Financing a home has become more difficult than it was in previous years. Even though lenders have relaxed a little since the housing crisis several years ago, it is still harder to get the home of your dreams. This is especially true for buyers who are just trying to get a foot in the door.
If you are considering loans backed by the Federal Housing Administration (FHA), this guide shows you all the things you need to know before you can start house-hunting.
Note, we are not mortgage lenders. For mortgage advice specific to your home-buying needs & financial situation, always consult with a licensed mortgage professional.
What is the FHA?
The Federal Housing Administration is under the umbrella of the Department of Housing and Urban Development (HUD). Its origin dates back to the Great Depression, when there were few guarantees on funding from banks. The FHA promotes homeownership and aims to make it easier for buyers to get into homes, among other services they provide.
Does the Federal Government Loan Me Money?
FHA loans are a way that the federal government can help prospective buyers get a mortgage, without necessarily giving them the money directly. With an FHA loan, a home buyer receives money from a lender who agrees to fund the loan under FHA terms. Lenders accept these terms because the federal government insures the loan. This guarantee makes lenders more secure in lending money to home buyers who might not otherwise qualify for loans.
How Do FHA Loans Help Home Buyers?
There are many ways that FHA loans help buyers get into a home, but probably the most important is the low down payment, rather than the typical 10-20 percent required for conventional financing.
FHA loans are a very popular option for many types of home buyers, including first time home buyers, buyers with previous credit issues, buyers who have declared bankruptcy in the past, and in general, anyone who doesn't have a large downpayment. Also, some buyers wish to preserve as much as their savings as possible, rather than put so much of their liquid savings into a new home.
Compared to conventional loans which typically require a 10-20 percent downpayment, FHA loans allow home buyers to close on a mortgage with as little as 3.5 percent down. That is $7,000 on a $200,000 loan, which is more accessible to a wider spectrum of potential buyers.
Additionally, FHA loans also allow more room for housing and debt-to-income ratios. In short, buyers may be able to incur a higher rate of debt on an FHA loan than a conventional mortgage. When you go to buy a home, FHA terms set limits on the closing costs required by sellers. In many cases, the sellers are asked to assume some of these costs.
Do I Qualify for an FHA Loan?
Home buyers must meet the following requirements to qualify for an FHA loan (as of July 2016):
- Credit score of at least 500 (above 580 for lower down payment)
- Down payment of 3.5 percent or more
- Housing ratio of no more than 30 percent
- Debt-to-income ratio of 43 percent or less
Standard mortgages usually require that your monthly mortgage payment be less than 28 percent of your gross monthly income, and that your total monthly debt-to-income ratio is less than 36 percent, including your mortgage. FHA loans allow a housing ratio of 30 percent, and a debt-to-income ratio of 43 percent. To calculate these numbers, divide your mortgage or total debt by the gross monthly income.
Are FHA Loans Only for First-Time Home Buyers?
While FHA loans are particularly useful to first-time home buyers, they are not exclusively reserved for this demographic. Almost anyone could benefit from an FHA loan, especially if they may struggle to come up with a much larger down payment. FHA loans cover a variety of loans, even so-called “reverse mortgages” intended to give money back to seniors who own their homes outright.
However, the biggest reason many home buyers gravitate toward FHA loans is that they cannot qualify for a mortgage otherwise. FHA loans usually have higher interest rates, so people who could get a traditional mortgage with a lender may find it less costly long-term.
Are There Limitations on FHA Loans?
There are additional limitations and requirements that home buyers must meet in order to get an FHA loan. First, all FHA loans with a down payment of less than 20 percent require the buyer to pay private mortgage insurance (PMI) to back the loan in the case of foreclosure.
Buyers are also required to get a home inspection, with strict rules on what responsibilities the buyer must assume. FHA loans are also limited by size. In most areas, the current limit is 115 percent of average home prices, the lowest being $271,050. In regions with a high cost of living, the maximum could be as high as $625,000.
How Do FHA Loans Affect the Home Buying Process?
If millions of people apply for and receive FHA loans, and the vast majority of lenders accept them, it may seem like FHA loans make the home buying process a lot easier. While this is generally true, having an FHA loan can also be a bit of a liability.
"In a competitive market and buying with FHA? Talk to your agent about other ways to make your offer as strong as possible."
Sellers are not required to accept offers from buyers with FHA loans, which can present serious challenges in strong seller's markets with multiple offers. For example, a seller may insist upon a higher offer or reject the offer outright, on the basis that they will be expected to pay higher closing costs. Sellers may also worry that the strict inspection requirements will make them pay more for repairs than they would with other buyers.
What is the Difference Between FHA, Fannie Mae and Freddie Mac?
Although all of these organizations deal in mortgages, none of them lends money directly to consumers. FHA insures loans for lenders. Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) buy debt from lenders so that they will have more money to lend to home buyers. Fannie Mae and Freddie Mac buy mortgage debt for traditional mortgages, as well.
Bottom Line... Is an FHA Loan Right For You?
When you first start researching mortgages on your home buying journey, you realize quickly that the expectations can be difficult to meet. FHA loans aim to ease your entrance into homeownership, with loan guarantees that allow your lender to offer you better terms.
If you qualify for an FHA loan, you can get a mortgage with a smaller down payment and a lower credit score, in exchange for a higher interest rate. FHA loans are not always the best for everyone, but they may allow you to buy a home when traditional mortgages are not an option for you.