What is an FHA Loan, and How Do They Work?

If you are in the market for a mortgage, you may have heard of an FHA loan. These loans can be an excellent way for buyers to purchase a property (even their first) with a small down payment and lower credit scores, but they have some conditions. Let's see how these valuable mortgages work.

How do FHA Loans Work?

The Federal Housing Administration (FHA) provides approved credit unions, banks, and other mortgage lenders with a guarantee for certain loans made to homebuyers (they don't have to be first-time buyers) that cover the mortgage lender in case of default. These FHA loans require a smaller minimum down payment, and borrowers can also be approved with lower credit scores than would generally be required of a conventional loan.

These differences mean that FHA loans have been designed to help those with low to moderate incomes become homeowners. Because of that, they are popular with first-time home buyers. These mortgages with more lenient guidelines for borrowers also come with additional requirements.

FHA Loan Requirements

FHA loans can be used to purchase or refinance several types of dwellings. These include:

• Single-family homes
• Duplexes, triplexes, and fourplexes
• Condominiums (on approved condo list)
• Some manufactured homes on permanent foundations (not all lenders lend on these)

There are also FHA loans that can be utilized for new construction, renovating existing homes, and buying and renovating a property.

FHA loans have limits that vary by county for single-family properties. Multi-family dwellings and homes needing renovations have their limits also.

The FHA loan must be for a principal residence with a borrower occupying the property within 60 days of closing. It cannot be for investment, except for a multi-family with the borrower occupying at least one unit.

Unless it is a renovation, the property must meet minimum property standards.

FHA mortgages also have mortgage insurance premiums. One is paid upfront. The other is paid monthly.

What Does an FHA Loan Mean for a Buyer?

If your credit score is 580 or above, you can borrow up to 96.5% of the home's value with an FHA loan. That means you only need a down payment of 3.5%.

An FHA loan is still possible for borrowers with scores between 500 and 579, but a 10% or greater down payment is needed. Many lenders still require a minimum credit score of 580.

The down payment for an FHA loan can come from savings, a gift from a family member, or a down payment assistance grant (from the state or another source).

FHA loans look at two ratios:

1. Total mortgage payment to effective income ratio (PTI or "Front End debt ratio") is the value of the proposed mortgage divided by income.
2. Debt to income ratio (DTI) is the percentage of pre-tax income spent on monthly debt payments (mortgage/rent, credit cards, student loans, and other debts.)

FHA loans have no minimum or maximum salary requirements for qualification, but buyers must have:

• A minimum of two established credit accounts (credit cards, auto, student loans).
• No delinquent federal debt or any debt from another FHA-insured mortgage.
• Down payment gifts must be verified in writing by the donor.

What Does an FHA Loan Mean for a Seller?

Not all properties are possible for FHA loans, and there are some requirements (called minimum property standards) to help the buyer and the mortgage holder. FHA loan properties must meet soundness, security, and safety standards, including but not limited to critical elements like electrical, roofs, water heaters, and access to the property.

If they do not affect the home's soundness, safety, or security, then repair minor defects, cosmetic issues, or normal wear and tear is not needed. However, sometimes to meet the standards, the seller must make repairs. If this is impossible, the buyer can use an FHA 203(k) loan to purchase and renovate the property.

Do I Qualify for an FHA Loan?

Borrowers should be aware that even if a lender follows FHA guidelines to the letter and meets the minimums, it does not mean that a lender will give you a loan. They will have their own set of guidelines.

Additionally, you may find better terms (lower down payment, higher existing debt allowance) if your credit score is higher with a conventional loan. And the mortgage rates will also be better with a more robust credit score saving you thousands over the life of the loan.

FHA Loans are Great for the Right Borrower and Property

If you and your desired property fit into the criteria suitable for FHA loans, they can be a great way to get into a new home or refinance your current home. If your credit score is higher or you have a significant down payment, you may be eligible for a conventional loan that matches your needs, credit, and financial position.

It is good to shop around and find the best deal that fits your needs and capabilities.

As you can see, an FHA loan can be the perfect mortgage to get your foot in the door. Then once you’ve improved your credit and gained some equity, you can always consider refinancing into a conventional home loan.