Don’t let high interest rates deter you from realizing your dreams of homeownership. Multiple loan programs are available to address the diverse needs of prospective and current homeowners. One of the leading programs is a loan backed by the Federal Housing Agency, called an FHA loan. Read on to see what you need to know about this lending option and if it could be the right mortgage program for you.
Get to Know the FHA Loan
An FHA loan is a mortgage program insured by the Federal Housing Administration (FHA). The agency is part of the Department of Housing and Urban Development (HUD).
This type of mortgage loan, created in 1934, allows people to buy homes with less stringent financial requirements than most other loans from private lenders. You might be the ideal candidate for an FHA loan if you have high debt or a lower credit score. Getting an FHA loan can even be possible if you have a bankruptcy or other financial issue on your record.
Note that the government does not finance FHA loans. Instead, approved third-party mortgage lenders underwrite these loans. The government agency simply insures them against default or loss. This government backing helps lenders feel confident extending mortgages to more at-risk borrowers.
Loan Limits & Interest Rates for FHA Home Loans
FHA loans are designed with flexible underwriting but are restricted to 15-year and 30-year fixed-rate terms.
The maximum FHA loan limits are determined by where the home you want to buy is located. High-cost areas like large metropolitan areas, Alaska, and Hawaii had a maximum limit of $1,089,300 in 2023 for single-family homes. Lower-cost regions may be limited to $472,030. The HUD must change its maximum limit each year to reflect the economic conditions of that time and the loan limits set for the conventional mortgages guaranteed or owned by Fannie Mae or Freddie Mac. You can look up the FHA Mortgage limits for the MSA you’re looking at with the HUD tool.
FHA loans have a minimum down payment requirement of 3.5%, but if your credit score is lower than 580, you may be required to supply a 10% down payment.
Besides location, the maximum loan amount for a specific borrower is determined by the down payment size, the borrower’s credit score, and other factors. For example, borrowers with a down payment amount of 10% or more will have higher loan limits than those with low down payments under 10% of the purchase price.
The interest rate for an FHA loan is often more competitive than a conventional loan because it’s a government-backed loan. Lenders feel the loan package is less risky because they know any potential loss will be covered.
The current mortgage rates depend on a kaleidoscope of economic and borrower factors. The lower the down payment or credit score, the higher the interest rate may be. On February 9, 2023, Bankrate found that the national 30-year fixed-rate FHA loan had an average interest rate of 6.76%.
Mortgage Insurance Is Required
One way these differ from conventional loans is in the FHA mortgage insurance requirement. This requirement exists to protect the agency from loss or foreclosure. Every loan will have a mortgage insurance premium (MIP) rolled into the loan that you pay for the life of the loan. However, if you put down at least 10%, the MIP is owed for the first 11 years.
The MIP premium comes in two parts. The upfront mortgage insurance premium is 1.75% of the loan amount, due on closing. This amount can be rolled into your loan. Next, you’ll pay 0.45%-1.05% of the loan amount as an annual insurance premium. This is due each month you are in repayment, with the figure varying depending on the down payment you made and (if applicable) the mortgage loan terms. It can be rolled into your monthly mortgage payments.
Type of FHA Loans
The most common type of FHA home loans are purchase mortgages, where borrowers can finance up to 96.5% of the primary residence cost.
There are also various refinancing options and other less conventional types of FHA home loans that you can look into. For instance, the FHA Rate/Term Refinance allows you to switch from an adjustable-rate mortgage (ARM) to a fixed-rate one, take advantage of better interest rates, or change your debt term.
The FHA Streamline Refinance lets borrowers lower their monthly payments and mortgage insurance premiums if they are underwater on their home without a new downpayment or income verification.
A cash-out refinance allows FHA borrowers to pay off debts, improve their home’s value, or make a down payment.
For seniors aged 62 and over, the Home Equity Conversion Mortgage (HECM) is an FHA-backed reverse mortgage option. A HECM enables homeowners with high equity or those who fully own their home to access some of its value as cash. The amount you’ll receive depends on factors like borrower age, current interest rates, and the lower of either the appraised property value, sales price, or FHA limit.
The FHA 203(k) loan is a home improvement loan where you can buy and finance some eligible renovations concurrently. You can also use it on a home you currently own. The renovation costs are limited to a minimum of $5,000 and a maximum of $35,000. The home value plus repairs must fall under that area’s FHA loan maximum amount.
You can also explore other loan programs like the energy-efficient mortgage (EEM) program or the 245(a) loan/graduated payment mortgage.
Benefits of the FHA Home Loan
While you’ll hear about this program as an option for first-time homebuyers, it’s actually available to all home buyers, whether this is your second, third, or whatever number home. The generous flexibility in downpayment and loan terms make it easier for first-time home buyers and other buyers in high-demand markets to afford real estate. The goal is to move people with low credit scores or insufficient downpayment from renting to homeownership, so they can start building wealth through equity in real estate.
FHA lenders are bound by law to cap all closing costs at a maximum of 3-5% of the loan amount. Additionally, FHA allows up to 6% at closing to be rolled into the loan for covering various fees associated with real estate transfer, such as appraisal, credit report, or title search via sellers, builders, and lenders.
The FHA Loan Requirements
The eligibility requirements for an FHA loan are less stringent than other types of loans, but specific standards exist. For instance, the loan can only buy a primary residence. Investment or second homes are off-limits.
Down payment
You can put down as little as 3.5% when buying a primary residence with an FHA loan. The downpayment can be “gifted,” but the documentation must be clear that there is zero expectation of payback to family members or friends. Of course, you are welcome to put more down for your initial payment, giving you more favorable loan terms.
Credit score
An FHA loan’s minimum credit score requirement is usually a FICO score of around 500. However, many lenders require a higher score for approval. If your credit score is between 500 to 579, you may need a down payment of 10%, depending on the lender. Those with good credit are eligible for more favorable mortgage terms.
What credit score is required may also be impacted by your debt-to-income ratio (DTI) and the loan-to-value ratio.
When lenders pull your credit history, they check your credit utilization, payment history, and other factors to determine your creditworthiness.
Debt-to-Income Ratio
No income requirements exist, but your total income must meet a certain debt-to-income ratio (DTI) to qualify. Generally, your monthly back-end DTI, which rolls the mortgage payment with your current debts, should not exceed 43% of your total income.
Some lenders use the front-end DTI ratio. This is calculated by taking your total monthly debt payments (not including mortgage payments) and dividing it by your total gross income.
It’s a good idea to ask your potential lender which DTI ratio they will use to evaluate your loan application.
To qualify you for the loan and assess DTI, the lender will ask to verify your employment and income history. You must provide pay stubs, federal tax returns, and bank statements.
Home Inspection
The property must be inspected by an FHA-approved appraiser that shows it meets the minimum property standards set by the U.S. Department of Housing and Urban Development.
Move-in
Finally, you must move in within 60 days of your close date.
How to Apply for FHA Home Loans
To apply for an FHA loan, you must submit a complete mortgage application and go through the approval process.
First, you’ll need to find an FHA-approved lender. Institutional size doesn’t matter; large mortgage institutions provide FHA loans down to your local credit union. It’s okay to shop around, as the different lenders will have varying loan terms and requirements even under the FHA umbrella.
Once you’ve selected your lender, gather your documents. The lender will run a credit check and ask for proof of income. To get pre-approved, you’ll need the following:
- driver’s license
- two years of tax returns
- bank statements
- full statements of any assets, from retirement accounts to savings
- debt statements, such as credit cards, student loans, or auto loans
The lender will also determine if the loan meets the DTI requirement and other criteria put forward by FHA.
The lender will also evaluate your home’s appraisal and condition to ensure it meets the FHA minimum property standards.
How do FHA Loans Compare?
FHA loans are popular because they have a lower down payment requirement than conventional loans, allowing you to buy a home with less money down. These conventional mortgages often require from 3-20% down on 8-30-year terms.
FHA loans have more lenient credit requirements, and a lower debt-to-income ratio than standard mortgages, meaning borrowers with lower credit scores and/or higher debt levels may still qualify for an FHA loan. The credit score minimum on a conventional loan is usually closer to 620.
However, the mortgage insurance premiums (MIP) required for FHA loans are generally higher than for conventional loans, making them more expensive in the long run. If you put down less than 20% on a conventional loan, the lender requires private mortgage insurance (PMI). Refinancing could drop this when the borrower has achieved 20% equity in the home.
Overall, FHA loans can be an excellent option for people who need assistance with down payment money or who have lower credit scores and debt-to-income ratios that don’t meet traditional loan requirements. With down payments as low as 3.5%, an FHA loan may be the perfect way to get into your dream home!
However, it’s essential to consider all your options before making a decision, and it’s always wise to consult a financial professional in your area.
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