What is a FHA Loan?

FHA loans are a great mortgage vehicle for those borrowers that don’t have the means to qualify conventionally. Here’s a look at what is a FHA loan and what you should know.

What is an FHA loan

An FHA loan is a mortgage that’s insured by the Federal Housing Administration. The FHA promises to pay the lender in the event that the homeowner defaults on the mortgage. FHA loans differ from conventional loans because they don’t require large down payments and have less strict credit requirements. The government insures the loan, but banks and private lenders actually provide the money that funds FHA loans.

Qualifying for an FHA Loan

FHA loans allow borrowers to finance up to 96.5% of the home’s purchase. The loans are popular among first-time homebuyers because they require a minimum 3.5% down payment, which can be a gift. By comparison, many conventional loans require a minimum 20% down payment. Other homebuyers (who are not buying for the first time) can receive an FHA loan for their home purchase if they meet the qualifications.

The FHA only allows borrowers to have one FHA loan at a time on a home that you occupy. Meaning FHA loans can’t be used to pay for rental properties. FHA loans have a maximum lending amount that varies by region. However, the maximum amount is often high enough for borrowers to afford a home, ranging from $270,000 to $730,000.

The FHA also has standards on the type of properties that can be purchased – fixer uppers usually don’t qualify. Some homes may need repairs before the FHA will approve a loan. This could make foreclosure and short sale home unavailable for FHA loans as the FHA has a list of repairs that must be paid to a property before the loan can be issued.

FHA loans have a minimum credit rating of 580 (somelenders may be higher) to qualify for the mortgage withmaximum 97% financing. Homebuyers with credit scores below 580 may be able to qualify if they can make a 10% down payment. Borrowers with a credit score below 500 can’t qualify for an FHA loan. The FHA allows borrowers to have higher debt to income ratios than conventional mortgages and accepts borrowers who’ve filed bankruptcy or gone through previous foreclosure, as long as the blunders were two to three years ago, and credit is in good standing.

While the FHA sets minimum credit score of 500, lenders may have higher credit score restrictions. Banks still have to protect themselves from losses, not only because they simply don’t want to lose money, but because the FHA insurance may not cover loans that were made to risky borrowers. It’s sort of the way your auto insurer provides coverage for your vehicle, but may deny your claim if you did something to cause an accident, like drive under the influence of alcohol.

Borrowers making less than 20% down payment are required to pay private mortgage insurance (PMI) on the loan. Mortgage insurance is a monthly premium paid until the borrower has lived in the house for five years and paid the principle balance down to at least 78%. At the point your servicer will automatically cancel PMI. Mortgage insurance is based on the mortgage amount and can add hundreds of dollars to the monthly mortgage payment. The FHA also requires an upfront mortgage insurance cost of up to 3% of the mortgage, which is one of the biggest drawbacks when it comes to these loans. Mortgage insurance would also be required on a conventional loan for which you have less than 20% equity.

Loan Types and Transferring the Loan

FHA insures several different types of loans offered by lenders, but there may not be as many options lenders typically have. You’ll typically choose between a 15- or 30-year fixed rate mortgage, an adjustable rate mortgage, and a 2-1 buy down mortgage where you “buy down” your interest rate for the first two years of the mortgage.

If you decide to sell your home, the FHA allows you to transfer your loan to the new homeowner as long as they meet the credit standards.