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FHA Loan Basics

Pros and Cons of FHA Loans

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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’re 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 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’d otherwise be unwilling approve loan applications The FHA, an agency of the United States government, has plenty of dough to deliver on that promise.

Why are They so Great?

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 don’t 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’s 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’re most likely to benefit from that in a buyer’s market, but those do come around from time to time.

Prepayment penalty: there is none (a big plus for subprime borrowers)

Assumable: a buyer can “take over” your FHA loan if it’s assumable. That means they’ll pick up where you left off – benefiting from lower interest costs (because you’ve already gone through the highest-interest years). Depending whether or not have changed by the time you sell, the buyer might also enjoy a low interest rate that’s unavailable elsewhere.

A chance to reset: If you’ve recently come out of bankruptcy or foreclosure, it’s 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’s 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’re 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 won’t 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’re fortunate enough to have a high income, you aren’t disqualified like you might be with certain first time home buyer programs.

Debt to income ratios: to qualify for an FHA loan, you’ll 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 better than 31/43, but in some cases it’s possible to get approved with D/I ratios closer to 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’re 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.

Why Not Use an FHA Loan?

While they come with appealing features, you may find that FHA loans are not for you. They may not provide enough money if you need a large loan. But the main drawback is that the upfront mortgage insurance premium (and ongoing premiums) can cost more than private mortgage insurance would cost.

In some cases, you can still buy a house with a very little down using a standard loan (not an FHA loan). Especially if you’ve got good credit, you might find competitive offers that beat FHA loans.

As always, you should compare offers from several different lenders – including FHA loans and conventional loans – before you agree to anything.

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