Many wonder what is a FHA Loan. FHA loans are home mortgages that are issued by qualified and federal lenders. The Federal Housing Administration (FHA) insures these loans to protect lenders against financial risk. A majority of FHA loans are availed by borrowers with low or moderate incomes who cannot make a significant down payment.
FHA loans are an attractive option for a lot of borrowers as they allow borrowers to purchase a house with smaller down payment amounts. These loans help promote home ownership, making it much easier for individuals to become eligible for a mortgage. According to the latest regulations, an FHA loan allows you to borrow as much as 96.5% of your home’s value; you can fund the remaining 3.5% down payment amount using a grant or a gift. This makes an FHA loan very attractive to first-time home buyers.
The government introduced the FHA loans in the 1930s following the Great Depression. Foreclosures and defaults had skyrocketed during this period. In the aftermath of these defaults the government sponsored insured loans to give mortgage lenders some security and peace of mind. The reduced risk for the lenders helped stimulate the US housing market during the troubled financial times.
As mortgages were insured, a majority of lenders felt more inclined and secure to offer large mortgages in situations where the loan application would normally have been declined.
How Does an FHA Loan Work?
The FHA guarantees to pay a lender in case borrowers default on their FHA loans. In order to finance its obligation toward lenders, the borrowers are charged a fee. Homebuyers who avail FHA loans have to pay PMI or Private Mortgage Insurance. They are also required to pay a small fee with every monthly installment.
Whenever borrowers default on their FHA loans, the insurance premiums collected by FHA are used to compensate or reimburse the lenders.
Why are FHA Loans so Appealing?
Although FHA loans have a few drawbacks, they are an ideal option in a number of situations. Their main attractiveness is that they tend to make the process of buying properties easier; however, do not ignore the fact that these benefits usually accompany some tradeoffs. The following are a few attractive features of FHA loans:
Low Down Payments
An FHA loan allows a borrower to purchase a house with a very small down payment which can be as low as 3.5%. In contrast, other loan programs usually stipulate relatively large down payments. Usually they are 20%.
Benefit from Other Peoples’ Funds
It is much easier, for most people, to use a gift or grant to pay for closing costs and down payment. Moreover, a seller is allowed to pay about 6% of the total loan amount toward the closing costs of a buyer. However, keep in mind that you are more likely to take advantage from this when the market is favorable for buyers.
Opportunity to Reset
In case you have just come out of foreclosure or bankruptcy, you will find it easier to qualify for FHA loans compared to loans that do not have government guarantees. These loans can also be used to finance home improvement projects.
FHA Loan: Qualification Criteria
It is easier for borrowers to qualify for an FHA loan. However, in some cases, lenders often set more stringent standards compared to FHA requirements. In case you are having issues with an FHA lender, you may be successful with another one.
Income Limit Requirements
You will be glad to know that there are no income limits as FHA loans are usually geared toward moderate and low income borrowers. However, you should have enough to demonstrate your ability to repay your loan. On the other hand, if you are a borrower with high income, you will not be disqualified from availing the loan.
Debt to Income Proportion
Borrowers should have reasonable loan to income ratios to be eligible for FHA loans. This implies that your monthly spending should be reasonable in comparison to the monthly income. In most cases, the ratio needs to be higher than 31/43; however, sometime, you can get a loan with a ratio of about 55%.
If you have a low credit score, you will easily get the approval if you apply for FHA loans. Your score can be as little as 580 in case you would like to make a down payment of 3.5%. And if you can afford a higher down payment, an even lower score can work.
FHA Loan vs Conventional Loan
Conventional loans have advantages over FHA Loans in certain situations. If you are able to put down 20% for a down payment, you will not have to pay mortgage insurance. An FHA loan -– no matter the amount of down payment — requires an upfront premium and also a monthly premium.
The Drawbacks of FHA Loans
FHA loans do come with a number of tempting features. However, you may realize that a FHA loan may not be suitable for your needs. The loan might not provide sufficient money, especially in cases where you are looking for a large loan. Moreover, these loans may require upfront insurance premiums that may cost you more compared to private mortgage insurance. These are some of the downsides of FHA loans:
- With an FHA loan, it is likely that you will end up paying higher rates of interest as a type of compensation for your smaller down payment amount; this is not the case for more conventional loans.
- You will need to pay a funding fee for an FHA loan; this fee will include monthly insurance premiums along with upfront premiums that will add to the total cost of your home mortgage.
- In case of traditional loans you are allowed to terminate the insurance policy as soon as you have accrued sufficient equity on your home. However, with an FHA loan you are required to continue the payment of mortgage insurance premium on a monthly basis.
Although you may initially think that an FHA loan is ideal for you, these loans are not for everyone. Individuals who have credit scores of lower than 500, are not eligible for FHA loans. Similarly if you can make a big down payment on your loan, you will be better off choosing a traditional mortgage because it can save you more in the long term.