What is an FHA Loan?

You may have heard the term 'FHA loan' before... but what type of loan is it and who is eligible for one?

What is an FHA loan?

An FHA-insured loan is a US Federal Housing Administration mortgage insurance backed mortgage loan that is provided by an FHA-approved lender. FHA-insured loans are a type of federal assistance. 

The FHA insures mortgages issued by lenders, like banks, credit unions, and non-banks. That insurance protects lenders in case of default, which is why FHA lenders are willing to offer favorable terms to borrowers who might not otherwise qualify for a home loan. 

The FHA was created as part of the National Housing Act of 1934 to stem the tide of foreclosures and help make homeownership more affordable. It established the 20% down payment as a new norm by insuring mortgages for up to 80% of a home's value - previously, homeowners had been limited to borrowing 50%-60%. Today, the FHA insures loans for about eight million single-family homes.

An FHA home loan can be used to buy or refinance single-family houses, two- to four-unit multifamily homes, condominiums, and certain manufactured and mobile homes.

Specific types of FHA loans can also be used for new construction or for renovating an existing home.

What is an FHA Loan?

Who are FHA loans for?

FHA Loan Requirements Summary

  • Credit score of at least 500
  • Debt-to-income (“Back End”) ratio of 50% or less; Payment-to-income (“Front End”) ratio of 40% or less
  • 3.5% down payment if your credit score is 580 or higher (can be gifted by a family member)
  • 10% down payment if your credit score is 500-579
  • The house must be your primary residence, must meet the FHA’s minimum property requirements, and must have an approved appraisal
  • Steady employment or two years on job
  • Must have social security # and be a US resident
  • No bankruptcy in past two years (as little as one year in some circumstances)
  • No foreclosure in past three years

The full list of FHA loan requirements is published in a handbook more than 1,000 pages long.

The standard FHA DTI requirements are 31% for the ratio of housing-related expenses to income and 43% for the ratio of total debt that appears on the credit report.

The FHA guidelines permit lenders the flexibility to allow for a total DTI of up to 50% if there are additional compensating factors such as no payment shock, a high level of cash reserves, or additional income that may not be documented on the loan application.

The mortgage insurance is an insurance policy that protects the lender in the event that you default on the loan. The FHA charges borrowers for providing the mortgage insurance using a two-tiered mortgage insurance premium (MIP) schedule. The first tier includes an upfront mortgage insurance premium (UFMIP) equal to 1.75% of the base loan amount at closing is required, and is normally financed into the total loan amount by the lender and paid to FHA on the borrower's behalf. The second tier consists of a monthly mortgage insurance premium (MIP) which varies based on the amortization term, loan amount, and loan-to-value ratio.

The monthly payment is not permanent, however, as there are several ways to get rid of the MIP. One way to remove the monthly payment is to establish at least a 20% equity on the FHA loan, which will allow the homeowner to apply for a refinance on their loan. The second way, which does not involve a refinance, is to establish a 22% equity. The MIP at various amortization term, loan amounts, and loan-to-value ratios is summarized below:

What is an FHA Loan?

FHA PROPERTY REQUIREMENTS

FHA loans can be used to purchase primary residences only and they must be single-family homes or condos up to a maximum of a 4-unit building. The FHA-approved condo lookup tool should be used to determine whether the condo you are interested in buying qualifies for an FHA loan.

Additional FHA property requirements:

  • The property cannot be a fix and flip project
  • The property must meet minimum property living standards and be deemed to be “safe”, “sound”, and “secure”
  • The property cannot be an investment
  • There may not be an encroachment onto a neighboring property or vice versa
  • No overhead power lines are permitted
  • There must be sufficient access to the property for emergency vehicles
  • Property must be free of hazards or toxins

FHA LOAN LIMITS

The FHA loan requirements also outline very specific loan limits for each county.  Check out our post on FHA loan limits to determine what the loan limits are in your county for the coming year.

FHA APPRAISAL REQUIREMENTS

Every home purchased with an FHA insured loan must have an appraisal performed by an approved appraiser.  In addition to estimating the value of the property, an FHA appraisal will also investigate the following issues which could disqualify the home:

  • Lead paint
  • Systems such as heating and cooling are operating
  • Operational fixtures and appliances
  • Plumbing and electrical problems
  • Foundation problems
  • Hazards
  • Poor drainage
  • Roof in good condition
  • The overall condition of the home

How do I get an FHA loan?

The FHA does not make loans. Rather, it insures loans made by private lenders. 

The first step in obtaining an FHA loan is to contact several lenders and/or mortgage brokers and ask them if they are FHA-Approved by the U.S. Department of Housing and Urban Development to originate FHA loans.

Applying for an FHA loan will require personal and financial documents, including but not limited to, a valid Social Security number; proof of U.S. citizenship, legal permanent residency or eligibility to work in the U.S.; bank statements for, at a minimum, the last 30 days. You'll also need to provide documentation for any deposits made during that time (usually pay stubs). Your lender may be able to automatically retrieve some required documentation, like credit reports, tax returns, and employment records. Special circumstances - like if you're a student, or you don't have a credit score - may require additional paperwork.

  • Social security number or card
  • Driver’s license or some other form of ID
  • Pay stubs and W2s (unless self-employed)
  • Tax returns 
  • Bank Statements
  • Account statements for any other liquid financial accounts
  • 1003 loan application
  • Form HUD-92900-A – this is an addendum to the 1003 loan application
  • Written verification of employment
  • Credit report
  • Appraisal Report
  • Sales contract for purchases
  • Copy of the deed for refinances

Second, the potential lender will assess the prospective home buyer using the Desktop Underwriter (DU). DU considers the potential borrower's debt ratio, reserves and credit score to make an automated credit decision. The lender will also check your financial history particularly for delinquencies on other US government loans.  Mortgage lenders can add their own rules, also known as overlays on top of these minimum standards. Each lender sets its own rates and terms, so it can pay to shop amongst multiple lenders to find the one that’s right for you.

Third, assuming you pass preliminary underwriting, you will need to have an approved property under contract to move forward. In order to close, the lender will have to complete the underwriting process, and satisfy a complete closing checklist including items such as title insurance, homeowners insurance, appraisal, and verification of funding sources.

What are the pros and cons of FHA Loans?

In general, FHA loans are higher-cost loans that exist for people that need more flexibility on credit score or down payment requirements compared to conventional loans.

Benefits of FHA loans:

  • Lower minimum credit scores than conventional loans
  • Down payments as low as 3.5%
  • Debt-to-income ratios as high as 50% allowed
  • Gift funds allowed
  • Seller closing cost contributions allowed
  • Co-signers allowed

Disadvantages of FHA loans:

  • Mortgage insurance charged upfront (1.75%)
  • Mortgage insurance lasts the full term of the loan with a down payment of less than 10%
  • Property must meet strict health and safety standards
  • Can’t be used for high-priced homes (above limits set by FHA)

It is important to note that each individual lender can overlay their own stricter standards on top of the FHA requirements, so you may have to shop around to find an FHA-approved lender whose internal requirements are flexible enough for your needs.

READ NEXT: Good News! Loan Limits Will Increase in 2021

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