First-time buyers and those with sketchy credit are the ones who should be asking, ‘What is an FHA loan?’
You’re a few years out of college, you’ve started a family and you’re trying to figure out how to come up with a mortgage down payment, traditionally 20%.
Or you’ve had some tough financial times in the past and your credit score took a hit, and you despair of ever owning a home.
This is when you should ask, “What is an FHA loan?” This loan program from the Federal Housing Administration is made for you: Intended to stimulate the housing industry, the program allows down payments of 3.5% and credit scores as low as 500.
The FHA itself doesn’t provide the loan, but instead works through approved lenders, and insures the loans to entice lenders to work with lower-income or less credit-worthy buyers. It was first established in the 1930s during the Great Depression when hundreds of thousands of people lost their homes due to foreclosures and defaults.
What’s an FHA loan and what’s the catch?
As with everything, of course, there are catches – several of them. So if you’re thinking that an FHA loan might be just the thing for you, be sure to understand the drawbacks.
First, the interest rate on an FHA loan, because of the lower down payment, will be higher than on a conventional mortgage. And the worse your credit score, while still qualifying you for an FHA loan, the higher the interest rate will go.
Basic requirements for an FHA loan:
- You must have a valid Social Security number and lawful residency in the U.S., and be of legal age to sign a mortgage in your state.
- You must have a steady employment history or worked for the same employer for the past two years
- If you’ve declared bankruptcy in the past, you much be two years out of it and have re-established good credit, with some exceptions allowable.
- If a property you owned previously went into foreclosure, you must be three years out of that, and have re-established good credit, with some exceptions allowable.
- The property must meet certain minimum standards at appraisal. Either the buyer or seller may pay for required repairs.
In addition, you can only use an FHA loan for a property that will be your primary residence – this isn’t something you can leverage to buy investment property. As LegalKnowledge, an Expert on JustAnswer explained to a customer who realized she couldn’t afford to live in an “impetuous” home purchase:
“When you closed on the home and took out the loan, they likely had you sign a disclosure that said you would reside there for a period of time, use it as your primary residence and agree to not rent it out.”
A primary residence is the address on your driver’s license and where your bills are sent, the Expert noted.
Another “catch” stems from something intended as a benefit. Your down payment can come from a gift from a family member – such as a parent – unlike many conventional mortgages.
However, it’s the Wild West out there among FHA-approved lenders and their underwriters, and it can be agonizing to get the form of that gift approved, because the FHA won’t approved loans based on down payments that come from non-collateralized sources such as credit card cash advances, payday loans and the like.
Wrote one customer to JustAnswer, “The underwriter is very specific in that this 'gift' [to my daughter] should not come from untraceable funds.
“I put $4,000 cash into my personal account and wrote her a check. This was not acceptable. I talked to the underwriter personally. She said I could get a cashier's check from my business account and have it deposited into her account.
“I specifically asked her over and over again if that would be acceptable. She said yes, as long as I had the past 30 days bank statements signed and stamped by the teller.
“All these things I did exactly as she told me to do. A day later, she says a gift from my business account is not acceptable. I am losing my mind here trying to figure out what will be acceptable!”
It’s easy to imagine the frustration this customer was experiencing. The Expert who responded to this parent, Attyadvisor, was quite sympathetic, and offered the ultimate hack:
“After 28 years of dealing with the fictitious and ever-changing rules provided by lenders and underwriters, I found the one way to actually get a loan approved when the requirements mysteriously change.
“I contact HUD directly and speak to an FHA advisor. Telephone: (800) CALL-FHA (225-5342).
“The lenders and underwriters play games that impact people’s lives.”
While Attyadvisor cited regulations regarding who may and may not give gifts that qualify as FHA loan down payments, there’s no easy way to access or understand these regulations at the FHA website, or at the website for the department of Housing and Urban Development (HUD), the parent agency to the FHA.
Your best resource for finding these regulations is at a website that translates them into laymen’s language, such as FHAhandbook.com.
What’s an FHA loan, and what’s debt-to-income ratio?
Debt-to-income ratio (DTI) plays a major part in an FHA lender’s decision to give you a mortgage. DTI is the percentage of monthly income you spend on debt payments.
FHA guidelines consider two separate DTIs. First is the “front-end” ratio, which includes your anticipated monthly mortgage payment plus other monthly costs of homeownership such as homeowner association (HOA) fees, property taxes, mortgage insurance and homeowner’s insurance. The FHA limits this DTI to 31%, though some lenders might allow a bit of wiggle room.
Then there’s the “back-end” ratio, which includes all your other expenses, such as credit card debt, car payments, child support, student loans and so on. The FHA limit for this is 43%.
With many first-time homebuyers, student loans can be a problem. When calculating DTI, a lender will count your either your actual student loan payment, or 2% of a projected payment if your student loan is currently deferred.
Oh, and that mortgage insurance mentioned just above? That’s another FHA loan “catch.” Because such loans are riskier for lenders than conventional loans, you’ll pay two kinds of mortgage insurance:
- Upfront mortgage insurance premium (UFMIP) is a one-time upfront monthly premium payment of 1.75% of the loan amount. This can be paid upfront or it can be included in the mortgage.
- Annual MIP is actually a monthly payment that will be figured into your mortgage payment. It’s based on your loan-to-value (LTV) ratio, loan size, and length of loan. It ranges from 0.8% to 0.95% of the value of the loan.
Unlike conventional loans, FHA loan insurance cannot be canceled once you’ve paid in a larger percentage of the loan.
What’s an FHA loan, and how do I get one?
Only brokers who have been approved by the FHA can offer FHA loans, and not every lender takes part in the program. One JustAnswer customer was doing his due diligence when he asked, “I’m looking for an FHA loan to reduce my down payment. What are the steps I should take? Should I go through a broker? Agent?”
LegalKnowledge outlined the best practices for seeking an FHA loan.
- Start by finding a mortgage broker who handles FHA loans. You can start with this tool from HUD to find FHA-approved brokers.
- Speak with a few brokers, ask about their fees and decide which one you feel the most comfortable with.
- Have your broker pre-approve you for a mortgage so you know what price range to look in when house-hunting.
- Find a realtor to help you locate and find properties in your desired area and price range, and whose sellers accept FHA financing. If you find a real estate agent you like first, he or she might be able to recommend a good broker they’ve worked with before.
- If you see a home you like that’s for sale, you can contact the listing agent and speak with them. They would likely be willing to represent you and the seller.
What is an FHA loan? It’s a program that might seem overly complicated, but conventional loans come with plenty of rules, too, so you should be prepared to jump through hoops no matter what you decide. And the best way to do that is to start getting your financial life in order.
As Expert LawTalk told a customer, “The mortgage loan application process is nothing but hurdles – but if you have a good paper trail of your finances over the last few years, including tax returns, it can go smoothly.”
And remember, millions of people go through the mortgage loan process every year, so it’s not a pipe dream for you. Do your research, even if you’ve had a mortgage in the past – because lending rules have changed frequently since the 2008 housing market crash – and you’ll be more likely to get that dream home, and a dream mortgage.
Have you gotten an FHA loan? Please share your experiences, good and bad, with us in the comments below.