What Is an FHA Loan?
What is an FHA loan? The literal definition of an FHA loan is pretty straightforward: It’s a mortgage that’s insured by the Federal Housing Administration. But that doesn’t really tell you much.
So … let’s try again. What is an FHA loan, really? FHA home loans are geared toward borrowers who have lower down payments or credit challenges that may make it difficult to buy a home. This makes these loans particularly attractive to first-time homebuyers.
FHA loans can be a great resource for these borrowers because they feature:
-Down payments as low as 3.5%
-Flexible qualifying credit scores
-No income limits on eligibility
-Higher monthly debt allowances
-They’re also applicable for those who want to purchase either a single- or multi-family residence. Borrowers can purchase a property with up to four units as long as they make one of the units their primary residence.
Now that you know what an FHA loan is, you can dig into the intricacies of this loan program.
Different Loan Options
Like a conventional mortgage, an FHA loan can come with a fixed or adjustable (ARM) interest rate. This is a perk for borrowers, as they can choose the option that works best for their budget and long-term goals.
A fixed interest rate can provide security and predictability, since your rate and payment will never change over the course of your loan. An ARM can be an attractive option if the payment on a fixed-rate loan is too high.
An ARM has a low starting interest rate for an initial period, and then it adjusts higher or lower based on the current market during the life of the loan. If you’re relatively confident you won’t stay in the home long-term, or if you feel the initial rate break would benefit you more than locking in the current fixed rate, then an ARM could be right for you.
Down Payment Requirements
A “standard” down payment on a home can set you back between 10% and 20%. Not so with an FHA loan. You can put as little as 3.5% down and even use gift funds to cover the full cost of your down payment.
To be considered a “gift,” this money must be given with no expectation that it will be repaid, as this would make it a loan and not a gift. This gift of cash can be given by a borrower’s relative, employer, labor union, close friend, charitable organization, or government or public agency with a homeowner’s assistance program.
Donors cannot be affiliated in any way with the sale of the property. This includes the seller, real estate agent/broker, contractor, lender, or any entities associated with the funding, sale, or building of the home. This also includes government agencies selling foreclosed properties.
Any funds you receive to buy a house will be verified by the lender prior to the loan’s closing to ensure that the gift complies with all of the above. If it does, you’re in the clear and ready to accept the keys to your new home!
Lending standards, including minimum credit scores, have been tight since the Great Recession. Thankfully, FHA loans are a little looser on the FICO credit score requirements than many other types of mortgages.
Conventional loans generally require a score of 620 or higher to qualify for a mortgage. However, you can qualify for an FHA loan with a FICO score as low as 580. Those 40 points can make a world of difference to many borrowers who might have had a bump or two in the road.
Another advantage of the FHA loan is that this lower credit score won’t affect your qualifying interest rate. On a conventional loan, you’ll typically have to pay a higher interest rate if you can’t hit the 620 score, but there are no add-ons for FHA rates for credit.
Debt-to-Income Ratio (DTI)
Like your credit score, the FHA loan has more lenient loan terms when it comes to qualifying debt-to-income ratios. A conventional loan will generally require a DTI of 36% or lower. This means lenders want to see that the sum of all your monthly debts doesn’t eat up more than 36% of your gross monthly income.
On an FHA loan, though, the DTI can be as high as 50%, but it generally sits at around 43%. This takes into account your total debts, including credit cards, car payments, and child support payments, as well as the mortgage you’re qualifying for.
FHA borrowers are also allowed to use certain “compensating factors,” which allow them to qualify with a higher DTI ratio.
These factors include:
-Higher credit scores
-Residual income (having funds left over each month after paying all debts)
Minimal payment shock (the mortgage won’t be much more than the cost of renting)
On top of all this, closing costs tend to be less expensive for an FHA loan. One thing you should remember about FHA loans, however, is that they require mortgage insurance. This protects the FHA lender from loss if the borrower defaults on the loan, especially since the down payment requirement is so low.
Whether you’re a first-time buyer or not, if credit or down payment challenges are keeping you out of the housing game, then an FHA loan could be the solution you’re looking for. So what is an FHA loan? It’s a game-changer for many would-be homeowners.