Loans from the Federal Housing Administration (FHA) are popular options for
borrowers because they allow you to buy a home with a relatively small down
payment. Designed to promote home ownership, FHA loans make it easier for
people to qualify for a mortgage. But they are not for everybody, so it pays to
understand how they work and when they work best
What is an FHA Loan?
An FHA loan is a home loan that is insured by the FHA. In other words, the FHA offers a
guarantee to your bank: if you fail to repay the mortgage, FHA will step up and
repay the bank instead. Because of this guarantee, lenders are willing to make
large mortgage loans in cases when they may otherwise be unwilling to approve.
Why are they so attractive?
FHA loans are not perfect, but they are a great fit in some situations. The main appeal
is that they make it easy to buy property, but do not forget that those benefits always
come with tradeoffs. Here are some of the most attractive features:
Down payment: FHA loans allow you to buy a home with a down payment as small
as 3.5%. Other loan programs generally require a much larger down payment.
Other peoples’ money: it is easier to use gifts for down payment and closing costs. In addition,
sellers can pay up to 6% of the loan amount towards a buyer’s closing costs. You are most
likely to benefit from that in a buyer’s market, but those opportunities do come around from time to time.
Assumable: a buyer can “take over” your FHA loan if it is assumable. That means
they will pick up where you left off – benefiting from lower interest costs
(because you have already gone through the highest-interest years).
Depending whether or not rates have changed when you sell, the buyer may
enjoy a below market interest rate.
A chance to reset: If you have recently come out of bankruptcy or foreclosure, it is easier
to get an FHA loan than a loan that does not come with any government guarantee
(two or three years after financial hardship is enough to qualify with FHA).
Home improvement: certain FHA loans can be used to pay for home improvement
(through FHA 203k programs)
Qualification: It is easier to qualify for an FHA loan.
How do you qualify for an FHA Loan?
The FHA makes it relatively easy to qualify for a loan. Again, the government guarantees
the loan, so lenders are more willing to approve loans. However, lenders can (and do)
set standards that are stricter than FHA requirements. If you are having trouble with one
FHA approved lender, you might have better luck with another.
Note: you never know until you apply. Even if you think you will not qualify after reading
this page, talk with an FHA approved lender to find out for sure.
Income limits: there are none. You’ll need enough to show that you can repay the loan
(see below) but these loans are geared towards lower income borrowers. If you are fortunate
enough to have a high income, you are not disqualified like you might be with certain first time
home buyer programs. The FHA
Debt to income ratios: to qualify for an FHA loan, you will need to have reasonable debt
to income ratios. That means that the amount you spend on monthly payments needs to
be “reasonable” when compared to your monthly income. In general, you have to be
lower than 31% (mortgage payment divided by total income) /43% (total monthly dent payment divided by total income), but in some cases it’s possible to get approved with debt to income ratios as high as 55%.
Example: assume you earn $3,500 per month. To meet the requirements, it is best
to keep your monthly housing payments below $1,225 (because $1,225 is 31% of $3,500).
If you have other debts (such as credit card debt), all of your monthly payments combined
should be less than $1,505.
To figure out how much you might spend on a mortgage payment, use our online calculator.
Credit score: borrowers with low credit scores are more likely to get approved if they
apply for an FHA loan. Scores can go as low as 580 if you want to make a 3.5% down
payment. If you’re willing and able to make a larger down payment, your score can
potentially be lower still.
Loan amount: there are limits on how much you can borrow. In general, you are limited
to modest loan amounts relative to home prices in your area. To find the limits in your
region, visit HUD’s Website.
How do FHA Loans Work?
The FHA promises to pay lenders if a borrower defaults on an FHA loan. To fund this
obligation, the FHA charges borrowers a fee. Home buyers who use FHA loans pay an
upfront mortgage insurance premium (MIP) of 1.75%. They also pay a modest ongoing
fee with each monthly payment.
If a borrower defaults on an FHA loan, the FHA uses those collected insurance premiums
to compensate the bank.