(Jun 7, 2023)
The agency is designed to be self-sufficient, capable of funding its operations and generating enough profit not to place any additional burdens on taxpayers. Since it was instituted back in 1934, the agency has managed to run without taxpayer dollars, even in the aftermath of the 2008 financial crisis, which heavily impacted real estate markets.
In this piece, we'll be diving deep into the world of FHA loans, how to qualify for FHA loans and everything you need to know as a property owner, buyer, or seller.
Let's get right into it.
The Role of the FHA
Acting under the U.S. Department of Housing and Urban Development (HUD), the agency guarantees loans to Americans as long as they meet their stipulated guidelines. This means that when you take out an FHA loan, they essentially underwrite it so that the lender faces minimal liability if you default on your payments.
The agency has been responsible for making it possible for countless citizens who might otherwise have had difficulty securing financing from conventional lenders. People with low credit scores, flawed credit histories, modest incomes, first-time homeowners, minority borrowers, and so on have received loans that helped them achieve their homeownership aspirations.
Types of FHA Loans Available
There are various types of loans offered by the FHA, and most people will choose from among them depending on what their plans are and what they qualify for. They come with different requirements, conditions, and protocols, meaning that applicants need to pay close attention to the fine print when making their decision. These options are as follows:
Home Purchase Loans
The basic loan package offered by the FHA is the 203(b). The basic home loan program is a fixed-rate mortgage that typically runs for 30 years, although borrowers can opt for the 15 or 20-year loan programs, depending on their capabilities and the type of rates they wish to pay.
They also have a concurrent Adjustable Rate Mortgage (ARM) known as the Section 251 loan, divided into the 1-, 3-, 5-, 7-, and 10-year-old fixed-\categories, with the mortgage payment rates being adjusted every year afterward. With 1- and 3-year ARMs from the FHA, the rate will not change more than one percentage point each year over the loan's lifespan, with a cumulative upper limit of 5 percent each year. However, with the 5-, 7-, and 10-year options, borrower payments may adjust by 2 percent each year, with an upper limit of 6 percent in total.
They also have the Section 245(a) FHA Graduated Payment Loan, a mortgage plan for people who currently receive a modest income but have optimistic future earnings prospects. Such borrowers will often include young professionals at the outset of their careers. Loan payments for Section 245(a) loans are initially low but grow with time, meaning that applicants need to be confident of increasing their income as time passes. Down payments here can be as low as 3.5 percent of the property value.
Standard Refinance Loans
FHA refinancing loans are known as Section 203(b) loans and feature similar guidelines and rates as home purchase loans described above. You can access this loan with only 3.5 percent equity on the home, which falls just shy of the 3.5 percent down payment requirements when making a purchase.
Section 203(b) loan guidelines are more flexible than standard home purchase loans and are a good option for applicants who have non-FHA mortgages on their homes but lack home equity or have low credit scores. Borrowers may use this option to shorten their current mortgage terms, obtain lower rates, or convert from a fixed-rate mortgage to an ARM and vice versa.
In some cases, lenders will be willing to allow you to combine your closing costs with the loan payments for your refinancing, although you might prefer taking on higher loan repayments in exchange for a waiver of those costs.
Streamline Refinancing
This is one of the positive critical programs that make the FHA desirable to borrowers. This program allows you to get refinancing without going through the usual rigorous processes. As an applicant, you can get approved for the program if you are up-to-date on your payments, have not missed more than one payment within the past 12 months, and have not missed a payment in the past three months. There are no income verification, home appraisal, or credit check requirements.
This loan is available in 15- or 30-year modules, either on a fixed or adjustable-rate format, following the same protocols as standard refinancing rates. Should you hope to have your closing costs included in the loan package, you will need to appraise the property. You can also choose to pay higher rates and have them waived entirely. Note that there is no cash-out option here.
Cash-Out Refinancing
Another helpful program offered by the FHA is their cash-out refinancing option, where borrowers are allowed to borrow money against their home equity. If you have already completed a certain percentage of your mortgage or if your property has increased in value since you purchased it, you will be eligible for this program.
Consider, for example, a house worth $400,000 with the mortgage borrower still owing their lender $200,000. The owner here will have access to refinancing to pay off their remaining mortgage obligation, borrow another $100,000, and be left with a new $300,000 mortgage balance.
While the FHA guidelines allow applicants to borrow against 95 percent of their property value, few lenders will take this figure past 85 percent. Aside from these details, the mortgage rates, income requirements, and associated guidelines are similar to regular loan programs.
How to Qualify for FHA Loan
While FHA loans are significantly easier to qualify for compared to conventional mortgages, there are still certain conditions and requirements that they scrutinize when deciding whether or not to lend out money. These conditions help ensure that borrowers can pay back the loan amount. Note that the conditions listed below are the basic FHA standards; individual lenders have the freedom to tighten them where they see fit.
Credit Score Stipulations
On paper, FHA guidelines state that borrowers will be able to have their loan applications approved as long as they have a FICO credit score of no less than 500. The reality is that you will have difficulty finding a lender willing to give you a loan with a low credit score. The housing market crash of 2008 triggered the gradual falling of the minimum credit score lenders are willing to lend out to, with many of the more prominent players willing to go as low as 580, with some outfits going even lower still.
Down Payment Requirements
As most people know, FHA loans make it possible to purchase a home with a down payment of as little as 3.5% of the home's price tag. However, buyers might desire or be compelled to put down a higher amount in some scenarios. For example, many lenders will give you a better deal on your Mortgage Insurance Payments (MIP), a strong incentive for many borrowers seeking more favorable loan terms.
FHA mortgage insurance is mandatory if your down payment is less than 10% and carries on for the lifetime of the mortgage. FHA mortgage insurance is mandatory if your down payment is less than 10% and carries on for the lifetime of the mortgage.
If you make a down payment of 5% or more on a 30-year loan or put down 10% or more when taking out a 15-year loan, your premiums will be significantly reduced. To cancel it, your only recourse will be to refinance it into a conventional mortgage as soon as you attain 20% of your home's equity.
Debt-to-Income Ratio Standards
A person's debt-to-income ratio is a useful figure when determining whether they can take on more debt and pay it off successfully. This ratio calculates the borrower's income against their total debt burden. The ratio is expressed in percentages, and the FHA guidelines state that the maximum debt-to-income ratio for borrowers should be no more than 31:40. This means that one's monthly mortgage should be no more than 31 percent of your paycheck, while your total monthly debt burden (mortgage payments, credit cards, auto loan, student loan payments, etc.) does not exceed 41 percent of your monthly income.
There are, however, cases where exceptions are made, such as instances where large down payments are made, or the borrower has excellent credit, large cash reserves, or other factors that will allow them to take on additional debt comfortably. Note that bills such as cable fees, internet fees, gym memberships, utility bills, etc., do not count as part of the 43 percent limit, even though they are billed regularly.
The Property Appraisal Process
The FHA will need to make an appraisal of the property in question before approving any mortgage loans. The process will be somewhat similar to what happens when one applies for conventional loans, with the critical difference being that the FHA has its own appraisal agents.
Appraisals need to occur when applying for a mortgage and when seeking standard refinancing or reverse mortgages. Another advantage of dealing with the FHA is that they do not require appraisals for streamlined refinancing. It should be noted that appraisals are different from home inspections, which are only conducted to ensure that a house meets the minimum safety, livability, and sanitary standards.
Home Equity Loans
Conventional home equity loans can be put to any use the borrower wishes. There are, however, different types of loan programs that can be used for other purposes aside from home purchases, such as making home improvements backed by the borrower's home equity. They also offer seniors reverse mortgages. These loans include:
Home Improvement Loans
The FHA 203(k) Loan is designed to allow borrowers to take out a single loan that will enable them to buy a house and simultaneously make improvements and repairs. You will be able to borrow based on the home's price plus the cost of repairs or the projected property value once the upgrades and repairs are complete.
Even if the total cost is higher than the property's value, this can be done. This loan program may also be taken as a form of cash-out refinancing, although the funds will need to be directed towards home improvement.
The 203(k) comes in the streamlined and standard version, where the streamlined program is set up for more minor, non-structural improvements and repairs. The standard version is designed to facilitate more extensive projects such as new roofing, adding new rooms, structural repairs, or any jobs that cost more than $35,000 and have a minimum loan value of $5,000.
Title I Loans
FHA Title I loans are similar to 203(k) loans as they allow borrowers to get financing for home improvements without the need to refinance their mortgage completely. They come at a fixed repayment rate lasting as much as 20 years. Single-family homes have an upper loan limit of $25,000.
However, you cannot call these loans actual home equity loans since there are no home equity or collateral requirements for loans below $7,500. This type of loan is available to borrowers working on rental properties or manufactured (mobile) homes.
These loans are designed to help people improve the livability and utility of their residences, which might entail furnace installation, minor repairs, window installation, insulation fitting, exterior finishing, etc. 'Luxury' improvements, such as swimming pools or hot tub installations, are not included under this umbrella. You should ask your lender what is and what is not allowed here before embarking on the project.
Energy Efficiency Mortgages (EEMs)
EEMs are part of the FHA's efforts to improve our nation's environmental responsibility by encouraging energy-efficient additions to our homes. This particular financing program includes energy-efficient air conditioning, furnaces, windows, insulation, solar panels, etc.
To arrive at the amount a person can borrow, the cost of the property is added to the cost of the new additions, much like how 203(k) home improvement loans work. The Home Energy Rating System (HERS) is used by energy consultants to figure out an estimate of how much energy savings these fittings will bring to the home.
The upper limit on EEMs is taken as the lowest among the following costs:
- The price tag of the energy-saving improvements, inspection, and reports, or
5 percent of the lowest of the following:
- The value of the property
- 115 percent of the median local price for a single-family home in the applicant's location
- 150% of the Freddie Mac limit that applies to the property
Reverse Mortgages
To provide financial assistance to senior citizens, the FHA offers reverse mortgages to those who are 62 years old and above. These loans allow borrowers to take out loans against their home equity without requiring them to pay back the loan, just as long as they remain living in the house in question.
The intention is that the home loan will be paid off by selling the house once the occupants are gone, although a person's heirs may opt to pay off the loan out of their own pockets and retain ownership of the house. Utilities, property taxes, insurance, and other costs will still need to be paid by the inhabitant. This unique feature of this loan program makes it especially suitable for people on fixed incomes, as many elderly citizens are.
The most popular type of reverse mortgage loan offered is known as the HECM (Home Equity Conversion Mortgage). This loan comes in many forms. You may borrow as a solitary lump sum, select an annuity paying off for the length of your occupancy, or set up a credit line that you can draw on at your convenience. While the mortgage and insurance charges on the property will continue accumulating for the length of your occupancy, the mortgage will be paid off at no more than the house's value when it is vacated.
FHA Home Inspection Protocols
The overriding objective of the FHA is to facilitate the acquisition of safe, secure, and affordable housing for Americans. This is why an integral part of their loan proceedings is carrying out house inspections to assess their conditions.
Inspectors check common problem areas such as asbestos insulation, lead paint, soil contamination, leaky roofing, excessive moisture (black mold risk), indicators of decay, etc. In n cases where such red flags are found and fail to be rectified, the FHA reserves the right to reject loan applications for the said properties.
County Limitations on FHA Loan Limits
While the FHA is a federal agency overseeing the entire country, individual counties have the leeway to set their lending limits according to their particular circumstances. These limits are usually determined by the property values in their areas, with cities and coastal regions being accorded higher lending limits. However, in most parts of the United States, the FHA sets an upper limit of $271,050 when single-family homes are in question, although some areas push this limit up to as high as $625,500.
Understanding FHA Mortgage Insurance
Mortgage insurance is mandatory on all FHA loans. Borrowers will have to pay an upfront premium (MIP) when the sale is finalized, and an annual premium tacked onto their monthly mortgage payments.
Typically, the upfront MIP is pegged at 1.75%, while the annual premium rate will vary depending on the size of your down payment and the size and duration of your mortgage engagement.
FHA Vacation Home Loan Guidelines
While FHA loans can't be used to buy vacation or second homes, it's possible to make such a purchase if you plan to relocate to another primary residence outside your commuting range from your current residence. This provision is designed to allow people to buy new properties without refinancing or selling their existing properties. This can be done even though they have outstanding mortgage balances on their current homes.
Pros of Taking Out FHA Loans
FHA loans come with a variety of advantages to loan applicants. These advantages are the reason for their popularity among borrowers and give us good reasons to consider them when seeking mortgage financing.
Low Minimum Credit Score
A person's credit score plays a vital role in having their loan applications approved by financial institutions, whatever the intended purpose for the money may be. Low credit scores make it almost impossible for many people to access conventional mortgage financing. The FHA helps people facing challenges connected to their credit score by offering mortgages to people with scores as low as 580 or 500 with a down payment of 3.5 % or 10%, respectively.
Their policy makes it possible for underwriters to confidently approve loans to people whose credit scores were brought down through no fault of their own, those who have made solid efforts to re-establish healthy credit scores, and those who might have low credit scores but have established a good credit track record.
Low Down Payments
One of the biggest obstacles standing in the way of potential homeowners is the down payment required before a purchase can be completed. The FHA helps people out in this area by offering them loans while requiring down payments that reach as little as 3.5 percent. This minimum percentage may be sourced from the borrower's pocket or a gift/loan from an acceptable source.
Flexibility for Underwriters
The task of an underwriter is to figure out whether or not a loan applicant has a pattern of credit misuse or if their lapses come with valid reasons behind them. The FHA policy allows its underwriters to be more flexible regarding this duty than conventional financial institutions.
In many instances, a borrower who has demonstrated an effort to maintain responsible payment habits will be treated with more leniency when their application is being considered. In addition to this, FHA loan guidelines allow for higher debt-to-income ratios for their clients than most conventional programs do.
Streamlined Refinance Options
In these tumultuous times, financial ups and downs are a reality for many. One of the ways homeowners can try to strengthen their financial position after their incomes, credit scores, or property values fall is through refinancing. The FHA has a streamlined refinance program that allows homeowners to convert their mortgages into a loan with better terms.
Chapter 13 Bankruptcy
In most instances, conventional lenders will require that borrowers wait for several years after discharging their bankruptcy before becoming eligible again for a loan. In the case of Chapter 7 bankruptcy filings, this makes some sense since they pay out the debt at once. Chapter 13 bankruptcy cases, where people spend up to 5 years paying back their creditors, hinder potential borrowers.
The FHA seeks to bridge this gap by offering loan options to people who have filed for Chapter 13 bankruptcy as long as they can show that they have made at least 12 monthly payments on time. Their loan application may be approved if their bankruptcy trustees do not object to it.
Chapter 7 Bankruptcy
Most mortgage programs hold that borrowers who have filed for Chapter 7 or Chapter 11 bankruptcies wait for anywhere between 2 to 4 years before they qualify for financing once again.
FHA mortgages cut the waiting period down to half, especially in cases where the borrower can demonstrate the presence of extenuating circumstances such as the passing of a wage earner or the loss of a job. As long as the applicants have shown an effort to re-establish a healthy credit score, they will be eligible for a home mortgage.
Assumability
When a homeowner who purchased their home through an FHA loan wishes to sell it to another person, FHA loan policies allow the new owner to take over the mortgage repayments owed by the first owner. This feature can result in thousands of dollars in savings on the closing cost of the transaction for the new buyer.
The buyer may enjoy much lower interest rates than they would have to pay on a new mortgage, and sellers might sell their homes faster than they otherwise might have been able to.
Cons of Taking Out FHA Loans
While there might be plenty of advantages to FHA loans, they may not be a perfect fit for everyone. There are downsides as well. When choosing between conventional and FHA loans, these negative factors are important to consider.
Usage Restrictions
The FHA loans have restrictions regarding what borrowers are allowed to purchase, which do not exist with conventional loans. You cannot, for example, use FHA loans to buy investment properties or second homes.
The logic behind these restrictions is to ensure the purpose of the FHA - to make it possible for lower to middle-income earners to own their own homes rather than help the already wealthy accumulate more.
Mortgage Insurance Expenses
The premium payments that borrowers have to pay when they have FHA loans are relatively higher than those that come with conventional loans. These Mortgage Insurance Premiums (MIP) are charged alongside the annual premium, which is usually 8.5% of the mortgage balance yet to be paid. The MIPs are pegged at 1.75% of the loan's total amount, which can be added to the mortgage or paid in cash and last for the loan's lifetime.
Loan Limits
FHA loans exist to make it possible for people with modest incomes to own their own homes. They are not there to help wealthy people buy more mansions, so there are limits to their loan sizes. Different states have different loan limits depending on their particular policies.
FHA Appraisal Process
To attain financing eligibility, any home up for financing by the FHA must meet certain livability and safety standards. These appraisals are similar to home inspections, but these have to be carried out by qualified FHA appraisers. These appraisers cost more than standard home inspections, and the FHA insists on having these carried out by their officers.
Paperwork Volume
The application process for FHA loans is somewhat more complicated than where conventional loans are concerned. Various documents and forms need to be signed and filled out, lengthening the application process. These documents are designed to protect the loan applicant, making them worth the extra steps. The FHA Amendatory Clause, for example, alters the purchase contract so that the buyer has the option to cancel the proposed purchase if the house fails to meet the expected standards after the appraisal is done.
Condominium Restrictions
There are restrictions on the types of projects that the FHA may approve. The reality, in most instances, is that an extensive application has to be submitted to the HUD by the Homeowner's Association (HOA) or relevant body before approval is secured for a project.
The FHA will make an exception for a single-unit project within a non-approved development if the project funding from the FHA does not exceed 10% of the total project cost.
Credit Alert Interactive Voice Response System (CAIVRS)
CAIVRS is a federal database that all lending institutions check against before approving government-backed loans. The system is a register of all people that owe money to the government. These might include people with federal liens on their property, court-mandated to pay the government, and those who have defaulted on any other government-backed loans.
While this might not be an issue for most borrowers, people with their name in the CAIVRS system are not eligible for a loan unless they establish a viable repayment plan or have the agency that listed their name delete the entry.
Alternatives to FHA Mortgage Loans
While many people will tell you that FHA loans are the best option for prospective buyers, the reality is that they will vary depending on your circumstances, market conditions, loan amount, and location. No matter how homes a borrower owns, FHA loans will be a good option if they have small down payments available to them.
People with substantial down payments (approximately 10 percent) might be better off taking conventional loans. Below are some of the options available to borrowers who think FHA loans might not be their most beneficial financing solution:
Conventional 3-Percent Down Loans
Freddie Mac and Fannie May, the biggest mortgage lenders in the country, offer borrowers mortgage loans requiring only a 3 percent down payment. These are available to first-time homebuyers as long as they meet their eligibility criteria. They can be obtained without upfront mortgage insurance payments and come with lower annual premiums.
Like FHA loans, you can also get flexible underwriting terms on these loans. In many cases, borrowers will be able to have their mortgage insurance payments halted once their mortgage balance drops below 80 percent of the home's value.
USDA & VA Home Loans
Other loan programs are running alongside what the FHA offers in the United States, geared towards helping people of various economic standings and demographics. The Veterans Association (VA) and the United States Department of Agriculture (USDA) are two of the most prominent agencies. The VA is set up to facilitate home financing without down payment requirements or mortgage insurance payments to veterans, service members, and their families where applicable.
The USDA is more attuned to the needs of borrowers in rural, agricultural regions of the country. Approximately half of United States citizens live in areas that make them eligible for USDA loans, which do not require down payments. They still require mortgage insurance payments, but they are lower than FHA loan payments.
Seller Financing
There are sellers in the U.S. real estate sector who are willing to provide financing to buyers hoping to purchase their properties. With this option, buyers will be able to circumvent fees and costs such as title insurance, loan fees, etc. Certain sellers will even be willing to overlook poor credit histories and modest incomes on the buyer's part. Even so, would-be buyers need to have appraisals conducted on seller-financed properties to avoid the possibility of overpaying on their purchase.
Final Thoughts
Homeownership lies at the heart of most people's aspirations and dreams for the future. For this reason, access to mortgage loans and financing plays a vital role in our society. The Federal Housing Administration has a proven track record of providing viable financing solutions for millions of American homeowners.
It continues to play a central role in the country's real estate industry. If you're interested in making a home purchase or renovating existing properties, they will be worth considering as a financing partner.
(Jun 7, 2023)
