Loans are backed or insured by the government or the private sector. However, some loans are issued by private lenders, and those are insured and regulated by government agencies. For instance, FHA loans are insured and protected by the Federal Housing Administration. The FHA is a government organization created in 1934 and is also part of the HUD (Housing and Urban Development) agency. The main goal of the FHA is to help people purchase homes with better interest rates and lower down payment requirements. Let’s find out more about FHA loans and how they work.
What Is an FHA Loan?
An FHA Loan is a home loan insured by the federal government, allowing you to make down payments as low as 3.5%. These loans are helpful for first-time home buyers and borrowers with lower credit scores or little to no savings. The FHA does not act as the direct lender, private lenders provide the loans, but FHA insures and guarantees them. You can obtain these loans from banks, credit unions, and financial institutions, and FHA provides the insurance or guarantee.
FHA loans are easy to qualify for if you can’t qualify for conventional mortgages or VA and USDA loans. These loans are typically designed to help low and moderate-income families who find it difficult to purchase homes.
How Do FHA Loans work?
Only a lender that the FHA approves of can offer FHA loans. FHA loans are available in 15, and 30-year terms and have fixed mortgages. If you have a credit score of 580, you can get an FHA loan of up to 96% value of a home. If your score is below 580, you can still get an FHA loan, but you’ll have to make a 10% down payment instead of 3.5%.
With FHA loans, borrowers must pay FHA mortgage insurance. This insurance is required to protect the lenders from borrowers’ default. When the borrower cannot pay the loan amount, the lender is compensated with the mortgage insurance premium. All borrowers who take FHA loans and pay less than 20% down payment must pay insurance premiums. There are two types of insurance premiums which include upfront mortgage insurance premiums and annual mortgage insurance premiums. The upfront insurance premium is 1.75% of the loan amount, and the borrower must pay this when the lender provides the loan. The annual insurance premium is 0.45% to 1.05%, depending on the loan term.
FHA vs. Conventional Loans
Conventional loans are not backed or insured by the government, whereas FHA loans are federally insured. Besides this, other factors differentiate these loans from each other. The following are the main differences between FHA and conventional loans:
Minimum Down Payment:
FHA loans come with a minimum down payment of 3.5%, which is fixed throughout the term. This down payment is for those borrowers who have a minimum credit score of 580. On the other hand, a few conventional mortgages offer a 3% down payment, but it is only for borrowers with a credit score of 600 or more, along with good savings. Thus, qualifying for conventional loans with a 3% down payment is difficult.
FHA loans are easy to qualify for as compared to conventional loans. To be eligible for conventional loans, the borrowers must have a score of 620 or higher. However, if the borrower has a credit score of 500 to 579, qualifying for conventional loans is not possible. FHA loans are available for those borrowers who have a credit score between 500 and above. The credit score requirement of both types of loans also depends on the lender. Though FHA sets standards, lenders can also set their credit score requirements. Additionally, if the borrower has a good credit score, they can get better interest rates with any loan.
DTI, or Debt-to-income ratio, is the percentage of monthly income used to pay monthly debts. Monthly bills and debts include student loans, mortgages, auto loans, credit card payments, and child support. The lenders determine this ratio to evaluate the creditworthiness of a borrower.
Generally speaking, the higher your DTI, the more difficult it is to pay your bills. To qualify for an FHA loan, the borrower must have 50% or less DTI, while conventional loan providers prefer borrowers with a DTI ratio of less than 43%.
FHA and conventional loans both limit the amount the borrower can take. Loan limits for conforming conventional loans are set by the Federal Housing Finance Agency. The FHA loan limit for low-cost areas is $420,680, and $970,800 for high-cost housing areas. In contrast, the loan limit for most conventional mortgages is $647,200.
Mortgage insurance is a type of protection for lenders in case of default. FHA mortgage insurance premiums are the same regardless of your credit score. Private mortgage insurance on conventional loans costs less if the borrower has a good credit score. However, both mortgage insurance premiums vary according to the amount of the down payment.
FHA Loans Examples
Example 1: Let’s take an example of a person with a credit score of 600 who wants to buy a home valued at $200,000. He tried to get a conventional loan but was rejected by most conventional lenders because of his low credit score. He has the option to take an FHA loan with a 3.5% down payment with this credit score. However, he will also have to pay the upfront and annual mortgage insurance premiums with the FHA loan. Following are the details of this loan:
- Home price: $200,000
- Down payment: 3.5% ($7,000)
- Loan term: 30 years
- Upfront mortgage insurance premium: $2,625
- Annual mortgage insurance premium: $131.25/ month ($1,575 total)
With the FHA loan, in this case, the borrower has to pay $2,625 as an upfront mortgage insurance premium when he gets the loan. Besides that, he’ll have to pay a 3.5% down payment which makes a $7000 amount the borrower has to pay to get the loan.
Example 2: John, 30, received a job transfer from his employer, and he has to move within a month. He has $10,000 saved as a down payment for a house that costs $300,000. John’s credit history is minimal, and his score is 640. A conventional loan provider offers a 5% down payment for a cost-effective loan for this home. However, since his credit score is not good, he’ll have to pay the lender a higher private mortgage insurance premium. On the other hand, an FHA loan offers an upfront mortgage insurance premium with a 3.5% down payment. In this case, an FHA mortgage is more cost-effective as it doesn’t require more money out-of-pocket at the start. Thus, it would be better for John to get an FHA loan instead of a conventional loan.
FHA Loans Frequently Asked Questions
Where to Find an FHA Loan?
FHA loans are available from FHA-approved lenders. These lenders offer loans with varying underwriting standards, costs, and rates. The lenders, however, make sure that all the minimum requirements set by FHA are met. FHA-approved lenders include big banks, community banks, credit unions, and independent mortgage firms.
A few reliable banks that provide FHA loans are PNC Bank, North American Savings Bank Mortgage, Homefinity, New American Funding, Rocket Mortgage, Carrington, Flagstar Bank, and Caliber Home Loans.
Is an FHA Loan a Better Option For a First-Time Home Buyer?
An FHA mortgage is specially designed for homebuyers who want to make smaller down payments. However, a buyer with a good credit score and affordability for a 10% down payment should go for a conventional loan because it is cheaper. It is better to compare the costs of conventional and FHA loans and then decide the best low-cost option for mortgages.
How Long Does it Take to Close on an FHA Loan?
To close an FHA loan quickly, the applicant must provide the lender with an accurate and complete application, including proof of income. These days most loans, including FHA loans, have automated underwriting systems that offer decisions within a few seconds. However, if there are issues like employment issues, identity theft, or no reported credit history, the decision would be written manually and might take more time.
How to Apply for an FHA Loan?
You must collect a few necessary documents to apply for an FHA loan. For instance, you must provide two months’ bank statements, the last 30 days of your pay stubs, the contract for sale, the last two years’ tax returns, any W2s, a copy of the homeowner’s insurance policy binder, deeds, and a current mortgage statement for refinances.
What to Know About the Real Estate Exam?
FHA loan is a conventional loan backed by the government. FHA is a housing agency that provides mortgage insurance on loans through FHA-approved lenders. FHA provides protection to lenders because these loans are riskier than conventional loans. Thus, the lenders take a risk because they know that FHA will pay claims to cover the loss if the borrower defaults on the mortgage loan. First-time home buyers, low to moderate-income buyers, borrowers with high debt-to-income ratios, and borrowers with no credit history can benefit from FHA loans. If you want to learn more about loans for preparing for your real estate exam, go through this list of 255 Real-Estate Terms and Flashcards.