You may have heard the term 'FHA loan' before... but what type of loan is it and who is eligible for one?
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.
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:
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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 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.
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:
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.
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.
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.
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.
To ensure that the buyer (and lender) is paying a fair amount for the home, buyers insert an appraisal contingency, which allows the buyer the ability to walk away from the purchase without penalty if the appraisal returns a value lower than a set value (usually the purchase price). Aside from walking away, the buyer can renegotiate for a lower price with the seller, request that their lender make an exception, and approve their loan as if the property had appraised to match the purchase price or make up the difference between the purchase price and appraised value via their own funds. In most cases, if the buyer makes use of the appraisal contingency to walk away, they are likely to receive a complete refund of their earnest money. However, buyers must be cautious and include this in the contract to avoid problems at a later stage.
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