Many potential home buyers have questions about the FHA loan and the process needed to secure a home mortgage. Some people are even confused about what is a myth and what is a fact about FHA loans. Listed below are the common FHA mortgage facts along with brief explanations.
FHA Mortgage Facts: Basics About The FHA Organization
Definition of FHA
FHA is an acronym that stands for Federal Housing Administration. The administration was founded by the United States Federal government in 1934.
The main purpose of FHA was to allow people with sufficient income to purchase a home without the need for a major down payment.
FHA Does Not Lend Directly to Borrowers
Many people work under the assumption that they will receive a loan directly from the FHA office. This is not true.
Instead, FHA provides rules about home loans. Lenders that are qualified to offer an FHA insured loan must follow all the rules set forth by FHA (some lenders will add their own mortgage overlays as well). This allows multiple lenders across the country to offer low down payment loans to qualified applicants.
FHA Insures the Mortgage Loans
When a lender offers a home loan according to the FHA guidelines, that loan is insured by the FHA. The insurance protects the lender in the event the borrower is not able to make all the payments and the home is foreclosed.
Source of FHA Insurance
In order for FHA to insure the loans, there must be a source of funds to pay to lenders in the event of a foreclosure. These funds come from Mortgage Insurance.
When a borrower is approved for an FHA mortgage, they are asked to pay an upfront mortgage insurance premium (UFMIP) as well as a monthly mortgage insurance premium. The current upfront amount is 1.75% of the loan amount. The upfront portion is typically financed into the overall mortgage amount to save borrowers from paying out of pocket.
The amount paid monthly is determined by the loan to value ratio.
FHA Mortgage Facts: Understanding FHA Loans
FHA Offers Different Types of Loans
FHA will allow borrowers a variety of loans. Fixed loans ranging from 10 years to 30 years are the most common type of mortgage.
Borrowers may also choose an adjustable rate option. This means that the interest rate on the loan will be fixed for a certain time, such as 1 year, 3 years, or 5 years. After the fixed period ends, the rate on the loan may go up or down each year depending on a market benchmark.
FHA loans do not require a penalty if a borrower pays the mortgage off early. In addition, it is possible for a borrower to sell their home to another qualified borrower and allow the 2nd borrower to assume the existing mortgage.
Rates for an FHA Loan
The prevailing rates for FHA loans are often equal or sometimes lower than rates for a conforming home loan. Mortgage lenders that have access to both types of loans can provide you with a side by side comparison.
FHA Loans are Designed for Owner Occupied Property
As mentioned earlier, the intent of the FHA program was to provide home ownership to people with a steady source of income. Therefore, people are not allowed to use the FHA program to purchase a rental property.
People that have an FHA mortgage are required to move to the home no later than 60 days after they sign all of the loan closing documents.
FHA Mortgage Facts: Primary FHA Loan Requirements
In order to qualify for the FHA mortgage, borrowers will need to meet a few basic requirements
- Average credit score
- Steady source of income
- Debt to Income ratios within accepted limits
- Down payment of 3.5% of the home’s purchase price
Each of the above items is explained in more depth below.
Average Credit Score
As the term implies, borrowers that are approved for an FHA loan only need to have an average credit score. In fact, people that have scores too low for a conventional mortgage often qualify for an FHA loan.
Steady Source of Income
A person needs to demonstrate that they have either worked at the same place or the same line of work for at least 2 years (exceptions to 2 years can be made). This will be proven by W-2 forms and regular paystubs.
For self-employed individuals, annual personal tax returns, as well as business tax returns, will be needed to document their income.
Debt to Income Ratios
The FHA guideline examines a borrower’s income in 2 ways. First, the anticipated new mortgage is compared to the borrower’s income. This is sometimes called a front-end ratio. This number should not be above 31%.
Secondly, all of the borrower’s existing debt payment, along with the new mortgage payment, are compared to the borrower’s income. This is sometimes called a back-end ratio. This number should not be above 43%.
The following chart provides an example for illustrative purposes.
|Existing monthly obligation
|| $ 65
|| $ 346
|student loan bill
|| $ 295
|Total monthly obligations
|| $ 706
|Borrower #1 income
|| $ 1,854
|Borrower #2 income
|| $ 2,138
|Total Monthly Income
|| $ 3,992
|Proposed mortgage payment
|| $ 1,011
|Front End Ratio
||(mortgage payment divided by monthly income)
|Back End Ratio
||(mortgage payment plus monthly obligations divided by monthly income)
As you can see, these borrowers meet both the front-end ratio and back-end ratio guidelines. It is important to discuss these figures with your lender. This calculation will allow you to determine the maximum home payment you can qualify for which will allow the lender to calculate the price range of your next home.
The FHA guidelines state that a qualified borrower must pay 3.5% of the home’s sales price up front as a down payment. The money needs to come from a documented source such as a savings account, certificate of deposit, money market account or retirement account.
For example, if a borrower has a certificate of deposit valued at $10,000 and they are considering the purchase of a home priced at $205,000 then the borrower would need to pay $7,175 up front as a down payment.
The down payment money may also be a gift from a relative. The money will still need to come from a documented source and there will need to be a paper trail that explains how the money was donated from the family member to the borrower. But getting a gift from a relative allows a borrower to buy a home with a very small amount of out-of-pocket money.
FHA Mortgage Facts: Special Features of FHA Loans
FHA allows a couple of special features that are not common among most other types of home loans. This allows more people to qualify and increase the chance of home ownership.
There are times when a young person, or even a young couple, may have the need to buy a home but either their income or their credit scores are on the fringe of the FHA guidelines, preventing them from approval. In these instances, FHA will allow a non-occupying co-signer.
The co-signer will be subjected to the same qualification process as the borrowers. They will need to meet the credit requirements, income and debt to ratio guidelines as mentioned previously. But, the co-signer does not have to live in the new home as their primary residence.
Essentially this allows a parent, or grandparent, to use their strong income and strong credit to help one of their children (or grandchildren) in the process of buying a home.
FHA will allow the seller of a home to pay the closing costs from the proceeds of the sale. A maximum of 6% of the sales price can be used to cover the prepaid items, closing items and the mortgage insurance.
Often times this is enough to cover the vast majority of the closing items. However, this is not a requirement of an FHA loan, it is merely allowed. A borrower will need to discuss this option with their real estate agent and negotiate this as part of the contract to purchase a home.
FHA Loans for Condos
It is possible to use an FHA loan to purchase a condo unit. However, the entire condo project must be first approved by HUD, the regulator of FHA.
HUD will look over the condo project’s budget, along with the mix of residential units to commercial units, legal papers, and the occupancy mix to determine if the project meets the guidelines. Some projects have been previously approved and will not have any problem with an FHA loan. However, new projects may not have submitted their documents for FHA approval yet. The process can likely take a few weeks and this could impact the home contract.
FHA Mortgage Facts: Unique FHA Loans
Along with all the facts mentioned above about FHA mortgages, there are 2 specific types of FHA loans that can aid a wide number of people. One type can aid in home repair or home improvement and the other can help senior citizens.
FHA 203k Loan
The FHA 203k loan will allow borrowers to get money to make home repairs or home improvements. This is ideal for people that find a home in a great location but wish to make some changes to the property before moving in.
The 203k loan is subject to the same guidelines as mentioned above regarding credit score, debt ratios, income and down payment. But the 203k program allows borrowers to receive money above and beyond the sales price. The extra money is used for things like:
- Repairing or replacing the heating & air conditioning unit
- Repairing or replacing the flooring
- Repairing or replacing the roof
- Adding energy efficient windows and doors
- Remodel the kitchen
- Add a room
- Improve the plumbing
- Modernize the electrical system
The program allows borrowers to receive the extra funds needed for the repairs and improvements and combine it with the purchase loan. This means that the borrower will pay only one interest rate and one mortgage rate on both the purchase and the improvement. This can save the borrower lots of money thanks to the lower interest rate for a home purchase loan compared to a 2nd mortgage or a home equity line.
The 203k program is vast and there is too much information to try and cover all of it in this article. But it is a good piece of information to keep handy for people looking at homes and thinking that they won’t have enough funds to cover any type of repair once they have purchased a home.
People that are at least 62 years of age can tap into their home’s equity and use the funds in their golden years. The official name of the program is the FHA Home Equity Conversion mortgage, but most people refer to the loan as a reverse mortgage.
As long as the borrower has an extremely small existing mortgage or no mortgage, they will likely be qualified for the loan.
Borrowers will also need to complete a financial assessment, according to FHA rules.
The idea of the reverse mortgage is that the homeowner will receive a monthly check for a pre-determined number of years. This money can be used for medical bills, debt payment or anything else that the borrower deems necessary.
So long as the borrower lives in the home as their primary residence, they will not be required to repay the loan. The loan must be repaid when the borrower moves out or passes away.
This program has been a benefit to many senior citizens that have retired and realized their retirement income was not quite enough to meet all of their needs.
Summing Up FHA Mortgage Facts
For many years the FHA program has been a great way for people to obtain a home of their own. Initially, the low down payment option attracted many borrowers. But as time has marched on and FHA has made adjustments to the loan, more people have been able to take advantage of this great program and carve out their slice of the world.