The housing prices in the last 30-40 years have skyrocketed in the US. There was a time when people could buy their dream homes for as little as $10,000! As unreal as it may sound, it’s true. The wage was low as well if you’re considering inflation, but the ratio is just not the same anymore.
This brings us to modern-day homebuying. It’s very rare that people buy their homes with cash or balance from their savings. Loans are usually the way to go. Now, when it comes to a housing loan, there are two major routes you can take.
One is the conventional loan procedure handled by various lending organizations like banks, mortgage companies, and so on. The other route is the FHA loans, which is our topic today.
In this post, we’re going to dissect FHA loans. We’re going to learn what they are, what are the requirements, and some general terms to help you out with your homebuying. If this is your first time getting your own home, take our congratulations in advance.
What is an FHA Loan?
FHA stands for the Federal Housing Administration. So, an FHA loan basically means a loan program backed by the federal government. There are massive upsides to this program when compared to traditional loan programs.
To start with, you get very loose requirements! Getting approved for an FHA loan is significantly easier than a conventional loan. It’s primarily designed for people with lower credit scores or people who are struggling with their finances.
FHA has been an integral part of the US Department of Housing and Urban development. The Department of Housing may have started its journey back in 1965, but the FHA’s history goes even back.
The stock market crash and the Dust Bowl drought had major contributions in forming the FHA. By the year 1933, almost all American homeowners defaulted their mortgages.
To tacked the situation and to prevent any similar future happenings, the FHA was formed as part of the National Housing Act 1934. The goal was to stem the massive waves of foreclosure. It was the first organization to accept as little as a 20% down payment!
To sum up, an FHA loan is cleared by an FHA approved lending organization. You get many incentives like a lower down payment, less interest rates on your mortgage.
But does that mean everyone should go with FHA instead of the conventional route? Of course, not. Why? We’ll find once we completely understand how the FHA loan works.
How Does an FHA Loan Work?
When it comes to such loans, there is a common misconception among people. They think that the FHA is paying the loan for them to buy the house. Which is not actually true. It’s still a financial organization like a bank or a mortgage company. It’s just that the FHA is guaranteeing the loan for you. It’s one of the reasons many people like to call these loans FHA-insured loans.
The catch is that you must get mortgage insurance on top of your loan to get approved by the FHA. The premiums for the insurance are paid directly to the FHA. In case you default on the loan, the risks are lower for your lending organization.
The Types of FHA Loans
When we say an FHA loan, we’re covering a large spectrum. There are various types of loans that come under the same umbrella. In this section, we’re going to shed some light on each of them.
Basic Home Mortgage 203(b)
As the name suggests, this is the most basic kind of FHA loan you can get approved for. It allows either fixed or adjustable rates and allows various properties as eligible homes for the borrower.
Rehab Mortgage
Also known as the FHA 203(k) loan, this one is quite famous among borrowers. It finances both the purchase and renovation of a primary residence. By primary residence, it means that there can only be an FHA loan active at a time.
So, the property you’re getting the loan for must be your primary residence. If you have another house that’s also covered by an FHA loan, you won’t get approved for a 2nd one unless you complete the payment on the previous one or arrange alternative financing.
The Rehab Mortgage is more flexible because you can take out this loan just to fix your existing house under the renovation costs.
Construction to Permanent Loan
It’s a massive loan that helps you purchase the land and build the house! It’s usually not for the low credit score bearers.
Title I Property Improvement Loan
This is quite similar to the 203(k). But it says that you can buy a manufactured home and/or repair an existing one with Title I Property Loan.
Energy Efficient Mortgage (EEM)
This loan is approved if you want to upgrade your home for energy-efficiency purposes during your purchase. It also applies to the existing homeowners as well. So, if you already have a house and you want to minimize your energy costs as well as help the environment in the process, you can apply for the EEM loan.
Requirements to Qualify for the FHA Loan
Now that you have a pretty generous idea of what the FHA loan is and how it works, we believe we can move on to getting you approved for one. So, what are the things that matter the most when you’re trying to take out your first FHA loan?
The Credit Score
Just like any other loan, your credit score is the first obstacle you need to overcome. But the difference with conventional loans is that you can get away with a much less score. As long as you’re in the 600 range, you can bring your down payment down to 3.5%. To be more precise, you need to be over 580 FICO (Fair Isaac Corporation) score.
For other house loans, you need to be around the 700-800 range to qualify for a better mortgage rate. It’s one of the main reasons why FHA is such a lucrative option for first time homebuyers.
The best thing is, you can go even lower! As long as your score is over 500, you’ll still have the chance to get approved. It’s just that you need to put down a 10% down payment instead of 3.5%.
However, the range for minimum score required can vary from state to state. So, you’re better off with contacting your local FHA approved lending institution to know exactly how much FICO score you need.
Have Your Down Payment Funds Ready
As we’ve already mentioned, you can bring the down payment on your new house by 3.5% if your credit score is over 580. It also means that you need to have your down payment funds ready before you apply for the FHA loan.
At this point, you might be thinking that you need to save up enough according to your preferred property’s market value to cover the funds. The fun fact is that it doesn’t have to come out of your savings funds all the way.
According to the FHA regulations, you can use gift money as a down payment! How awesome is that? It means that your friends, family, or even a colleague might be able to help you out with the money.
All you’ll need is a signed document by the donor stating their relationship with you, their contact information, and the statement that says they won’t’ need the money back from you.
There are even various down payment assistance programs in states. You need to look for one in your local area! They usually target the first time homeowners. It doesn’t mean that you absolutely have to buy a house for the first time. It just means that you can’t have any house bought in the last three years.
Debt/Income Ratio
This is another very important metric to determine whether you’re going to get approved for an FHA loan or not. As the name suggests, it’s the ratio between your earning and your monthly debt payment. It’s known widely as DTI among homeowners.
To get approved for the loan, your DTI should be below 50. It’s all that better if you can get it up to 57%. It means that the debt payment cannot be more than 43% of your monthly income.
This is in place to ensure that you’re not going to default on your mortgage payment. To calculate the DTI, the loan underwriter will count 1% of your total student loan as repayment if you have any. For all other types of loans, it’s 5% of the loan’s total value.
Have the Same Job for At Least Two Years
It’s part of the verifiable income clause. All of your income must be verifiable to the source including taxes. You need to prove that you’ve had a sustainable income for at least two years prior to applying for the loan.
The Property Must be Approved by the FHA
Last but not the least, the property you’re trying to purchase must be approved by the FHA. It doesn’t matter if it’s a manufactured home, a condo, a regular house, or even a multifamily home, it must meet the FHA minimum property requirements.
The requirements include an appraisal outside of the home inspection. It’s to give FHA the confidence that the property you’re purchasing is worth it. And if you’re going for the 203(k) loan, the property must have two separate appraisals. It includes the value before renovation and after renovation.
Mortgage Insurance
If it were any conventional loan, the mortgage insurance would be optional. But in the case of an FHA loan, you must accept it. Every mortgage under the FHA loan program is covered by this insurance. Just like the down payment, you can pay upfront for the insurance to the FHA and pay the premiums on a monthly basis from thereon.
For the buyers with better credit scores, meaning those who paid less than 10% in down payment, will need to pay the premium for the life of the loan. It means if you take out an FHA loan for a 15-year term, you’ll need to pay for 15 years.
And for borrowers who give more than 10% in down payment will pay the insurance for 11 years.
How to Apply for an FHA Loan?
After you’re sure that an FHA loan is the way you want to go, the next step is to apply for one. As we’ve discussed what the loan is and how it works quite extensively, we believe you know how it works by now.
So, it’s time for us to move onto the next big step. Fining and FHA lender and applying for the loan.
The first thing you need to make sure of is that you’re finding the FHA approved lenders in your area. Different lenders will have different rates, underwriting procedures, and costs. It’s your job to evaluate them and decide which one will work best for you.
Here are the key steps in ensuring you’re getting what’s best for you.
The Budget
Before you apply for the loan or scour the housing market for FHA approved lenders, you need to determine your budget for a property. It means you need to be aware of your finances and know you can afford the loan.
You need to consider things like your income, expenses, debts, savings, etc. factors. There are mortgage calculators available online that can help you calculate these things easily.
Get the Documents Ready
This is extremely important. Especially when the federal government is involved, you need to make sure that you’re doing extra work to keep get your documents in check. Any loan lender, no matter how small the amount is, will ask for all concurrent papers to validate you.
It’s your job to provide them. Papers like tax returns for at least two years, pay stubs, statement of your assets, driver’s license, etc. are the most likely ones that you’ll need to prepare. Based on where you live, the documentation process can vary a bit.
Compare Multiple Lenders
When you’re dealing with such a huge investment as buying a house, it would be unwise to walk into the first FHA approved lender you find and get the money.
You should compare all available options in your area to see the rates and costs to see which one works best with your current financial conditions.
Limits of the FHA Loans
Just because you’re getting a loan doesn’t mean you can get a million dollars to buy your dream home in Hollywood. There are limits in place that determine how much an individual can get in the form of an FHA loan.
The loan limits are updated every year. It’s very important in our opinion because it keeps the option open for new buyers and keeps the loan procedures standard at all times.
In 2020, the maximum for a single-family FHA loan was $331,760. It means that even if you have an 800 credit score, you won’t get more than the mentioned amount.
In 2021, the amount has been raised to $356,362. And it’s likely to rise every year because the real estate market is constantly changing. It’s very unlikely that housing prices will come down any time in the future.
If you want to buy a home in a high-cost area identified by the FHA, you can get up to $822,375 as of 2021. In 2020, it was $765,600. FHA calls these limits as ceilings and floors for easier understanding.
It’s required by law to adjust the loan limits which are set by the Federal Housing Finance Agency (FHFA). If you’re going the conventional route, the limits are controlled by Fannie Mae and Freddie Mac.
Both the floor value and the ceiling value are updated regularly based on the living cost in a certain area. For example, housing prices are skyrocketing in Los Angeles County while it’s very manageable in Las Vegas.
Hawaii, Alaska, Virgin Islands, and Guan are some special-case states where constructing or buying a house is more expensive than the norm. It means the ceiling values are going to be higher when it comes to the FHA loans.
Advantages of the FHA Loans
If you’ve read our post so far, you have a pretty good idea about the merits and demerits of the FHA loan program. But it’s still good to find all the good things in one place, right?
So, let’s find out what are the advantages you can enjoy if you get approved for one.
No Discrimination Between Credit Scores
We’ve already established that you can get away with quite a low credit score when you’re trying to get approved for an FHA loan. It’s the same across the spectrum. It means the estimated approval value will be the same for a person with a 580 credit score and an 800 credit score!
Less Down Payment
The opportunity of getting your first home for as little as a 3.5% down payment is a literal dream come true for every individual. And you can do it with FHA loans! To recap, if your credit score is over 580, you get a 3.5% down payment. And if you’re credit score is between 500 and 579, you get a 10% down payment.
You Get Insurance
It’s a debated area. Not everyone agrees whether mortgage loans are a good idea or not. But in our opinion, every kind of insurance matters because you never know what the future holds for you.
Disadvantages of the FHA Loans
FHA loans sound great. But they’re not invincible. If they were, the conventional loan programs wouldn’t exist. So, what are the demerits of FHA loans?
No Getting Away from the Insurance
The mortgage insurance that comes with the FHA loans is like a coin. It has two sides. That’s why it made its place both in our advantages and disadvantages list!
The reason insurance is mandatory is because of your credit score. In general, lower credit scores indicate that you have a greater chance of defaulting on the loan. Even if you don’t have any intentions for it, the datasets aren’t in your favor.
The insurance is placed to safeguard the lender. You need to pay the premium upfront along with the closing costs when you’re buying your house with the FHA loan.
The annual premiums will then to part of a 12-month installment process and will be added to your mortgage bill every month. People who give less than a 10% down payment, they’ll need to pay the premium for the lifetime of a loan.
It means if you’ve taken out the loan for 30 years, you’ll need to pay the insurance premium installments for 30 years. It’s a price you have to pay for putting down so little upfront.
The reason it’s a demerit is that you can’t escape from it. Conventional loans get the edge in this case when you get 20% equity on your property, the private lender will let you off the hook for mortgage insurance.
Finding an Approved Property is Hard
We’ve already established the fact that if you want to get an FHA loan, the property you’re targeting must meet some minimum requirements. But getting your hands on one can become tiring and time-consuming.
It’s understandable because everyone will have their eyes locked onto these properties. So, as soon as a property becomes available, potential homebuyers jump on them!
Wrapping Up
Taking a loan is always scary. Especially when you’re going for a loan to buy your first house, it can be scarier. But the trick is to own it. Instead of getting blindsided by future complications, the way is to know everything there is about any loan so that you’re prepared.
We’ve tried our best to give you a head start with FHA loans. As they’re relatively easy to get, it should be your first target. Now that you know how it works, you can go out in your local area and find the best FHA-approved lender.
Need a Realtor? (Elkhart & St. Joseph Counties – Northern Indiana)
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Best Regards,
Nick Foy, Broker
RE/MAX Oak Crest Realty
574-387-2501
NickFoyHomes@Gmail.com