Federal Housing Administration (FHA) Loan

So, What’s a FHA Loan?

An FHA loan is a mortgage issued and insured by a Federal Housing Administration (FHA)-approved lender. Made for borrowers with low to moderate incomes, FHA loans demand lower minimum down payments and credit ratings than other traditional loans.

As of 2020, you can borrow up to 96.5 percent of the value of a home with an FHA loan (meaning you’ll only need to make a 3.5 percent down payment). For applying you would need a credit score of at least 580. If your credit score falls between 500 and 579, you can still get an FHA loan if you can make a down payment of 10 percent. With FHA loans, the down payment will come from investments, a family member’s financial contribution or a down-payment assistance grant.

All of these factors make FHA loans common with homebuyers at first.

Main Points

  • FHA loans are federally subsidized mortgages intended for low-to-moderate-income borrowers whose credit scores may be lower than average.
  • Loans from the FHA need lower minimum down payments and credit ratings than other regular loans.
  • FHA loans are provided by licensed banks and lending agencies, which can determine the credit qualifications.
  • Such loans come with some constraints and loan restrictions that are not found in traditional mortgages.

It is important to remember that in fact the Federal Housing Administration does not lend you money for a mortgage. Alternatively, like a bank, you get a loan from a lender approved by the FHA, and the FHA guarantees the loan. For this reason some people refer to it as an insured loan from the FHA.

You pay for the protection by the FHA’s mortgage premium insurance payments. The lender assumes the risk, because if you default on the loan, the FHA must pay the lender a fee.

Important: Although loans from the Federal Housing Administration (FHA Loans) allow lower down payments and credit scores than traditional loans, certain strict conditions are brought.

Comprehending FHA Loans

A loan from FHA allows you to pay two forms of mortgage insurance premiums — Upfront Mortgage Insurance Premium (UFMIP) and an Annual MIP (Monthly charged). The Upfront MIP is equivalent to 1.75 percent (as of 2020) of the base loan amount. You pay this at the time of closing, or it can be rolled into the loan. For example, if you’re given a home loan for $350,000, you’ll pay a 1.75 percent UFMIP x $350,000 = $6,125. The payments will be deposited into a U.S. generated escrow account of the Department of Treasury, and the funds are used to make mortgage payments if you default on the loan.

You make annual MIP payments every month, in spite of the name. Based on the amount of the loan, the duration of the loan, and the initial loan-to-value ratio (LTV), the payments vary from 0.45 percent to 1.05 percent of the total loan sum. Generally the average MIP expense is 0.85 percent of the sum of the loan. For eg, if you have a $350,000 loan, you would make 0.85 percent x $350,000 = $2,975, or $247.92 monthly average MIP payments. This is payable in addition to UFMIP’s costs.

Depending on the length of the loan and the LTV, you must make annual MIP payments for either 11 years, or for the duration of the loan.

HOW LONG YOU PAY THE ANNUAL MORTGAGE INSURANCE PREMIUM (MIP)

TERMLTV%HOW LONG YOU PAY
THE ANNUAL MIP
≤ 15 years≤ 78%11 years
≤ 15 years78.01% to 90%11 years
≤ 15 years> 90%Loan term
≤ 15 years≤ 78%11 years
≤ 15 years78.01% to 90%11 years
≤ 15 years> 90%Loan term

You will be entitled to subtract the amount you pay in premiums; but, you must determine your deductions — instead of taking the standard deduction (as much as $24,400 for 2019 taxes due in April 2020 if you are jointly filing while married) — to do so.

Is An FHA Mortgage Still A Bargain?

Tale of the FHA Loan Program

The Federal Housing Administration was established by Congress in 1934 during the Great Depression. The housing industry was in trouble at the time: default and foreclosure rates had skyrocketed, loans were limited to 50 percent of the market value of a house, and mortgage terms — including short repayment periods combined with balloon payments — were hard to reach for many homebuyers. As a result, the U.S. was predominantly a renter nation, with only 40 percent owning their homes.

The government developed a federally subsidized loan system to boost the housing market that reduced lender liability and made it easier for the lenders to apply for home loans. According to reports from the St. Louis Federal Reserve Bank, the homeownership rate in the U.S. gradually rose, hitting an all-time high of 69.2 per cent in 2004. (Against 65.1 percent for the fourth quarter of 2019)

FHA Loan Forms

The FHA provides many other loan services in addition to the conventional first mortgages, including:

  • Home Equity Conversion Mortgage (HECM) program — a reverse mortgage program that allows senior citizens aged 62 and older to turn home equity into cash while keeping home ownership. You chose whether to borrow the money, either as a fixed monthly sum or a credit line (or a combination of both).
  • FHA 203(k) loan for improvement which factors in the cost of certain repairs and loan renovations. This one loan helps you to borrow money for both home buying and home renovations, which can make a huge difference if after making a down payment you don’t have a lot of cash on hand.
  • FHA’s Energy Efficient Mortgage plan is a similar idea as it looks at improvements that will reduce your electricity costs, such as new insulation or installation of new solar or wind energy systems. The hope is that energy-efficient homes have lower maintenance costs, reducing expenses and generating more money for mortgage payments.
  • Section 245(a) loan-a plan for lenders planning to increase their profits. Under Section 245(a), the Graduated Payment Mortgage begins with lower initial monthly payments that rise slowly over time, and the Growing Equity Mortgage has scheduled rises in monthly principal payments resulting in loan terms that are shorter6.

THE 5 FHA LOAN-TYPES

FHA LOAN TYPEWHAT IT IS
Traditional MortgageMortgage used to finance a principal residence
Home Equity
Conversion
Mortgage
Reverse mortgage enabling homeowners aged 62 + to swap home equity for cash
203(k) Mortgage
Program
A mortgage which includes additional funds to pay for energy-efficient home improvements to lower your utility bills
Energy Efficient
Mortgage Program
A mortgage which includes additional funds to pay for energy-efficient home improvements to bring down your utility bills
Section 245(a) LoanA Graduated Payment Mortgage (GPM) with lower initial monthly payments that slowly increase (used as income is expected to rise), and a Growing Equity Mortgage (GEM) where planned rises in monthly principal payments result in loan terms that are shorter

FHA vs. Conventional Loans

To recap the numbers: FHA loans are available for credit ratings of up to 500. If your credit score is between 500 and 579, you can receive a 10 percent FHA loan with a down payment. If your credit score is 580 or higher, you will get a downward FHA loan of as little as 3.5 percent. For contrast, in order to qualify for a traditional mortgage, you would usually need a credit score of at least 620, and a down payment of 3% to 20%.

You must be out of bankruptcy for at least two years for an FHA loan or other mortgage unless you can prove the bankruptcy was due to an uncontrollable situation. You must be exempt from all foreclosures for at least three years, and show that you are trying to regain good reputation. You’re not going to apply if you’re delinquent with your federal student loans or income taxes.

FHA LOANS VS. CONVENTIONAL LOANS
FHA LOANCONVENTIONAL LOAN
Minimum Credit Score500620
Down Payment3.5% with credit score of 580+ and 10% for credit score of 500 to 5793% to 20%
Loan Terms15 or 30 years10, 15, 20, or 30 years
Mortgage InsuranceUpfront MIP + Annual MIP for either 11 years or the life of the loan, depending on LTV and length of loanNone with down payment of at least 20% or after loan is paid down to 78% LTV
Mortgage Insurance PremiumsUpfront: 1.75% of the loan +
Per year: 0.45% to 1.05%
 PMI: 0.5% to 1% of the loan amount annually
Down Payment Gifts100% of down payment can be a giftJust a part can be a gift if down payment is lower than 20%
Down Payment Assistance ProgramsYesNo

Unique Considerations

The lender must determine the FHA eligibility credentials like any mortgage applicant should. Nevertheless, instead of using your credit report, a lender might look at your past two years’ job history as well as other records of payment history, such as service payments and rent payments. Whether you have gone through bankruptcy or foreclosure, you will apply for an FHA loan, provided you have regained good credit. For general, the lower the credit score and down payment, the higher the interest rate on the mortgage you will pay.

Keep in mind that you might be responsible for such out-of-pocket expenses like loan origination fees, attorney’s fees and valuation costs when you purchase a house. One of the benefits of an FHA mortgage is that the seller, home owner, or lender will pay on your behalf some of those closing costs. If the seller finds a buyer tough, they may only try to help you out as a deal sweetener at the closing.

For such loans, along with the credit score and down payment criteria, there are clear FHA mortgage lending conditions provided by the FHA. Your lender must be an FHA-approved lender and over the last two years you must have a stable job background or have worked for the same employer.

If you’re self-employed, you need two years of productive self-employment experience, recorded by tax returns and current year-to-date balance sheet, and statement of profit and loss. If you have been self-employed for less than two years but for more than one year, then you can only be qualified if you have a strong job and income background for the two years preceding self-employment and self-employment is in the same or similar occupation. To sign a mortgage, you must have a valid Social Security number, live lawfully in the U.S. and be of legal age in your State.

Special Mortgage Considerations

The property that is being financed will typically be the principal residence and must be occupied by the lender. This loan plan is not used for investment or rental property. Under FHA-approved housing developments, detached and semi-detached homes, townhouses, row houses, and condos are all eligible for FHA funding.

Your front-end ratio (your mortgage payment, HOA fees, property taxes, mortgage insurance, and homeowner’s insurance) must be less than 31 per cent of your gross income. You can be accepted with a ratio of 40 percent in some cases.

Your back-end ratio (your mortgage payment and all other monthly consumer debts) will amount to less than 43 percent of your gross sales. Nonetheless, a ratio as high as 50 percent may be accepted. You will need a property appraisal by an FHA-approved assessor, and the house needs to meet certain minimum requirements. If the home does not meet these requirements and the seller will not consent to the repairs needed, you will have to pay for the repairs at closing (funds will be kept in escrow before repairs are made).

Limits on FHA Loans

One drawback of FHA loans is that as far as you can borrow, they have outside limits. They are determined by the region you live in, with low-cost areas having a lower limit (the “floor”) than the normal FHA loan and higher-cost areas (the “ceiling”). Then there are regions with “special exceptions “— including Alaska, Hawaii, Guam and the Virgin Islands — where very high building costs expand the limits even more. The cap is set anywhere else at 115 percent of the county’s median home price, as calculated by the U.S. Housing and Urban Development Dept.

The following figure outlines the loan caps for 2020:

FHA LOAN LIMITS 2020

PROPERTY TYPELOW-COST AREA
‘FLOOR’
HIGH-COST AREA
‘CEILING’
SPECIAL EXCEPTION
AREAS
One-Unit$331,760$765,600$1,148,400
Two-Unit$424,800$980,325$1,470,475
Three-Unit$513,450$1,184,925$1,777,375
Four-Unit$638,100$1,472,550$2,208,825

FHA Loan Help

FHA loans are not without their benefits: if you have one, you will be eligible for loan relief if you have undergone a genuine financial hardship, such as a loss of income or a rise in living expenses, or if you have trouble paying your monthly mortgage payments. For example, the FHA Home Affordable Modification Program (HAMP) will help you prevent bankruptcy by consistently reducing your monthly mortgage payment to an acceptable level. To become a full participant in the program, you must successfully complete a trial payment plan in which you make three planned payments, on time, at the lower, adjusted rate.

Decide what suits you best

While it may sound great to have an FHA loan, it is not for everyone. It does not benefit those with less than 500 in credit scores. A personal loan, instead, could be an option for those with bad credit. On the other hand, prospective homeowners who can afford a significant down payment would be better off choosing a traditional mortgage, because they might save more money in the long run by the lower interest rates and mortgage insurance premium offered by conventional lenders.

As the Federal Housing Administration puts it, an FHA loan does not satisfy those who shop at the higher end of the price spectrum—nor is it designed to do so. The FHA loan system was created to help low- and moderate-income home buyers, particularly those with little cash saved for a down payment.