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What is a FHA Loan?

By Arvin Sahakian · Mar 24, 2015 · Mortgage

What is a FHA Loan?

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An FHA Loan is a mortgage that is insured by the Federal Housing Administration (FHA). This type of loan is intended to reduce the risk of loss by lenders in cases where borrowers default on their mortgage payments.

It is very likely that the initial term you will hear from your real estate agent or mortgage professional when intending to buy a home with less than 20% down payment is FHA Loan. Many of these new home buyers erroneously believe that FHA is a mortgage company or bank. The truth is the FHA does not make loans and isn't a type of bank.

Let us explain, FHA stands for Federal Housing Administration, a government agency. This governmental agency provides insurance to banks that issue mortgages. This insurance allows banks to safely loan money to home buyers who may not have perfect credit scores or large down payments. FHA loans have opened up the dream of home ownership to millions that otherwise would not be able to qualify to banks rigid mortgage standards. It wasn't always this way.

What is the FHA?

The FHA was formed in 1934 to help salvage a housing market that was knocked down during the Great Depression. Prior to the FHA, mortgage banks required 50% down payments and just a maximum five year term with a balloon payment at the end. Imagine trying to buy a home with such parameters. It would be near impossible for most of us.

How Do I Qualify For a FHA Mortgage?

As wide open FHA made the housing market, you still need to pass stringent lending guidelines to qualify for a FHA loan.

1. Your Credit Score

If your credit score is between 500 and 579, the FHA requires a down payment of 10%. For those with credit scores above 580, the FHA will permit down payments as little as 3.5%. An improved credit score will give you more favorable rates and terms. The down payment can be from the borrower's savings, a local or state government grant, or even a gift from a family member.

2. Your Mortgage Payment to Income Ratio

Your total monthly housing payment cannot exceed 31% of your income. This means to add up your monthly mortgage payment, insurance, homeowner association costs etc. and divide it by your gross monthly income. The resulting number cannot be over 31%.

3. Your Debt to Income Ratio

This ratio cannot exceed 43% to qualify for a FHA loan.

The debt to income ratio (DTI) is your total monthly debt payments divided by your gross monthly income. This includes your total housing payment. An improved debt to income ratio (DTI) will give you more favorable rates and terms.

4. An FHA Approved Home Appraisal

The amount of the appraisal and other criteria is determined by local building codes. In other words, every region is a little different when it comes to FHA requirements for a property appraisal. The appraiser be approved to conduct appraisals for the FHA.

5. The Cost of the Home

The maximum mortgage amount you can qualify for is dependent on the statutory limit for the home's region. The exact limits change yearly, while the latest data indicates that $271,050 is the average loan limit for a single family home throughout most of the United States. This number can be stretched to $625,500 in high cost of living areas like Los Angeles County in California.

A FHA loan can be used for owner occupied single family homes and many town homes, row homes, and condos. One caveat is that the condo needs to be part of a FHA approved condo project.

On the other hand, a FHA loan cannot be used for investment or rental properties. This means that if you had any ideas of using a FHA loan for investment purposes, forget it!

Using FHA Loans to Refinance

A very popular use of FHA loans is to refinance existing mortgages. The FHA offers three different types of refinance loans. Let's take a closer look at each type.

1. FHA Streamline Refinance

This is the easiest of the FHA loans for qualification. There is very little new paperwork required because this loan uses the same paperwork you originally filled out for your initial FHA loan.

The only requirements are that you still have a job and your new payments will be less than they are on your current mortgage. Yes, that's all that is required. Believe it or not, your credit report will not even be considered. This means that if you had credit problems since you last qualified for your mortgage, no worries!!

2. FHA Cash Out

The criteria are a little more stringent to use FHA to cash out. This means taking cash from your home to spend or invest. You need to have enough equity in your home to cover the FHA down payment requirements. The amount of equity depends on your credit score. If your score is 580 or higher, only 3.5% equity is required. If your score is below 580, the FHA requires 10% equity. You also need to pay for a home appraisal to qualify. Finally, your new monthly payments must be less than 29% of your monthly income.

3. FHA Replacement

This type of FHA loan is for those homeowners who wish to refinance a non-FHA mortgage with a FHA mortgage. The requirements are the same as the cash out FHA refinance mortgage.

Using FHA Loans to Buy a Home

The FHA has truly streamlined the process to buy a home, using the same qualification requirements we discussed above. The first thing you need to do is to gather the following information to provide to your lender.

1. Everywhere you have lived for the last two years

2. Your employer's name and address for the last two years

3. Your gross monthly salary

4. W-2's for the last two years

5. 1040 tax forms for the last two years

If you are a veteran of the U.S. Armed Forces you also need to submit DD form 214 along with the above information. This is your official record of a discharge.

Advantages of FHA Loans

There are many advantages of FHA loans. Here are the primary advantages over traditional financing.

1. Low down payment required of just 3.5%

2. Borrowers can have lower credit scores than traditional loans

3. Interest rates are usually lower than traditional loans

4. Permits seller concessions up to 6% of sales price in closing costs for the buyer

5. FHA loans are assumable by another buyer

Disadvantages of FHA Loans

Mortgage Insurance

Every FHA loan requires an upfront mortgage insurance payment equal to 1.75% of the loan amount. This can be rolled into the loan if you choose to avoid the out of pocket expense. In addition, you will have to pay for an annual mortgage insurance premium on a monthly basis.

The FHA annual mortgage insurance premium on loans with terms of 15 years or more will range from 0.80% to 1.05% of the loan amount (depending on the loan to value ratio). For loan terms of 15 years or less, the FHA annual mortgage insurance premium can range from 0.45% to 0.95% of the loan amount (depending on the loan to value ratio).

Limited Loan Amounts

The maximum mortgage amount financed with FHA will depend on the State and County the home is located. Visit the U.S. Department of Housing and Urban Development (HUD) website to search for FHA mortgage limits in your area.

Limited Occupancy Types

FHA Loans are only available for owner occupied properties used as your primary residence. This means you cannot attain an FHA loan for a second property, investment property or vacation property.

Prepare Before You Apply for a FHA Loan

It is important to remember that although the FHA is more flexible with approvals than the tradition mortgage route, your credit score still matters. Wise borrowers will check their scores prior to applying for a FHA loan, because if you are close to qualifying for the FHA 3.5% down program with higher credit scores, working to improve your credit can be well worth it.

Look for obvious mistakes on your report and negative accounts that are over the statutory limits of seven years. Addressing these mistakes by sending a letter to the three major credit reporting bureaus explaining why the negative data should be removed can work wonders on your credit scores.

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