What Is An FHA Loan?

FHA loans are Federal Housing Administration loans backed by the federal government.

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Shopping for the cheapest mortgage loans can be challenging, but if you have several loan options by various certified lenders, the process can be made much easier.

Such an option is getting an FHA Loan.

These are federal housing administration loans that give you a very low option for down payment, and are also given to people with a fair credit rating. Let’s get into details to see what is an FHA loan and how it works!

FHA Loan Meaning

FHA loans, as opposed to conventional loans, are very popular in the mortgage market. FHA loans are backed by the federal government, meaning the government gives lenders some guarantee on the loan, making it easier for lenders to trust the borrower.

The lender or banks who give out these mortgages are backed by FHA, which is why they have a downpayment as low as 3.5%. This is what gives lenders an edge even if the borrower defaults on the loan.

As compared to a conventional loan, the interest rates of FHA loans are relatively low because of their backing from the FHA. The interest rate today is 2.81% as compared to the interest rate of conventional loans which is 2.99%.

Essentially, there are 5 types of FHA loans:

FHA LOAN TYPE WHAT IT IS
Traditional Mortgage A mortgage used to finance a primary residence
Home Equity

Conversion

Mortgage

A reverse mortgage that allows homeowners aged 62+ to exchange home equity for cash
203(k) Mortgage

Program

A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills
Energy Efficient

Mortgage Program

A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills
Section 245(a) Loan A Graduated Payment Mortgage (GPM) with lower initial monthly payments that gradually increase (used when income is expected to rise), and a Growing Equity Mortgage (GEM) where scheduled increases in monthly principal payments result in shorter loan terms.

 

FHA Loan Limits

Loan limits are the maximum amount a person can borrow on a mortgage. In 2020, the FHA limit is set at $331,760, an increase of nearly $17,000 over the 2019 limit of $314,827. The FHA ceiling is a higher limit that only applies to high-cost areas.

In 2021, that’s generally $331,760 for single-family homes in low-cost areas and $765,600 in high-cost areas.

FHA Loan Down Payment

Usually, if you get a loan through conventional methods, you’ll get a 20% down payment, as compared to a 3.5% down payment on an FHA loan- this makes a HUGE difference on the budget you’ve on the same home!

On a $300,000 home, a 3.5% down payment would cost $10,500. Compare that with the traditional 20% down payment, which would come out to $60,000 on the same home. Big difference. And that’s before closing costs and other buying-a-home expenses.

If you’re looking for other loans that serve as a solid alternative to FHA loans, there are Fannie Mae- and Freddie Mac-backed mortgages that are also known as conforming loans, which offer down payments to be as low as 3%. The down payment amount is super affordable because these loans are backed by the organization and are ONLY given out to qualified borrowers.

FHA Loan Credit Score

Credit scores are a measurement metric to determine the creditworthiness of a borrower. The higher the credit score, the bigger the loan.

Conventional loans are given to people with a higher credit score, like above 600 or 650. FHA loans are given to people with a fair credit rating- a borrower with a 580 score can also qualify.

But there’s more to credit scores and what rating is excellent.

So the highest score that you can go up to is 850. However, it is not necessary for you to exhaust yourself into reaching that 850. Any score in late 700s to early 800s is great! You are good to go with proceeding with that loan!

This is the average breakdown to be mindful of:

  • Excellent: 800 to 850
  • Very Good: 740 to 799
  • Good: 670 to 739
  • Fair: 580 to 669
  • Poor: 300 to 579

FHA Loan Requirements

Even though it may seem that it is relatively easier for a borrower to obtain an FHA loan, there are certain requirements that set the bar for applicants. Here is what you need to know.

Credit Score and Downpayment: Just like any other loan, an FHA loan is also heavily dependent on the credit rating of the borrower. It should be at least 500-579, that is when you get a downpayment of 10%. But if your score is 580+, you could be eligible for only a 3.5% down payment rate. It all comes down to this: having a higher credit score will get you a good deal.

Debt-to-income ratio: A DTI is a measurement metric that simply evaluates how much debt you have against your current income. More DTI will reduce your chances of being qualified. The DTI should not be more than 50%, and you’re in the safe zone if it is below 43%.

Primary residence: One of the requirements for an FHA loan is that the property should be the primary residence of the borrower, and that it should meet the minimum criteria of FHA property requirement.

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Proof of employment: The borrower needs to prove that he is employed and has a steady source of income to be able to pay for the mortgage loan. This is not a very hard requirement to fulfil though, because most people look for mortgages while they already have a steady income from their employment.

FHA Loan Calculator

If you’re meeting the above set requirements for an FHA loan, the next step is running the numbers through an FHA Loan Calculator to see how much loan you can qualify for based on your credentials.

You will enter the basic information like the property’s value, interest rate, downpayment, tax records etc into the calculator and it will run the numbers to give you a close estimate of what you should be expecting. Using a loan calculator beforehand can really tell you what your current financial position is before you start on with all the effort of obtaining an FHA loan.

How to apply For FHA Loan?

Once you’ve decided that you want to opt for an FHA loan, here are some of the requirements that are part of the FHA loan application process. First, you need to gather all the documents at your end:

  • W-2 forms for the last two years
  • Your last two pay stubs
  • Two years of tax returns
  • Bank statements
  • Statements on investment securities and earnings
  • Listing of all debts and minimum monthly payments for each
  • Names and addresses of employers over the past two years
  • Pension, Social Security or disability income, if applicable
  • If self-employed, two years of profit and loss statements

When you’re done submitting all your financial statements as part of the FHA loan, the lender will look through these and verify them. If the case looks genuine and authentic, they will move forward with the application.

They will look at your credit score, DTI, bank statements, how much downpayment you can make etc. Once you’re approved for the mortgage, you can talk about your specific requirements and obtain the loan accordingly.

FHA Loan vs Conventional Loan

A conventional loan is a type of mortgage loan that is backed by private lenders, or two government sponsored organizations: Fannie Mae and Freddie Mac. Conventional loans are NOT backed by the federal government, which is why the lending process is a lot stricter and the interest rates are high. Even though fixed, the high rate of interest makes it harder for people to qualify for the loan.

An FHA (Federal Housing Administration) loan is the one that is backed by the federal government, requires a down payment of minimum 3.5%, and people with a low credit score also have a chance to qualify for the loan.

Here is a comparison chart of conventional loan vs FHA loans that will make it easier to understand the minimum requirements for each type.

Category Conventional Loan FHA Loan
Minimum down payment 3% 3.5%
Minimum credit score 620 580
Maximum debt-to-income ratio 43% 50%
Loan limit for 2020 (in most areas) $510,400 $331,760
Income limit No income limit No income limit
Minimum out-of-pocket contribution 0%

(Down payment and closing costs can be 100% gift funds, grants, or loan)

0%

(Down payment and closing costs can be 100% gift funds, grants, or loan)

 

Note: Sample rates have been extracted online, courtesy of TheMortgageReports.

Conventional Loan Requirements

Credit Score: The first most important requirement for a conventional loan is the credit score. This type of mortgage loan is handed out to people with a minimum credit score of 620, but if your score is 700 or above that, it strengthens your chance of approval. A good credit score will also ensure that you have a low amount of interest on your loan.

Downpayment: The minimum down payment percentage is 3%, but it is usually 20% because private lenders take a bigger risk. The amount was reduced to compete with the 3.5% issued by FHA loans. The bigger the down payment, better the loan amount.

Debt-to-income ratio: This is the sum of your monthly debt payments, such as credit cards and loan payments, compared to your monthly income. Ideally, the debt-to-income ratio should be around 36% and no more than 43%. In other words, you should spend less than 36% of your monthly income on debt payments.

Documents: Once all of these prerequisites are done, the next step is submitting all documents. The lender will ask for your credit reports, tax history, and various other required records. Make sure all of these are up-to-date and ready to be submitted to save time.

How many FHA Loans can you have?

Naturally, a person may have one mortgage loan for one house, so no, it sounds absurd for a person to have two FHA loans under their name. If they wish to apply for another one, the first one needs to be paid off.

However, under the Housing and Urban Development (HUD), one borrower may ask for another FHA loan IF their job is being relocated or if the family size is getting bigger.

Even if all circumstances rule in the favour of the borrower, they will need to fulfil certain criteria to be approved for another FHA loan while they still already have one. Such as the current home equity must be at least 25%, and the debt-to-income ratio should be enough to support two mortgages now.

Mortgage Rates 2020

The current mortgage rates have dropped significantly, on 10th September 2020, from 3.93% to 2.86% in the last week only. Borrowers with a 30-year fixed-rate mortgage of $300,000 with today’s interest rate of 2.86% will pay $1,242.27 per month in principal and interest (taxes and fees not included). The total interest paid over the life of the loan will be $147,218.42. That same mortgage taken out a year ago would cost an additional $41,374.27 in interest over the life of the loan.

Here is how the rate has changed on a weekly basis in the last couple of months:

Weekly Rate Trends 30-Year Fixed 15-Year Fixed 5/1 ARM
9/10/2020 2.86% ↓ 2.37% ↓ 3.11% ↑
9/3/2020 2.93% 2.42% 2.93%
8/27/2020 2.91% 2.46% 2.91%
8/20/2020 2.99% 2.54% 2.91%
8/13/2020 2.96% 2.46% 2.9%
8/6/2020 2.88% 2.44% 2.9%
7/30/2020 2.99% 2.51% 2.94%
7/23/2020 3.01% 2.54% 3.09%
7/16/2020 2.98% 2.48% 3.06%
7/9/2020 3.03% 2.51% 3.02%
7/2/2020 3.07% 2.59% 3.00%
6/25/2020 3.13% 2.59% 3.08%

Note: Current sample rates have been extracted online, courtesy of MyMortgageInsider

Conclusion

Qualifying for FHA loans isn’t that hard; because of low down payments and low interest rates, it may actually work for some people. The eligibility criteria is also relatively smooth to facilitate low-to-moderate income borrowers.

Owning a home shouldn’t be made hard, but most lenders do keep their huge cuts in deals while closing. The best way of getting ahead of this is to shop around and look for reasonable rates. Or better yet, have an expert opinion about your personal case and see what they’re suggesting you should do.

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Nabeel Ahmad

Nabeel Ahmad

Nabeel Ahmad is a serial entrepreneur who has founded multiple successful businesses in the fields of marketing, software development, design, e-commerce, and more. He is the founder and CEO of Vertabyte, a full-service digital media agency that partners with enterprise-level companies, many of which have million-dollar valuations, and helps them achieve their business goals.

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