There are a few important steps people make to improve their financial situation. Buying a home is one of them. However, a significant number of people don’t have the required credit score to access standard mortgage loans. In such cases, they might still qualify for an FHA loan, which is a government-backed mortgage program offered to people with a weak financial history.
FHA loans have helped millions of first-time home buyers successfully purchase properties. However, there are some requirements that must be met before getting approved for an FHA loan. In this article, we explore what are FHA loans, what is required to qualify for one, and their limits and benefits compared to standard mortgages.
FHA loans were created as a response to the Great Depression, and have more generous terms than standard mortgages
An FHA loan is a mortgage backed by the U.S. government. These loans are offered by financial institutions which have been approved by the Federal Housing Association, or FHA. Lenders agree to issue FHA backed loans because the government agrees to make good if the borrower does not pay.
FHA loans are quite popular among first-time home buyers because they have much lower requirements when compared to standard mortgage loans. For example, people can qualify for an FHA loan with a credit score as low as 500, giving only 10 percent down payment. Families with scores above 580 are given a more generous offer, as they have to put a down payment of only 3.5 percent. These terms are quite different than standard mortgage loans, which might require a minimum score of 620 and a down payment of 20 percent.
FHA mortgage loans remain the best alternative for low-income families who have struggled to save money for down payment. In recent years, lenders have been issuing hybrid FHA loans, which combine a portion of fixed and variable interest rates. These mortgages start out with fixed interest rates for several years before switching to adjustable rates. The federal government has also developed additional grant programs that help low and very low income households cover down payments. One such program is called Homeownership and Opportunity for People Everywhere, or HOPE, and was designed to help families buy public housing units with funds provided by nonprofit organizations.
People who want to obtain funding through an FHA loan must meet certain income and employment requirements
People who want to get approved for an FHA loan have to meet specific requirements designed by the Federal Housing Administration and U.S. Department of Housing and Urban Development (HUD). The first requirement is to have a credit score within stipulated limits. In general, people with credit scores from 500 to 579 are approved with a 10 percent down payment. If their credit score is above 580, down payment falls to 3.5 percent. Down payment money can come from a verified gift or federal assistance program. Some local housing authorities operate grant programs that help very low income families cover down payment.
When it comes to income, FHA loans have more generous requirements than what financial institutions ask for standard mortgages. For example, housing authorities do not have set annual income requirements, though borrowers must have enough to cover potential monthly payments. To verify income, FHA-approved lenders ask for documents that certify steady employment for at least two years without salary decrease. In general, lenders are satisfied with pay stubs, federal tax returns, bank statements and employment letters. Most of these documents will be reviewed during the pre-approval process.
Financial institutions offering FHA loans have some additional debt requirements that must be met before approving an application. First, borrowers’ front-end debt ratio must not exceed 31 percent of their gross monthly income. This includes monthly debt payments except for mortgages. Some lenders may allow as much as 40 percent front-end debt ratio under certain conditions. Second, borrowers’ back-end debt ratio should be lower than 43 percent. This includes mortgages and all other monthly debt payments. In some cases, borrowers with up to 50 percent back-end debt ratio may be approved for an FHA loan.
Finally, borrowers must wait at least two years after a bankruptcy and three years after a foreclosure before applying for an FHA loan. They should have also improved their financial history to meet other requirements such as a credit score of at least 500. People who have foreclosures related to government-backed loans might have to wait longer. However, people with previous foreclosures are generally not approved for an FHA loan unless they happened under extreme circumstances.
People approved for an FHA loan pay mortgage insurance to offset additional risk caused by lower requirements
In general, mortgage insurance is required when down payment is less than 20 percent of the loan amount. Mortgage insurance protects lenders if borrowers default on their loans. The most common type is private mortgage insurance, which is paid for by borrowers when they purchase a home. FHA loans have significantly low down payments. As a result, borrowers are required to pay two mortgage insurance premiums.
The first one is called upfront mortgage insurance premium. It equals 1.75 percent of the loan amount and must be paid when the mortgage is approved. However, most financial institutions allow borrowers to roll the mortgage premium into the total loan amount. The second premium is called annual mortgage insurance. It goes from 0.45 to 1.05 percent of the loan amount and is paid monthly along with mortgage payments.
The final percentage is determined by the total loan amount, loan-to-value ratio (LTV) and credit score. Annual mortgage insurance is paid until the loan-to-value ratio reaches a certain amount. Usually, borrowers stop paying when the value reaches 78 percent of the purchased home’s original appraisal value or current sales price, whichever is lower.
Like standard mortgages, FHA loans have closing costs that vary according to circumstances
FHA loans have closing costs that must be paid when borrowers get approved. However, the U.S. Department of Housing and Urban Development (HUD) limits how much FHA-approved lenders can charge in closing costs. In general, FHA mortgages have closing costs of around 3 to 5 percent of the total loan amount. The final number will depend on where borrowers live, loan size, and whether some practices are used to lower interest rates.
The Federal Housing Administration (FHA) allows home sellers, builders and lenders to cover part of the total closing costs. In general, real estate agents and homebuilders cover appraisals, credit reports and title expenses to push borrowers towards purchasing a new home. In contrast, lenders often increase interest rates when they agree to pay closing costs. Borrowers can request assistance from an experienced broker to determine which option is more affordable for them.