What is an FHA loan and how does it work?
The Federal Housing Administration (FHA) was created to make it easier for homebuyers to qualify for mortgage loans. The FHA does not issue any loans, they insure them in case a borrower defaults on their mortgage loan.
Because this added layer of protection, lenders lower their minimum requirements for getting a loan, making it easier for first time homebuyers and others with lower credit scores and smaller down payments.
FHA loans are a great alternative to conventional lending.
Who qualifies for an FHA loan
Anyone who wants to take out a mortgage or refinance an existing mortgage can use an FHA loan as long as they meet certain eligibility criteria. Highlights of those criteria include:
- Credit score of at least 500.
- Debt-to-income ratio of 43% or less.
- 3.5% down payment if your credit score is 580 or higher. By contrast, conventional loans may require as much as 20% down.
- 10% down payment if your credit score is 500-579.
- The house must be a primary residence and must meet the FHA’s minimum property requirements.
- Compliance with loan limits which vary by county. In 2019, that is generally $314,827 for single-family homes in low-cost areas and $726,525 in high-cost areas.
- The loan must be for a principal residence, and at least one borrower must occupy the property within 60 days of closing.
- It can’t be an investment property.
- An FHA appraisal includes a strict inspection, assessing a home not only on value but also on minimum property standards.
- The property can’t be a flip, meaning you can’t buy a house within 90 days of a prior sale.
- Have at least two established credit accounts such as a credit card and a car loan.
- Not have delinquent federal debt or judgments, tax-related or otherwise, or debt associated with past FHA-insured mortgages.
- You can buy a home with up to four living units.
- FHA loan rules prohibit loans for commercial enterprises and short-term occupancy rentals (i.e. VRBO or Air BnB). You can rent out unused living spaces in your home if your renters are long-term defined as 30 days or longer).
The good news is that there is no minimum or maximum salary you can earn that will qualify you for or prevent you from getting an FHA-insured mortgage.
Also, although the FHA insures the loan, it is the lender that makes the final decision whether to approve the loan. They have the final say in what specific qualifications are for each loan.
Debt-to-income ratio requirements for FHA loans
To protect borrowers from entering into a mortgage agreement they can’t afford, the FHA has put in place debt-to-income (DTI) ratio guidelines as part of the loan process. DTI measures the percentage of pretax income that you spend on monthly debt payments, including a mortgage, credit cards, student loans and other obligations.
These guidelines are used to determine if a borrower is in a financial position to afford the house they want to buy and own.
To qualify a borrower’s DTI ratio must be no greater than 31% for housing-related debt (known as front-end debt) and 43% of their overall debt (known as back-end debt). Part of this requirement also includes that the borrower(s) must have steady income and proof of employment.
But the back-end ratio can be as high as 50% for some borrowers, particularly those with good credit and other “compensating factors. Such as taking a loan on an energy efficient home, verified and documented cash reserves, residual income, or significant income not reflected in effective income.
What is PMI?
When a loan is insured through the FHA, loans are required to have mortgage insurance to protect lenders from defaults. PMI is short for private mortgage insurance. It is also sometimes referred to as MIP, or mortgage insurance premium.
PMI is not optional and is generally rolled into monthly house payments or is paid through an annual premium up front. It’s important to note that with monthly payments, there are some interest costs you’ll also have to pay as well.
You will be required to pay two kinds of PMI when using an FHA-insured mortgage. They are upfront mortgage insurance and annual mortgage insurance.
Upfront PMI is collected when you close your loan, or it is rolled into your loan amount. The upfront premium is 1.75% of your loan amount.
The annual premium is divided into 12 monthly payments and is included into your mortgage payment.
Depending on the terms and conditions of a loan, most will require PMI for either 11 years or for the lifetime of the mortgage.
The amount of the PMI is determined by the size and length of the loan and the Loan-to-Value (LTV) of the property that you are buying.
Is PMI required?
For conventional loans, PMI is required if a borrower is putting down less than 20% of their home’s cost. This is based on calculations performed by lenders that indicate they will only be able to recover about 80% of a home’s value at a foreclosure auction if the homeowner defaults on their loan. PMI is simply protection for the lender to make up the difference.
However, with FHA loans, all mortgages are initially required to have PMI.
You may be able to get rid of your PMI if you got your FHA-insured mortgage between December 31, 2000 and July 3, 2013, and you have paid the LTV of the mortgage to 78% or less.
Under these circumstances, you may be able to contact your lender and ask them if you’re eligible to have your annual insurance premium removed.
If you received your FHA loan after July 3rd, 2013 and put
less than 10% as a down payment you will have to pay the MIP for the life of
FHA loan down payment requirements
The amount of down payment required for an FHA loan will vary depending on basic minimum credit standards.
You must have a minimum credit score of at least 500 to be eligible for an FHA mortgage.
If your credit score is less than 580, you’ll be required to put down 10% of the purchase price.
If your credit score is 580 or above, you will only be required to put down a minimum of 3.5% of the purchase price.
As you can see, the better your credit history is, the more flexibility you’ll have when it comes to making a down payment. Potential borrowers who have kept their credit in top form will have the easiest time when it comes to successfully getting an FHA mortgage.
Borrowers can get help with the down payment but FHA loan rules not only regulate the source of funds, it also governs who may provide such gifts.
Be prepared to provide supporting documentation for the source of any financial gift which may be provided by:
- Borrower’s employer or labor union
- A close friend with a clearly defined and documented interest in the borrower.
- A charitable organization.
- A governmental agency or public entity with a program providing homeownership assistance to low- or moderate-income families or first-time homebuyers.
If you don’t meet FHA requirements
The FHA considers a lot of different factors related to income and debt. Sometimes, when applicants don’t meet requirements, borrowers may perform a manual underwriting process. This simply means they may still consider your loan application, but they will review it more closely before making a final decision.