WHAT IS AN FHA LOAN? YOUR GUIDE TO THIS KEY

PATH TO HOMEOWNERSHIP

by Third Party | Dec 5, 2022 | Mortgage Information, Real Estate Agent Tools

If you’re struggling to buy your first home, an FHA mortgage could save the day.

These loans, backed by the federal government, are designed to help would-be home buyers with low credit scores or who have trouble saving for big down payment. “An FHA loan can be a great way to get your foot in the door of homeownership,” says Will Foster, mortgage loan officer at First State Bank of St. Charles in St. Charles, Mo.

FHA loans’ flexibility comes at a cost, however, in the form of fees, which can add hundreds to your monthly bill. That means you may need to adjust your budget and consider refinancing to a conventional loan, once you’ve built equity in your home.

Read on to learn more about the ins and outs of FHA loans, including how they compare to conventional mortgages.

WHAT IS AN FHA MORTGAGE?

Created in the 1930s as part of the New Deal, FHA loans are designed specifically to help more Americans become homeowners. Also known as 203(b) Basic Home Mortgage Loans, they remain one the most popular loan products in the U.S., representing about 1 out of 7 mortgages, according to the National Association of Realtors.

While issued by private lenders, FHA loans are backed by the U.S. government. The government guarantee allows them to have more flexible borrowing requirements than conventional loans, such as those backed by Fannie Mae or Freddie Mac.

For instance, while a conventional loan requires you to put 20% down to get the best possible interest rate, with an FHA loan you can access decent rates with as little as 3.5% down. FHA loans also have relaxed requirements regarding credit scores, allowing borrowers with scores as low as 500 to qualify. While you don’t have to be a first-time home buyer to use an FHA loan, more than 8 in 10 home buyers who do are.

While FHA loans come with competitive interest rates that are often at or below market average, they come with extra costs you should budget for. That’s because of mortgage premiums, which you pay both upfront when you close on your home and annually as long as you keep your loans, that can add to your monthly bill. It may be possible to roll these fees into your FHA loan.

The upshot is that while FHA loans are a great way to get into your dream home, you might not want to stick with one forever. Rather, the idea is that you will use the FHA loan to build equity then, hopefully, refinance to a conventional mortgage.

FHA LOAN REQUIREMENTS

FHA loans are easier to qualify for than conventional loans, here is a list of requirements.

FHA CREDIT SCORE MINIMUMS

You don’t have to have perfect credit to get an FHA loan. Depending on the size of your down payment, the FHA loan credit score minimums are:

500, with 10% down
580, with as little as 3.5% down

These levels are official minimums, however. Most FHA borrowers have better credit. In 2021, the average credit score on FHA loans was 672, according to a 2021 Mutual Mortgage Insurance Fund report.

All the same, FHA loans are more forgiving than so-called conventional mortgages. The official minimum credit score for a conventional mortgage is 620, and borrowers’ median credit score in 2021 was 786, according to Federal Reserve Bank of New York data.

FHA DOWN PAYMENT MINIMUMS

FHA loans are designed for first time home buyers and don’t require the same down payment as a conventional loan.

3.5% down, a credit score 580 or above. This requires you to pay mortgage insurance premiums for the life of the loan.
10%, down, if your credit score is 500 to 580. You must pay mortgage insurance premiums for 11 years.
What Is an FHA Loan? Your Guide to This Key Path to Homeownership
Here’s what to know about requirements, limits and how FHA loans compare to conventional mortgages What Is an FHA Loan? Your Guide to This Key Path to Homeownership Here’s what to know about requirements, limits and how FHA loans compare to conventional mortgages

What Is an FHA Loan? Your Guide to This Key Path to

Homeownership

Here’s what to know about requirements, limits and how FHA loans compare to conventional mortgages

FHA loans are designed to help home buyers without a big down payment. PHOTO: iStockphotoDec. 3, 2022 7:01 am ET

By Rebecca SafierSHARE

If you’re struggling to buy your first home, an FHA mortgage could save the day.

Read on to learn more about the ins and outs of FHA loans, including how they compare to conventional mortgages.

What Is an FHA mortgage?

FHA loans vs conventional loans

Here’s how the two types of mortgage compare

LOAN TYPE	CONVENTIONAL	FHA
Minimum credit score	620	500
Minimum down payment	3% to 5%	3.5% for credit scores of 580 or higher; 10% for credit scores of 500 to 579
Maximum debt-to-income ratio	43%	50%, depending on your credit score
Repayment terms	8 to 30 years	15 or 30 years
Mortgage insurance premiums	PMI of 0.58% to 1.86% of loan amount if down payment is less than 20%. Can be eliminated once you’ve built up enough equity.	Upfront premium: 1.75% of loan amount; annual premiums: 0.45% to 1.05%. Lasts for 11 years or life of loan, depending on your down payment amount.
Interest type	Fixed or adjustable-rate	Fixed or adjustable-rate
Who backs the loan	Fannie Mae or Freddie Mac might purchase the loan	Federal Housing Administration

FHA loan requirements

FHA loans are easier to qualify for than conventional loans, here is a list of requirements.

FHA credit score minimums

You don’t have to have perfect credit to get an FHA loan. Depending on the size of your down payment, the FHA loan credit score minimums are:

500, with 10% down
580, with as little as 3.5% down

These levels are official minimums, however. Most FHA borrowers have better credit. In 2021, the average credit score on FHA loans was 672, according to a 2021 Mutual Mortgage Insurance Fund report.

FHA down payment minimums

FHA loans are designed for first time home buyers and don’t require the same down payment as a conventional loan.

3.5% down, a credit score 580 or above. This requires you to pay mortgage insurance premiums for the life of the loan.
10%, down, if your credit score is 500 to 580. You must pay mortgage insurance premiums for 11 years.

The low down payment option makes FHA loans a potentially attractive option for young home buyers—58% of home buyers between the ages of 23 and 31 put down 10% or less, according to the National Association of Realtors. The median down payment was 8%. (It’s 13% for all home buyers.)

FHA loan limits

FHA loans come with limits, but there’s no standard amount across the country. Instead, the limits vary by county and are adjusted on an annual basis. In 2022, the maximum FHA loan amount you could borrow ranged from $420,680 all the way up to $970,800 in high-cost counties. The value of the home can be higher, but you can’t get a larger loan once you’ve maxed out the limit.

The FHA makes additional exceptions for certain unusually high cost-of-living areas, including Alaska, Hawaii, Guam and the Virgin Islands. In these expensive locales, FHA loan limits can be as high as $1,456,200 for a single-family home.

You can find FHA mortgage limits for your area on the U.S. Department of Housing and Urban Development website.

FHA DTI maximum

You typically must have a debt-to-income ratio of 43% or lower. This ratio includes mortgage and other debt payments and may go up to 50% if you have strong credit. Debt-to-income ratio compares how much you owe to how much you earn. Specifically, a lender compares your credit card, student loan and other debt payments to your pretax income.

Other FHA loan requirements

In addition to these major financial requirements, you must meet several other criteria to qualify for an FHA loan.

Show proof of income and an employment history of at least two years
Purchase a home that you’ll use as your primary residence
Get the property appraised by an FHA-approved appraiser and make sure it meets HUD guidelines
Not have a history of bankruptcy or foreclosure in the past year or two

FHA costs: mortgage insurance

FHA loans often come with attractive interest rates, as a result of their government guarantee. But you should expect your savings to be at least partially offset by extra costs in the form of mortgage insurance premiums, which are designed to cover costs if you default on the loan.

If your down payment is 10%, you’ll pay these premiums for 11 years. Otherwise, you’ll be stuck paying them until you sell your home or refinance your mortgage.

Here’s what the upfront and annual mortgage insurance premiums typically cost:

Upfront mortgage insurance premium: 1.75% of your loan amount
Annual mortgage insurance premiums: 0.45% to 1.05% of your loan amount, depending on your term and other factors

Let’s say, for example, that you borrow a $200,000 FHA loan. Expect to pay an upfront mortgage insurance premium of $3,500 and annual charges of $900 to $3,000. On a monthly basis, those annual premiums would cost somewhere between $75 and $250.

Assuming your FHA loan has a 7% interest rate, you’d be responsible for monthly payments of $1,331 on a 30-year term. Adding in premiums, that monthly bill would range from $1,406 to $1,581. That sum is based on the loan and premiums alone; it doesn’t include additional costs like taxes or utilities.

If you can’t pay the upfront mortgage insurance premium at closing, you might be able to roll it and other closing costs into your FHA loan. And if you want to ditch these premiums completely, you might eventually refinance out of your FHA loan into one with no premiums.

Conventional mortgages similarly require you to pay private mortgage insurance (PMI) if your down payment is less than 20%. However, you can ditch these PMI charges once your loan balance falls to 80% of the value of your home. You might reach this 20% equity through paying down your loan balance and having the value of your home increase over time.

FHA mortgage alternatives

Other types of HUD loans

The U.S. Department of Housing and Urban Development doesn’t stop at FHA home purchase loans. It also offers a few other types of loans to homeowners in need of financing.

FHA 203(k) rehab loan: This loan provides financing for home renovations, such as replacing old flooring or fixing the home’s foundation. You must borrow a minimum of $5,000 with an FHA 203(k) loan. Repairs must be completed within six months.
Energy Efficient Mortgage, or EEM: This program helps home buyers make energy-efficient upgrades to their homes.
245(a) growing equity mortgage: This is a graduated payment mortgage that allows for smaller payments at the beginning of the loan term. These payments increase over time.
Construction-to-permanent loan: This can be used to purchase land and build a new home.
Title 1 property improvement loan: You can borrow up to $25,000 to make improvements on a single-family home or more for multiunit dwellings.
Home Equity Conversion Mortgage, or HECM: This FHA-insured loan allows homeowners who are at least 62 years old to withdraw a portion of their home’s equity.

Other low-down payment mortgage options

FHA loans aren’t your only option for low-down payment mortgages. Here are some other programs worth exploring:

VA loans: The U.S. Department of Veterans Affairs offers VA loans to veterans and active military with a 0% down payment requirement and no PMI charges. Veterans who are Native American or have a spouse who is Native American might also qualify for VA Native American Direct Loans (NADL), which allow for a 0% down payment, don’t charge PMI and can subsidize closing costs.
USDA loans: The U.S. Department of Agriculture provides USDA loans to borrowers with low to moderate income and credit scores of 640 or higher (with some flexibility). Like VA loans, USDA loans offer 100% financing, meaning you don’t need to put any money down upfront.
Down payment assistance programs and grants: If you’re a first-time home buyer, you might qualify for a down payment grant from your state or a local organization. MassHousing, for example, is an independent, quasi-public agency that offers up to $50,000 in down payment assistance to first-time home buyers in Massachusetts who meet income guidelines and other qualifying criteria.

Can your refinance an FHA loan?

Refinancing your FHA loan to a conventional refinance loan can help you ditch your loan’s costly mortgage insurance premiums. “That can mean tens of thousands of dollars in lifetime savings on the same home even if you take a conventional loan at exactly the same rate as your FHA loan,” says Brad Cahoone, mortgage banker and broker and president of Global Home Finance based in Lewisville, Texas.

Depending on your credit, refinancing can also help you lower your interest rate, reduce your monthly payment and adjust your repayment term. “It’s often a substantial household savings,” says Cahoone.

To qualify for refinancing to a conventional home loan, you’ll need to meet a lender’s underwriting requirements for credit and income. Some lenders require a minimum credit score of 620 and maximum DTI ratio of 43%. You may also need to get your property appraised. If you hold at least 20% equity, you won’t have to pay PMI.

Despite the potential savings, refinancing can cost you, too. You may have to pay between 2% and 6% of your loan amount in closing costs. According to Freddie Mac, the average closing costs on a refinance are $5,000. Take these fees into account to make sure that the benefits of refinancing your FHA loan would be worth it.

If you don’t have strong credit, you could also explore FHA refinance loans, which include a simple refinance loan and cash-out refinance. These options may be easier to qualify for than conventional refinance loans, but you’ll probably still be stuck paying mortgage insurance premiums.

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