insured loan. Also, if you can't apply for conventional loans because of bankruptcy or foreclosure, you may still be able to qualify for an FHA loan.
FHA loans are very popular since they allow greater flexibility in calculating payment ratios and household income. In general, to be eligible for an FHA loan, you must have a valid social security number, be a US resident, and old enough to get a mortgage in your state.
FHA loans - What's the catch?
First of all, the properties have to be appraised by an FHA-approved appraiser, and they must meet certain conditions. However, the biggest disadvantage is the mortgage insurance premium (MIP). There are two kinds of MIPS, and both are required: one is the upfront mortgage insurance premium (UFMIP), which is financed into the mortgage (it increased from 1% to 1.75% in 2012), and the other is the annual MIP (which is actually paid monthly).
As of June 2013, mortgage insurance premiums must be paid for 11 years in loans which the original loan-to-value (LTV) is 90% or less. If the loan's starting balance is higher than 90% of the appraised value, the MIP will last the lifetime of a loan.
What are the disadvantages of an FHA loan?
Since an FHA has a very low down-payment (which can be as low as 3.5%), you will end up paying more interest than if you had a conventional loan with a 20% down-payment. This is a very important factor to consider when looking for a mortgage. If you are financially capable of paying 20% for a down-payment, then you should strongly consider opting for a conventional mortgage since it will save you a lot of money in the long run.
Plus, on top of the 1.75% upfront that you'll have to pay in insurance, you can't cancel the annual mortgage insurance premium, like you could before June 2013. In contrast, conventional loans let you cancel the insurance policy when you have enough equity.
How does an FHA loan differ from a conventional mortgage?
An FHA loan is different from a conventional mortgage in important ways. A conventional mortgage is not insured by the FHA, so it’s harder for you to qualify if you’re not the type of ideal buyer lenders look for.
Some of the key differences between an FHA loan and a conventional mortgage include the following:
FHA loans have different down payment requirements. You can get an FHA loan with a down payment as low as 3.5%. Most conventional lenders require you to put at least 5% down, although a few lenders will let you get a mortgage with just 3% down.
You can get more down payment help with an FHA loan. The FHA permits financial gifts or down-payment assistance from an approved source to provide up to 100% of the down payment, while some conventional lenders restrict the amount of your down payment that can come from a gift.
You can qualify for an FHA loan with a lower credit score. Many lenders require credit scores of 640 or higher to obtain a loan, while the FHA allows loans with credit scores as low as 500.
FHA loans typically have lower interest rates. When interest rates are lower, your loan can cost less over time.
FHA loans have different insurance requirements. Borrowers who get an FHA loan must pay an upfront mortgage insurance premium and annual mortgage insurance premiums. With a conventional loan, private mortgage insurance is typically required if a borrower puts less than 20% down — but there’s just one premium paid on a monthly basis. There are also different rules for when you can stop paying insurance, and you usually have to pay insurance for longer with an FHA loan.
Sellers can help with closing costs for an FHA loan. The FHA allows home sellers to pay up to 6% of the closing costs for a loan. Many conventional lenders cap a seller’s contribution at 3% of closing costs, although some allow sellers to pay up to 6%.
Begin the application process.
If you believe you qualify for an FHA loan and are ready to apply, the first step is to get pre-approved with your lender of choice.
Get pre-approved for an FHA loan online now »
As you have read above there are many options to the versatile FHA loan. There are pros and cons of choosing an FHA mortgage. To help you navigate the FHA landscape and perhaps other loan options, we suggest you contact one of our mortgage advisors to answer all your questions. There is no fee nor obligation to do so. We are here to serve you and consult with you with complete transparency and your best interest in mind. Call us today!