An FHA loan is a mortgage loan insured by the Federal Housing Administration (FHA). It is a government-backed loan that ensures lenders are covered financially if the borrower defaults on the loan. They typically require a lower minimum credit score and down payment than conventional loans, making an FHA loan ideal for many first-time home buyers.
How Do FHA Loans Work?
An FHA loan is provided by an FHA-approved mortgage lender. This means the government does not provide the loan directly. In addition, FHA loans are available in 15-year and 30-year mortgages One main reason FHA loans typically are easier to obtain is that they require the borrower to purchase mortgage insurance, especially if the home buyer puts less than 20 percent of the purchase price down. This protects the lender from a loss on the loan if the borrower is unable to make payments and defaults on the loan.
There are two different mortgage insurance payments to become familiar with: the upfront mortgage insurance premium and the annual mortgage insurance premium. The upfront cost is typically around 1.75 percent of the loan amount. The annual cost is less (typically less than one percent of the loan balance) and is made monthly.
FHA loans are available when purchasing a primary residence. Those who are looking to purchase a secondary residence — such as a vacation home, rental property, etc. — may have a harder time qualifying for an FHA loan.
How to Qualify for an FHA Loan
The FHA loan program only requires buyers to have a credit score of 500 for borrowers who intend to put 10 percent down, compared to conventional loans which typically require a score of 620 or better. For borrowers who only plan to put 3.5 percent down at closing, they will likely need a credit score of 580 or better.
In addition to checking the FICO score, lenders may also request documents to verify employment history for the past two years. This may include pay stubs, bank statements and federal tax returns. Lenders may also check the borrower’s front-end debt ratio, back-end debt ratio and bankruptcy history.
As mentioned, the borrower must also purchase the home as a primary residence. A real estate appraisal from an FHA-approved appraiser is also required to ensure the property meets the Department of Housing and Urban Development (HUD) guidelines.
Types of FHA Loans
Choosing the best type of FHA loan for you can save you from having to pay high prices at closing for renovation, and some can help homeowners who are looking to refinance. There are different types of FHA loans in addition to the traditional FHA loan. Among the most notable types are:
- FHA 203(k) loan – A 203(k) loan is a type of FHA loan that gives the borrower financing for home renovation. There are two types: limited and standard 203(k) loans. A limited 203(k) loan is easier to receive and involves less than $35,000 in renovations, whereas a standard 203(k) loan is harder to receive and involves more than $35,000 in renovations.
- Home equity conversion mortgage (HECM) – An HECM is a popular type of reverse mortgage that allows homeowners (typically older homeowners) who have paid off most of their home are able to borrow money backed by their home equity.
- FHA energy-efficient mortgage – This type of FHA loan allows borrowers to purchase energy-efficient homes or remodel a home to become more energy-efficient. The added cost of the “green” renovation is included in the loan.
- Section 245(a) loan – Also called a Graduated Payment Mortgage, the monthly cost of the mortgage goes up over time, and is tailored for borrowers whose income is expected to increase over time.
Benefits of an FHA Loan
Every borrower will have a unique experience. In general, FHA loans often offer lower down-payments for individuals with a lower credit score, are easier to acquire and offer competitive mortgage rates when compared against conventional home loans. The more notable benefits of FHA loans include:
- Lower down-payment
- Lower credit score requirements
- Competitive mortgage rates
- Easier application process (due to mortgage insurance)
- Good for first-time buyers and repeat buyers
The best way to determine if an FHA loan is right for you is to consider the benefits that apply to your unique situation and compare it to other available loan options. Often, an FHA loan is one of the only options available for younger home buyers with a less-than-ideal credit score. Many repeat buyers who are in good financial standing, however, may also find an FHA loan to be the most advantageous option.
Speak to an Experienced Mortgage Broker
Here at MyLendingPal, we can help you through the mortgage loan process. Our experienced mortgage brokers are more than happy to answer your questions, address your concerns and guide you through each step of the home loan process. Call us today to speak to one of our dedicated and experienced mortgage brokers.