A Federal Housing Administration (FHA) home loan is not for everybody. If you have a FICO score of 740 or above, and intend to make a 20 percent down payment on a home, you qualify for the best mortgage rates offered. FHA loans cost more but are often the only way for first-time buyers—or those with marginal credit—to get a home of their own. Here’s how to determine if an FHA loan is right for you:
What is an FHA mortgage?
An FHA mortgage is insured by the FHA, part of the U.S. Department of Housing and Urban Development (HUD). The federal government insures loans for FHA-approved lenders to reduce their financial risk caused by borrowers defaulting on payments. In the depths of the Great Depression, Congress passed the National Housing Act of 1934 that created the FHA. That year, the housing industry was moribund. Mortgage defaults and foreclosures soared. Home construction stalled, causing two million in that industry to be out of work. The number of homes sold tumbled. Prices collapsed. Mortgage terms were onerous: 50 percent down, with a three- to five-year term which ended with a balloon payment. Not surprisingly, the U.S. was a nation of renters—only four in 10 owned the roofs over their heads.
As part of the New Deal, the FHA had a mandate to improve the situation. It stimulated the housing market by making loans affordable; opening them up to a wide range of people. Since 1934 the FHA and HUD have insured more than 34 million home loans making them the largest insurers of mortgages in the world. Today, even after the housing bubble burst, home ownership in the United States stands at 65 percent.
What are the advantages of an FHA home loan?
It’s relatively easy to qualify for FHA mortgages which are backed for a borrower’s primary residence only. Borrowers must have a solid history of employment or have worked for the same employer for at least two years. They must be legal U.S. residents over 18 and have valid social security numbers.
Borrowers with FICO scores over 580 can get an FHA-backed home loan for as little as 3.5 percent down. That deposit can be given to the borrower by a family member. FHA home loans can be granted to borrowers with FICO scores as low as 500 although these home loans require at least a 10 percent down payment with a maximum loan to value (LTV) of 90 percent.
The loan to value is determined by taking the mortgage amount and dividing it by the appraised value of the property. If you’ve ever declared bankruptcy, it typically should be at least two years behind you, while foreclosures should be at least three years in the past. In both of these cases you need to have reestablished good credit.
Another big advantage of an FHA loan is that if you sell your property the buyer can assume the mortgage.
What are the disadvantages of an FHA mortgage?
An FHA loan requires that a property meet minimum standards of habitation at the appraisal by an FHA-approved appraiser. If the property doesn’t meet those standards, either the current owner has to pay for improvements or the borrower has to handle the repairs from funds placed in escrow (before the mortgage is granted). The FHA got hit hard by the mortgage meltdown.
For the first time in its 79-year history it had to ask Congress for a $1.7 billion bailout to cover its projected losses for the fiscal year that end ended September 30, 2013. To forestall another taxpayer subsidy, the FHA has lowered the ceiling of the mortgages it is backing from $729,750 to $625,500 in high-cost home areas, so it could prove impossible for it to finance your dream co-op in New York City.
Concerns about financial solvency have caused the FHA to raise insurance premiums. Because its lending standards are lower than others, the FHA requires two kinds of premiums. The first is the upfront mortgage insurance premium (MIP). Borrowers have to pay this no matter what their credit score is or the loan’s LTV. This MIP is 1.75 percent of the mortgage, so for a $300,000 mortgage the premium would be $5,250. This fee can be paid at closing or folded into the home loan. The second is the called the annual MIP, although it’s added to your monthly mortgage payments. This MIP is determined by the borrower’s LTV, loan size and duration. Because the numbers vary, this handy chart provides FHA insurance premium details.
A borrower’s front-end ratio (mortgage payment, home owners association fees, property taxes, mortgage insurance, property insurance) usually needs to be less than 31 percent of gross income, although due to extenuating circumstances borrowers might be approved with ratios as high as 46.99 percent.
On January 10, 2014, new Ability to Repay Rules, mandated by the Consumer Financial Protection Bureau, require that, for an approved loan, a borrower’s back-end debt-to-income ratio (mortgage plus all monthly debt service) needs to be less than 43 percent of gross income.
Like so many government-backed programs, there are strict rules and disclosures, but for many Americans an FHA mortgage is the best way to buy a home.