FHA loans 101
First-time home buyers, this loan type may be for you. Your down payment can be as low as 3.5%.
An FHA loan is a mortgage that’s insured by the Federal Housing Administration (FHA). They are especially popular among first-time home buyers because they allow low down payments. However, borrowers must pay mortgage insurance premiums, which protects the lender if a borrower defaults.
The FHA program was created in response to the rash of foreclosures and defaults that happened in the 1930s; to provide mortgage lenders with adequate insurance; and to help stimulate the housing market by making loans accessible and affordable for people with less than stellar credit or a low down payment. Essentially, the federal government insures loans for FHA-approved lenders in order to reduce their risk of loss if a borrower defaults on their mortgage payments.
FHA loan requirements
FHA loans generally allow down payments of 3.5% for borrowers with FICO credit scores of 580 or more; with a score of 500-579, a 10% down payment is required. Each lender sets their own credit requirements, however. Regardless, it's important to remember that the lower the credit score, the higher the interest rate you’ll probably qualify for.
The minimum credit score and down payment amounts are just two of the requirements of FHA loans. Here’s a complete list of FHA loan requirements, which are set by the Federal Housing Authority:
- Borrowers must have a steady employment history or have worked for the same employer for the past two years.
- Borrowers must have a valid Social Security number, lawful residency in the U.S., and be of legal age to sign a mortgage in your state.
- Borrowers must pay a minimum down payment of 3.5%. The money can be gifted by a family member.
- New FHA loans are only available for primary residence occupancy.
- Borrowers must have a property appraisal from a FHA-approved appraiser.
- Borrowers’ front-end ratio (mortgage payment plus HOA fees, property taxes, mortgage insurance, homeowners insurance) must be less than 31% of their gross income, typically. You may be able to get approved with as high a percentage as 40%. Your lender will be required to provide justification as to why they believe the mortgage presents an acceptable risk. The lender must include any compensating factors used for loan approval.
- Borrowers’ back-end ratio (mortgage plus all your monthly debt, i.e., credit card payment, car payment, student loans, etc.) must be less than 43% of their gross income, typically. You may be able to get approved with as high a percentage as 50%. Your lender will be required to provide justification as to why they believe the mortgage presents an acceptable risk. The lender must include any compensating factors used for loan approval.
- Borrowers must have a minimum credit score of 580 for maximum financing with a minimum down payment of 3.5%.
- Borrowers must have a minimum credit score of 500-579 for maximum LTV of 90% with a minimum down payment of 10%. FHA-qualified lenders will use a case-by-case basis to determine an applicants’ credit worthiness.
- Typically, borrowers must be two years out of bankruptcy and have re-established good credit. Exceptions can be made if you are out of bankruptcy for more than one year if there were extenuating circumstances beyond your control that caused the bankruptcy and you’ve managed your money in a responsible manner.
- Typically, borrowers must be three years out of foreclosure and have re-established good credit. Exceptions can be made if there were extenuating circumstances and you’ve improved your credit. If you were unable to sell your home because you had to move to a new area, this does not qualify as an exception to the three-year foreclosure guideline.
- The property must meet certain minimum standards at appraisal. If the home you are purchasing does not meet these standards and a seller will not agree to the required repairs, your only option is to pay for the required repairs at closing (to be held in escrow until the repairs are complete).
Remember that each lender sets their own minimum standards, which may be more stringent than minimum FHA guidelines. Your lender can discuss your unique circumstances with you and flag any potential issues.
Benefits of FHA loans
An FHA loan is usually one of the easier types of mortgage loans to qualify for because it requires a low down payment and you can have less-than-perfect credit.
Another advantage of an FHA loan: It's an assumable mortgage, which means if you want to sell your home, the buyer can “assume” the loan you have. People who have low or bad credit, have undergone a bankruptcy, or have been foreclosed on may be able to still qualify for an FHA loan.
Mortgage insurance is required for FHA loans
Because an FHA loan doesn't have the strict standards of a conventional loan, it requires two kinds of mortgage insurance premiums: one is paid in full upfront or financed into the mortgage, and the other is a monthly payment. Also, FHA loans require that the house meet certain conditions and must be appraised by an FHA-approved appraiser.
Upfront mortgage insurance premium (UFMIP) — Appropriately named, this is a one-time upfront monthly premium payment, which means borrowers will pay a premium of 1.75% of the home loan, regardless of their credit score. This sum can be paid upfront at closing as part of the settlement charges or can be rolled into the mortgage.
Annual MIP (charged monthly) — Called an annual premium, this is actually a monthly charge that will be figured into your mortgage payment. The amount of the mortgage insurance premium is a percentage of the loan amount, based on the borrower’s loan-to-value (LTV) ratio, loan size, and length of loan:
| <strong>Loan term</strong> | <strong>Loan amount</strong> | <strong>LTV ratio</strong> | <strong>Annual insurance premium</strong> |
|---|---|---|---|
| Over 15 years | $625,000 or less | 95% or less | 0.80% |
| Over 15 years | $625,000 or less | Over 95% | 0.85% |
| Over 15 years | Over $625,000 | 95% or less | 1% |
| Over 15 years | Over $625,000 | Over 95% | 1.05% |
| 15 years or less | $625,000 or less | 90% or less | 0.45% |
| 15 years or less | $625,000 or less | Over 90% | 0.70% |
| 15 years or less | Over $625,000 | 90% or less | 0.70% |
| 15 years or less | Over $625,000 | Over 90% | 0.95% |
For example, the annual premium on a $300,000 loan with term of 30 years and LTV less than 95% would be $2,400: $300,000 x 0.80% = $2,400. To figure out the monthly payment, divide $2,400 by 12 months = $200. So, the monthly insurance premium would be $200 per month.
How long do borrowers have to pay FHA mortgage insurance premiums?
The duration of your annual MIP will depend on the amortization term and LTV ratio on your loan origination date.
For loans with FHA case numbers assigned on or after June 3, 2013:
Borrowers will have to pay mortgage insurance for the entire loan term if the LTV is greater than 90% at the time the loan was originated. If your LTV was 90% or less, the borrower will pay mortgage insurance for the mortgage term or 11 years, whichever occurs first.
| <strong>Term</strong> | <b>Original down payment</b> | <strong>Duration</strong> |
|---|---|---|
| 15 years or less | less than 10% | Life of loan |
| 15 years or less | 10% or higher | 11 years |
| Over 15 years | less than 10% | Life of loan |
| Over 15 years | 10% or higher | 11 years |