What is an FHA loan and how to obtain it?

Zorica Lončar

FHA loan is an affordable mortgage insured by the Federal Housing Administration (FHA).

If you can secure a 10% for a down payment for your first home, then your credit score can be anywhere between 500-579. If your credit score is above 580, then you only need 3.5% for a down payment.

One option is to fund your down payment from your savings. But, you could even get a grant as down-payment assistance.

Although the deal might seem great at first glance, as a borrower, you'll still have to pay for mortgage insurance premiums known as MIP. The insurance serves to protect the lender in case of a failed payment.

Still, this is quite a popular option for many people because a perfect credit score is not necessary to apply. And if anything goes wrong, the lender will first file the claim with the FHA to collect the payment. As lenders have this option, they’re more likely to help you finance your first home.

The history of FHA

The National Housing Act, which saw the light of day in 1934, was beneficial for the establishment of the FHA as an organization. At that time, almost 2 million people lost their jobs in the construction industry. And only 4 out of 10 households weren’t actual renters.

The idea behind FHA is to help low-income Americans buy their first homes. In these beginning stages, it focused on helping war veterans and their families.

In 1965, the FHA became a part of the American Department of Housing and Urban Development’s Office. Since then, the production of new homes has taken off. They focused on housing the elderly and low-income Americans first.

By 2004, the homeownership was at an all-time high (69.2%). But, since then, it has been falling every year until 2016. That year had the lowest rate since the 1990s (63.7%). In 2019, the homeownership rate in the US was 65.1%.

Nowadays, the FHA insures about 8 million single home mortgages. This agency also protects 12,000 mortgages for multifamily properties. Among them are 100 mortgages for medical establishments.

The different types of FHA loans

Borrowers use the traditional FHA mortgage to finance a primary place of residence. Besides this one, there are other types of FHA loans on offer. These include:

  • home equity conversion mortgage program (HECM)
  • 203(k) mortgage program
  • energy-efficient mortgage program (EEM)
  • section 245(a) loan

Keep reading as we’ll uncover each type of FHA loan.

Home equity conversion mortgage program (HECM)

Home equity conversion mortgage (HECM) is a reverse mortgage made for people over 62 years old. It’s a program that allows seniors to use the equity in the home they own for everyday living expenses.

The user chooses how they’ll withdraw the money. It can be a line of credit, a fixed monthly amount, or a combination of both. Another advantage is that they don’t have to repay the loan until they sell the house.

It can help in a difficult financial situation, but people need to be careful. It's not rare that older borrowers become victims of scammers. The con artists often make suspiciously good offers, such as free or very cheap houses. They also send letters to seniors asking for money in exchange for some documents that they can get for free. Even the FBI published a warning and gave advice to potential or current victims.

203(k) mortgage program

The FHA 203(k) improvement loan is also known as the FHA construction loan or rehab loan. It can help borrowers buy and renovate a home at once. It can also cover the repairs and renovations of the house you already own. The downside for some is that you have to use a pro contractor, so you can’t do the work yourself.

Depending on the renovations, there are 2 types of FHA 203(k) improvement loans. The limited 203k mortgage is good for smaller repairs without any structural changes. Things such as kitchen and bathroom changes, floor, and roof work.

The 203(k) standard allows for pretty much anything, except for a few things. One is that you can’t add luxury amenities, such as swimming pools, and the repairs must last less than 6 months.

Energy-efficient mortgage program (EEM)

EEM helps homeowners save money on their utility bills. It does so by financing energy-efficient upgrades for the home, such as solar panels. This could help make your house more attractive to buyers.

This program makes your home more eco-friendly and your expenses smaller. Besides solar and wind systems, you can use the loan to replace windows and fix chimneys.

What’s in it for the lender? When the home is energy efficient, the operating costs are also lower. Ergo, the users have more money to pay off the mortgage.

Section 245(a) loan

Section 245(a) loan is perfect for those who expect their incomes to become higher in the future. Under this program, the Graduated payment mortgage (GPM) begins with lower monthly payments. They increase over time and you can decide how much. There are 5 payment increase options that you can choose from based on your finances.

This type of loan is more expensive than a regular mortgage. Also, if your income doesn’t increase as you expected, you still have to pay the higher rates.

How to apply for an FHA loan?

It’s important to know that you don’t apply to the FHA, but the FHA-approved lender. The first step is to get pre-approved for the loan by the lender. So, a bank, a mortgage broker, or an online mortgage lender. This will assure that you meet the minimum requirements for a loan.

There are several personal and financial documents you need for an FHA loan application. Your credit score is not one of them since your lender will get that from credit reporting agencies. Talk to your lender to find out what are the exact documents you should have ready to apply. Some of them are your last 2 bank statements, 2 years of tax returns, and your pay stub for the last 30 days. Also, an ID and a social security number are essential.

Some lenders will allow you to apply online, so make sure you check if that’s an option.

FHA requirements in detail

The credit score requirement is at least 500 and the down payment depends on it. So, if your score is 500-579, you should make a 10% down payment. If it’s 580 or more, it should be 3.5%. But, lenders can have their credit score minimums different from the government's.

FHA lenders will check the relationship between your monthly income and monthly debts. The restrictions can vary by lender, but your debt-to-income ratio should be around 50% or less. You’ll need some financial stability, so you must have a steady income and no foreclosure in the last 3 years. No minimum or maximum salary, though.

The house must be your primary residence and it has to be in your name or the name of a living trust. In case the lender doesn’t approve the loan, you can always try with a different one.

FHA has some standards when it comes to the type of property you can buy with their funding. They will check the rooms, plumbing, foundation, and mechanical systems within the house. If there’s no serious damage and the house is safe to live in, there won’t be a problem.

Two types of mortgage insurance premiums

The FHA mortgage insurance premium (MIP) is what encourages the lenders to give loans. This insurance protects them if the borrower can’t pay the money back. You, as a borrower, pay for the insurance, but it’s not all for nothing. Without it, lenders wouldn’t even offer such low-interest rates and take the risk of losing money.

The majority of FHA loans require MIP for 11 years or if your down payment is less than 10%, the lifetime of the mortgage.

The borrower pays two kinds of MIP for an FHA loan. One is an upfront fee of 1.75% of the loan amount and one is an annual premium ranging from 0.45% to 1.05%. The second one becomes less expensive as you pay off the loan balance.

Should you apply for an FHA loan?

Each loan, including FHA loans, has pros and cons. Depending on your needs, it might or might not fit the situation. FHA loans aren’t for everyone, but if your credit profile is not the greatest, this might be the best way to buy a home.

The FHA loan is appealing because of the low down payments and credit score requirements. If you’re looking to invest in your first house, this might be a good option. You can even apply if you have student loan debts, as long as your debt-to-income ratio is good enough.

If you’re looking to remodel and renovate a house, 203(k) FHA loans can cover that. Although some lenders might reject you, you can turn to others. When you meet all the FHA rules, there’s no limit to the number of times you can apply.

One of the downsides is that you pay the insurance for the lifetime of the loan if your down payment is less than 10%. Not everyone is comfortable with that, so keep that in mind when making your decision. Also, the property you want to buy has to meet FHA standards. In the end, the best way to decide is to look into theFHA-approved lenders and their rules.

Who are FHA loan lenders?

The FHA is not the actual lender, but just the middleman. The lender or a bank gives the money and the FHA protects them if someone can’t pay it back. The FHA has certain guidelines that it uses when approving a lender. Except for banks and mortgage lenders, credit unions can also be loan givers.

The difference between lenders is in the fees, rates, and other costs. They are competitive with each other, so you should take your time to find a match for your situation. Even if you get rejected by one lender, the other one can still approve your loan.

The difference between FHA and traditional loans

The main formal difference is that the government backs FHA loans. Private companies are those that provide conventional loans. The FHA belongs to the Department of Housing and Urban Development (HUD). Although the government protects the lender, the borrowers feel no difference.

To get a traditional loan, you need a higher credit score, and FHA allows lower numbers. This doesn’t mean that FHA loans are cheaper, but that it can be easier to get them.

Mortgage insurance is obligatory with FHA loans. If your down payment is not high, you’ll have to pay the insurance as long as you pay off the loan. Some conventional loans allow you to cancel the insurance at some point. With some, you don’t even have to pay it if your down payment is big enough.

FHA loans for first-time homebuyers

These loans aren’t only suitable for first-time buyers, but they’re very popular among them. The reason is that FHA loans have fewer requirements than traditional mortgages.

When your credit score is below 600, it’s easier to get an FHA loan than a conventional one. Also, if you’ve never owned a property before, it’s likely that you also can’t give a big down payment. The statistic says that in 2019, 83% of FHA loans went to first-time home buyers.

But, you should add up all the expenses and look at them as a whole, not only the rate. When you add the insurance costs, you might find that other options suit you better.

FHA loan limits

There are no FHA loan income limits. That means that you don’t need to have a big salary to get it. But, if you do have it, you can still be a candidate like everyone else. Applying for an FHA loan doesn’t mean you can’t afford another one. You won’t get any special treatment based on your earnings. Instead of income limits, they care about your debt-to-income ratio.

There is a limit to the amount of money you can borrow from the lender and they update it every year. It depends on the place where you live since some are more expensive or low-cost than others. Besides a few areas where the construction costs are high, the limit is usually 115% of the median home price. The biggest loan limit for 2020 can be 765,600 USD for single-family homes.

FHA loan relief

If you have legitimate financial hardships such as the complete loss of income or difficulty paying your rates, you might be able to get loan relief. There are also special relief options available during the pandemic.

If the COVID-19 pandemic affected your finances, you can get a forbearance for 180-360 days. This means that your lender can reduce or pause your mortgage payments. You don’t need to provide proof, your claim is enough. It should be as easy as filling out a form or making a phone call.

At the end of the forbearance, your lender should offer you a couple of repayment options to choose from. No extra fee should exist.

FHA loan calculator

To get an approximate idea of your loan costs, you could find some good online FHA loan calculators. The US Bank made one that allows you to look at your options.

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