The FHA loan is the most popular mortgage program in America, and for good reason. It's designed to help millions of people get into their dream homes by making it easier for them to afford a home with lower down payments, more flexible credit requirements, and better rates.
But like any other type of loan, there are still some important things you should know before signing on the dotted line! This article will cover five important things to know about FHA loans so you can make an informed decision before applying.
History You Should Know About FHA Loans
The FHA (Federal Housing Administration) was started in 1934 by the U.S. Government to help people buy homes during The Great Depression. This was when banks were failing and jobs had evaporated, thus making it impossible for many people to get approved for a mortgage. It was originally intended as an insurance program so lenders would have someone else to turn to if they made bad loans.
Thus, the FHA loan was designed specifically for first-time homeowners, lower-income borrowers, military vets, self-employed business owners, minorities, and others who might not meet strict underwriting guidelines. In fact, many conventional lenders were likelier to reject such borrowers outright, leaving them with no option for a loan or a loan that doesn't suit their needs. The FHA’s loan program has evolved over the years, often shifting in response to recessions and housing crises.
Financial Details
Although FHA loan requirements are much more flexible than conventional loans, there are still some financial requirements. Here is what you need to know about FHA loans in regards to financial details.
Credit Score
You typically need a credit score of at least 620 to be eligible for a conventional home loan. However, it's possible to get an FHA loan with a score as low as one in the 500s.
The Minimum Decision Credit Score (MDCS) refers to the credit score reported on the borrower’s credit report when all reported scores are the same. Where three scores are reported, the median score is used as the MDCS. Where two differing scores are reported, the MDCS is the lower of the two scores. Where only one score is reported, that score is the MDCS.
The FHA requires that borrowers have a minimum score of 500 MDCS to qualify for an FHA loan. However, if your credit score is less than 580, you may be subject to additional requirements, such as a higher down payment. Also, individual lenders may opt not to work with borrowers whose scores are lower than 580. It’s best to request your credit score online or from your banking institution before reaching out to a lender to see where you’re starting from.
Debt-to-Income Ratio
Other than credit score, the debt-to-income ratio (DTI) is the other major financial factor in determining your ability to get an FHA loan. To find out if you qualify, lenders will add up all your monthly debt payments such as credit cards and car loans then divide that number by your gross (before tax) income. The resulting percentage is considered your debt-to-income ratio.
The maximum allowed DTI for FHA borrowers is 50%, which means the total amount of debt they owe cannot exceed 50% of their gross incomes. The homeowner’s total monthly mortgage payment cannot exceed 31% of their gross monthly income. However, the borrower’s monthly total mortgage payment may be up to 35% of gross monthly income if their total debt does not exceed 48% of the gross monthly income. If it's higher than this threshold, most lenders won't approve an application unless there are compensating factors like high credit scores or significant down payment reserves.
Now if your head isn’t already swimming from all those numbers, here's where things get tricky: not everyone uses these same numbers to evaluate whether someone qualifies for an FHA loan! Some lenders might use 36% or 38%, which means borrowers with slightly higher DTIs could still get approved. And some lenders may require lower balances, so even someone with a 40% debt-to-income ratio would qualify if their credit score is high enough.
Proof of Income and Employment
Another financial requirement of an FHA loan is proof of income or employment. In this case, lenders will ask to see your most recent W-2 or two forms of income for the last few months, as well as your job history. If you've been self-employed, they'll also want tax returns from the previous two years so they know your business is stable and profitable enough that it can support monthly payments on an FHA mortgage.
Property Details You Should Know About FHA Loans
To qualify for an FHA loan, the home you are purchasing must meet certain specifications. For example, it must be an existing single-family home that is one to four units. Alternatively, it can be a multi-unit building with at least one of the units being occupied by the owner. It has to be your primary residence, and it can't be considered "luxury" housing with an appraised value above FHA limits (this is known as a loan limit conforming loan).
Home Types
Although there are several requirements borrowers need to know about before getting an FHA loan, perhaps the most important ones are those specifically related to their property. Borrowers may only purchase properties such as single-family homes, townhouses, or manufactured homes built after June 1976, which meet certain energy efficiency standards set by HUD at the time of construction. Condominiums are not eligible for FHA loans. And while it may sound like a lot of properties don't qualify, in reality, most single-family homes will work for this loan.
Loan Limits to Know About FHA Loans
Loan Limits are set annually and depend on where you live. FHA's nationwide forward mortgage limit "floor" and "ceiling" for a one-unit property in the calendar year 2021 are $356,362 and $822,375, respectively. However, this number may increase if local median prices go up. These are known as “High-Cost Area” adjustments. Check out this helpful link for updated numbers.
Insurance and Other Fees to Know About FHA Loans
Although FHA loans have many positive attributes that make them great for many buyers, you should be aware of some additional costs associated with these loans.
Mortgage Insurance
One downside of using an FHA loan over a conventional one is you will need to pay for some additional fees and private mortgage insurance (PMI). PMI payments remain in place until your equity in the property reaches 22%. The good news is, unlike with regular mortgages, PMI paid on an FHA loan can be added into your monthly payment so it's automatically deducted from your account each month. In addition, there are no prepayment penalties associated with paying off PMI early.
Appraisal Fee
When you use an FHA loan, the home you are purchasing will require an additional inspection called an FHA appraisal, which costs about $400. This is done to make sure the home doesn't have any major defects or damages that would require costly repairs and could possibly cause you to default on the loan.
Closing Costs
The total amount of closing costs averages between two and three percent of the purchase price and can include fees. Fees may be for appraisal, application, underwriting, title search/certification of property ownership records, courier services to get the paperwork done quickly, recording fees, and a survey fee if applicable. Specific fees will depend upon the lender, property, and even the seller. Your mortgage lender will be the one to walk you through these details, so keep that in mind as you shop for a lender. You want to find a team you feel comfortable working with and asking questions.
Pre-Payment of Your FHA Loan
Another helpful note to know about FHA loans is that there are no prepayment penalties associated with them. Thus, you can pay off your balance at any time without penalty. This is beneficial if there are changes in the market that make it advantageous to refinance, or if you come into some extra money unexpectedly.
Takeaways On What to Know About FHA Loans
Of course, an FHA loan isn't right for everyone's situation, so do some digging to learn what other options are available before deciding on one of these types of loans. The good news is that since FHA loans are backed by the federal government, lenders know how to help borrowers navigate their specific terms and guidelines. However, when it comes to private mortgages each lender can have an even broader set of different rules.
When done correctly FHA loans offer a lot of benefits. Our team at Texas United Mortgage is very experienced with FHA loans and walking borrowers through the process. So if you're in the market for a new home and you've heard about FHA loans, you’ve likely asked yourself some of these questions. What are they? And how do they work? Hopefully, the important points we've covered about FHA loans will help you make an informed decision on your home buying journey.
