What Is an FHA Loan?
A Federal Housing Administration (FHA) loan is a type of mortgage insured by the FHA and issued by an FHA-certified lender. FHA loans require lower credit scores, a lower down payment, and are intentionally designed for moderate to low-income borrowers. In 2020, FHA endorsed more than 1.3 million home mortgage loans through its forward mortgage program.
One of the critical responsibilities of a real estate agent is to help homebuyers understand their financing options. This guide explains how FHA works and its benefits so that you can pass this information along to your clients during the homebuying process.
How Do FHA Mortgage Loans Work?
First, it’s essential to know that FHA is not the lender of the FHA loan. The loan originates from an FHA-approved lender such as a bank or any other certified financial institution. The FHA guarantees or insures the loan for the borrower, meaning their lender bears less risk as the FHA will pay a claim if they default on the loan. For a client to secure the guarantee of FHA, they have to meet all FHA loan qualification requirements. Let’s break down the process of getting an FHA loan:
- Get preapproved. The first step to getting an FHA home loan is to get the mortgage loan preapproved. Although it is not mandatory, getting preapproval from an FHA-approved mortgage lender can help fast-track the loan process. The approving lender will issue a letter that shows the client has been preapproved for a specific loan amount.
- Complete form 1003. The FHA requires borrowers to fill in the Fannie Mae form 1003/ Uniform Residential Loan Application once they have found their ideal home. The eligibility application requires details about the address of the house and the specific loan they need. The form also requires details on income, employment history, debts and expenses, and other personal details that a lender needs when vetting a home mortgage application.
- Get the property appraised. The FHA uses the property's market value to make critical decisions on a mortgage loan. Your client’s FHA lender will hire a professional home appraiser to value the property and send an estimate to FHA for approval. The estimate must fall within the scope of the mortgage amount requested for your client to move to the next step.
- Begin the underwriting process. The next step involves an evaluation of your client’s FHA loan application from an underwriter appointed by the mortgage lender. The underwriter reviews all the financial details and credit scores for the FHA loan. If your client’s finances are in order, their loan will be approved. If there is an issue with their finances, they will get an opportunity to address those concerns by writing a formal letter to the lender through the underwriter.
- Secure FHA loan approval. Once your client addresses any issues raised by the underwriter, their mortgage loan will be approved. After getting the financing to buy the property, they will now move to the closing process and get the keys to their new home.
Did You Know?
The FHA was created through the National Housing Act on 6/27/1934. The main goal of FHA was to aid home financing, improve housing standards, and increase employment in the home construction industry following the severe effects of the Great Depression. The FHA mainly underwrote home mortgage loans made by financial institutions, thus encouraging private lenders and banks to make more loans available to prospective homebuyers.
Benefits of an FHA Loan
There are a variety of benefits that FHA loans offer to prospective homebuyers.
Lower Down Payment
In the current highly volatile real estate marketplace, it’s almost impossible to find options that allow for down payments of 5% or less. However, with an FHA mortgage, prospective homeowners can make a down payment worth as little as 3.5% of the home's price.
Allowing 100% Gift Funds
FHA loans typically allow borrowers to use up to 100% gift funds for down payments and closing costs. Essentially, with FHA, your client’s entire 3.5% down payment can be a gift from parents, some charitable groups, or government homebuyer programs.
Approving Higher Debt-to-income Ratios
The debt-to-income ratio or DTI is the portion of your client’s gross monthly earnings that will go into settling their monthly debt payments. Lenders use this ratio to determine borrowing risk. For conventional mortgage loans, the highest ratio a borrower can have and still be eligible for a loan is 43% DTI. However, the FHA can allow DTI ratios as high as 50%. Notably, the higher the DTI ratio, the more requirements the borrower must meet, including a higher credit score, larger savings, or a down payment that exceeds the minimum amount owed.
Lower Credit Score Requirements
The minimum credit score required for the FHA loan is 580 or higher with a 3.5% down payment or 500-579 with a 10% down payment. As such, if your client has a bad credit score, they won't have to wait a year or more for their credit to improve before buying a home. Most loan programs demand a credit score of up to 750 for a mortgage application to be approved. There are also instances where FHA borrowers with no credit scores may qualify for a mortgage.
More Housing Options
FHA financing can be applied to various housing types, including single-family homes, multi-family homes, condominiums, and more. Additionally, your clients can use an FHA loan to purchase a multi-family home with two to four units with a 3.5% down and rent the other extra units, provided they live in the house for a year.
No Private Mortgage Insurance (PMI) Required
Conventional loans typically require private mortgage insurance if your clients have less than 20% for a down payment. A PMI can cost anything between 0.2% and 2% of their mortgage amount. However, with an FHA loan, your clients won't need PMI.
No Income Limit
Government-sponsored mortgage companies like Freddie Mac and Fannie Mae offer conventional mortgages with just 3% down. However, your clients can't qualify for the 3% down if their household income is more than 80% of their area's median income. With an FHA loan, however, they’re eligible for a loan regardless of their income level.
Disadvantages of Getting an FHA Loan
While FHA loans offer many benefits to borrowers, there are also some known disadvantages to getting an FHA loan.
Mortgage Insurance Premiums
Although your clients won't have to pay for PMI, FHA loans feature a different kind of FHA mortgage insurance premium amounting to 1.75% of the loan at closing. Borrowers are also required to make an annual premium of 0.45% - 1.05% of the mortgage.
Limited Borrowing Limits
FHA loans typically restrict borrowing to specific amounts. Each year, the FHA sets loan limits by county. In general, the FHA limits are 65% of an area's conforming loan limits. Such limits can prevent your clients from buying their dream home.
Minimum Property Standards
With an FHA loan, your clients won't get approved for funding if their home has substantial structural or safety issues, or if it’s located in a hazardous environment. These restrictions can prevent borrowers from buying a fixer-upper house or exclude them from house-hunting in certain areas.
Limited to a Primary Residence Only
Ideally, borrowers will only use an FHA loan to buy a home meant for a primary residence. They cannot use an FHA loan to finance a vacation or investment in property. For such properties, they’ll have to apply for a conventional loan.
Lifetime Mortgage Insurance Expenses
An FHA loan comes with mortgage insurance premiums (MIP) that borrowers will pay for the life of the loan. The only way to get rid of the MIP is to refinance the FHA loan with other types of loan, such as a conventional mortgage.
What Type of Buyer Should Use an FHA Loan?
FHA loans open the door for people who otherwise couldn't afford to buy a home if they opted for a conventional loan. The best candidates for an FHA loan include:
- Low-income homebuyers
- Buyers with credit issues (such as little-to-no credit history)
- Buyers with a history of bankruptcy or foreclosure
- First-time homebuyers
- Buyers with debt
- Buyers who can only afford a low down payment upfront (less than 5-10%)
As in most sectors of the economy, the real estate industry thrives when money is able to flow easily through it. In essence, FHA loans help fuel the industry by helping lenders supply more capital with less risk — not only helping the financial institutions but also homebuyers and the real estate agents who are here to serve them.