How Do FHA loans Work – Here’s a Guide

How Do FHA loans Work - Here’s a Guide

FHA loans have been around in the market for quite sometimes now. This type of home loan was introduced many decades ago to help financially stricken population in buying their own property during the great depression. During 1930s, the United States economy was facing a tough moment in history. The buying power of general population went down a lot, and unemployment rate was at a record high.

Since home loans were a major risk, banking institutions followed strict eligibility criteria before providing mortgages. As a result, many construction workers went jobless and the housing industry started going downhill. To bail out the banking system which could not thrive on existing portfolio and could not accept high risk customers, government introduced FHA loans which were offered by banks but were insured by the government incase of default. Federal Housing Administration has insured over 35 million properties since then and helped regular income earners buy their own houses at a relatively low interest rate.

As a result of the introduction of FHA loans in the financial market, government allowed general population to own the property they were living in, reducing the overall rental expense of general population. Even today, FHA loan is quite popular amongst applicants with lower credit score. Using an FHA loan, potential borrowers with credit score as low as 580 can apply for a mortgage by paying a down payment of nearly 3.5%.

Minimum Requirements to apply for an FHA loan

  • There are certain number requirements that need to be met before an individual can apply for an FHA loan. These include:
  • The borrower must be the primary resident of the property against which the mortgage is being taken out.
  • Applicant should show a proof of steady source of income for the last two years.
  • They should be lawful residents of the United States, and should have a valid social security number.
  • The property needs to be appraised by a FHA approved appraiser.
  • The front-end ratio which includes interest payment, home insurance premium, home owner’s association fee, and property taxes should be below 30%.
  • The back-end ratio which includes mortgage plus other debts should be less than 43%.
  • To receive a higher loan to property value ratio and pay minimal down payment, applicants credit score should be above 580.
  • There should be no bankruptcy or foreclosure submitted by the borrower in the last one year.

Types of FHA loans

Like any other mortgage, FHA loan has different types as well. Mentioned below are some of the most popular Federal Housing Administration loans available in the market:

Reverse mortgage or Home equity conversion mortgage – These types of FHA loans are specially designed for retired individuals who have crossed 62 years of age. If a person has an existing mortgage loan under their name for many years, and the current value of their property is much higher than what it was when the loan was acquired, then they can be eligible for HECM. The equity that a retired individual has in their home can be used to avail a second mortgage. The funds disbursed can be used all at once or acquired through multiple payments.

FHA 203k or home improvement loan – This loan allows eligible borrowers to borrow money from the bank to purchase the home and renovate it as well. This is quite beneficial when the borrower does not have enough cash to cover the home improvement costs.

FHA Energy Efficient home loan program – Although this loan is quite similar to a 203k loan, the disbursement is made solely for the purpose of building energy efficient houses. The costs of improvements covered in this type of loan may include installation of solar panels or windmills to conserve energy. These types of loans help in preserving natural resources and helps the government in saving power generation costs.

FHA loan Rates

Like any other house loan, FHA mortgage provides borrowers with two options to pay off their loan. These are mentioned below:

Fixed Rates – As the name suggests, a fixed rate FHA mortgage allows borrowers to pay-off their loan using equal monthly installment throughout the tenure. In this way, borrowers remain un effected even if the interest rates go high for any reason. However, what if the economy starts booming and interest rates start to fall down? In this scenario, faxed rate mortgage borrowers will incur an opportunity cost due to the difference in their original rate and the current interest rate prevailing in the market.

Adjustable Rates – In this type of repayment schedule, the interest payments remain constant for the first few months, and after that, the interest rate starts to fluctuate based on the market conditions. An adjustable or variable repayment schedule allows borrowers to take advantage of the downside of the market. However, in case the interest rates go up, the borrower will have to pay higher premium than what was initially decided in the contract.

Benefits of an FHA loan

  • One of the major benefits of an FHA mortgage is that the down payment is usually lower than a conventional mortgage loan. Applicants can pay as low as 3.5% in down payment to borrow money from the bank to purchase their ideal home.
  • FHA loans are ‘assumable’ loans. What this means is that another buyer can purchase a property by assuming the mortgage that is being paid by the current owners. This helps in smooth transaction and relief of mortgage loan when home owners want to relocate to another state.
  • FHA loans are becoming popular amongst millennials as well. For this younger generation, a lower down payment is a great attraction for an FHA loan. With lower savings and higher financial prospects, individuals especially women in their early careers go for an FHA loan which provides them security and high loan to value.
  • Closing costs are often covered by the lender in an FHA loan. The lender can add those costs as part of the mortgage, saving some cash for the client. Lenders usually allow such levy to maintain good terms with the Federal Housing Administration. 

FHA loan Downside

  • FHA loans are insured by the government, and the state has to safe guard its interest as well while facilitating the general population. Government has put certain limitations on an FHA loan in order to control defaults. Some of the information that is quite useful for potential borrowers of an FHA loan include:
  • In a thriving market, the upper limit on an FHA loan usually hovers around $650,000, and during the down market, the mortgage limits can reach below $300,000.
  • To protect the lenders interest, FHA mortgage borrowers need to have their property insured all the time. The insurance premium on an FHA mortgage is quite high as well. A conventional mortgage borrower with decent credit history can pay as low as 0.5% of the property value as insurance premium. FHA mortgage insurance can go up to 1.75% of the total amount borrowed, which has to be paid upfront for the first year. In a conventional mortgage, home insurance can be forgiven once the owner acquires certain amount of equity on the residence. FHA loans however do not provide such option.
  • Although applicants of an FHA loan pay a lower than usual down payment. This may entice them to acquire properties that will put higher debt burden on their monthly income. Also, the overall interest paid on the loan will eventually be higher than the conventional loan.
  • FHA loan is a multi-organizational mortgage facility. What this essentially means is that there is more than one regulator associated with this loan. Hence, not every property that an applicant likes can be used for an FHA mortgage. Since the government will have to pay the lender in case the borrower of an FHA loan defaults, the property needs to be in good condition and should not show signs of decay.

Applying for FHA loan

Everyone knows that FHA loans are less stringent when it comes to eligibility criteria than a conventional loan. However, FHA loans do have minimum requirements that need to be met before you can be eligible for a Federal Housing Administration Loan. Mentioned below are some useful steps that can help any potential borrower in applying for an FHA loan:

  • Understand all the requirements and gather the documents before applying for Federal Housing Administration Loan. These documents may include pay slips, banks statement, and credit report.
  • Not every bank or financial institution is approved by the state to disburse FHA loans. Therefore, you need to find a lender which is approved by the federal government to offer a FHA loan. You can find a list of such lenders on HUD – Housing and Urban Development department website.
  • Like any other mortgage, an FHA loan requires a down payment as well. Applicants of this loan should start saving money in advance so they are not scrambling for cash when their mortgage application is finally approved. Borrowers need to pay at least 3.5% of the property value upfront, which is reduced from the total loan amount. The down payment of a FHA loan can be paid by a family member as a gift on customer’s behalf.
  • When applying for an FHA mortgage, you need to keep the following documents handy:
  • Address of locations where you have lived in the past couple of years.
  • Latest tax documents including W2s.
  • Names of employers with whom you have worked in the past 2 years along with how much you earned while working there.
  • Next step would be completing the application form. Start by going through each section of the application and look up any thing that you do not understand. It is better to reach out to the bank representative rather than making educated guesses. If you cannot reach the loan officer then try to look it up online before filling out the information that you are not sure about. It is always useful to get pre-approved by the lender before approaching the Federal Housing Administration. This will speed up the loan disbursal process. Getting pre-approved for an FHA loan means that the lenders finds you eligible for the loan based on the initial documentation that you provide.
  • It is always better to have your property appraised by your own contractor before it is inspected by an FHA approved appraising agency. Even if your application is pre-approved by the lender, it can still be rejected if the appraisal report is not up to the standards defined in the FHA policy manual. FHA loan applicants should ensure that the property being appraised complies with all the health and safety regulations stipulated by Federal Housing Administration.
  • Applications should consider additional costs that they may incur while initiating the mortgage facility with the bank. These costs may include attorney’s fee for preparing legal documentation, property appraisal fee, property taxes, and pre-paid interest.
  • If you still have any doubts after being approved for an FHA loan, you can always consult the HUD designated counselling agencies through the country. These and other housing counseling agencies provide useful advice about mortgage and other debts to prospective borrowers.
  • One of the best ways to increase your chances of getting an FHA loan is reduce your overall debt burden. Before applying for an FHA loan, potential borrowers should reduce their debt to income ratio. This can be done by making minimal purchases on credit cards and paying off outstanding loans.

Concluding Thoughts

Federal Housing Administration was formed nearly a century ago. Since then, the government has allowed millions of individuals in fulfilling their dream of owning a house. This has not only revived the mortgage industry, but has helped create many jobs over the years. To make best use of an FHA loan, potential applicants should ensure that they have enough savings for the initial down payment and a reliable source of income for meeting their future expenses related to the FHA loan.


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