Understanding FHA Loans

Whether you are buying your first home or refinancing a mortgage, you will probably have many questions along the way. What’s the best loan type? What does it take to qualify? What are my rights? How do I find a good lender? Is what the lender told me really true? How do I get the best deal?

FHA mortgages are a popular home loan option. They allow buyers to qualify with a low down payment and offer flexible underwriting guidelines. FHA loans are insured by the Federal Housing Administration, an agency of the U.S. Department of Housing and Urban Development (HUD).

The FHA does not actually lend money to homebuyers. Here is how the program works:

Borrowers apply for home loans with FHA-approved lenders such as banks, credit unions and mortgage companies. Their applications are evaluated according to HUD guidelines.

If approved, the loan is funded by the lender and insured by the FHA. The homebuyer pays for mortgage insurance. With the mortgage insured against default, the lender‘s risk of a borrower failing to pay is reduced. Therefore, the lender is able to approve mortgages for homebuyers with smaller down payments.

Read on for details that will help you decide if FHA loans are for you, including how FHA loans stack up to conventional loans and an overview of loan qualification requirements.

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FHA Loan Pros & Cons

FHA mortgages have advantages and drawbacks. Borrowers should compare FHA and conventional (nongovernment) home loans to choose the mortgage that best meets their needs.

Pros

Low Down Payment Requirement

For many would-be buyers, the down payment is the largest obstacle to homeownership. FHA’s minimum down payment is 3.5 percent. The money can come from the borrower’s own funds, a gift or a loan from an acceptable source.

Low Minimum Credit Score

FHA minimum credit scores are low — 580 for a loan with a 3.5 percent down payment and just 500 with 10 percent down. This allows underwriters to approve mortgages to an applicant whose credit was damaged by circumstances beyond his or her control, applicants with low scores who have successfully re-established credit or prospective homebuyers with low scores but acceptable credit histories.

Underwriting Flexibility

The FHA is more forgiving of credit mishaps than most other programs. Underwriters are instructed to distinguish between applicants who habitually misuse credit and those with valid reasons for their lapses. Consumers with past bad credit who have established good payment patterns are normally treated more leniently. In addition, FHA guidelines allow higher debt-to-income ratios (expenses divided by gross income) than most conventional programs.

Streamline Refinance

FHA’s streamline refinance program allows homeowners to easily refinance their mortgage to a home loan with better terms. Lenders are not required to verify the borrower’s income or employment, no appraisal is necessary, and there is no minimum credit score to qualify. This allows homeowners whose property values, incomes or credit scores have dropped to improve their financial positions by refinancing.

Borrowers Eligible During a Chapter 13 Bankruptcy

Most mortgage programs require borrowers to wait for several years after a bankruptcy discharge before they are eligible for financing. That makes sense for those who immediately wipe out their debts with a Chapter 7 filing. However, those in Chapter 13 bankruptcy spend up to five years in their plans repaying their creditors before they receive a discharge. The FHA recognizes the difference and allows applicants in Chapter 13 to be eligible for financing after making 12 monthly on-time payments to the plan, as long as their bankruptcy trustee approves it.

Short Wait for Eligibility After a Chapter 7 or 11 Bankruptcy

With many mortgage programs, applicants must wait four years (two if there are extenuating circumstances) after discharging a Chapter 7 or 11 bankruptcy before they are eligible for home financing. With FHA mortgages, that waiting period is cut in half for most applicants and just one year if there are documented extenuating circumstances (for example, the death of a wage earner or an employer going out of business) and applicants have re-established a good credit history.

Assumable

A homeowner who sells a property that was bought with an FHA loan can allow the buyer to take over the mortgage. This move can eliminate thousands in closing costs for the buyer. This can be a powerful advantage for the seller when the interest rate on the FHA loan is lower than what the seller would pay on a new mortgage. For the buyer, an assumable loan can translate into a higher selling price or swifter sale.

Cons

High Mortgage Insurance Costs

FHA mortgage insurance premiums (MIP) are on the high side. FHA borrowers pay an upfront fee of 1.75 percent of the loan amount, which can be paid in cash or added to the mortgage. They also pay an annual premium, which is added to their monthly payments. For most, that is 0.85 percent of the outstanding mortgage balance. Unlike mortgage insurance for conventional loans, FHA MIP lasts for the life of the loan.

Loan Limits

FHA loans were created to make home ownership accessible to people of modest means — not to help the rich buy mansions. For this reason, HUD imposes limits on the size of the loans it insures. FHA mortgage limits for specific counties can be found on this FHA Loan Limits page.

More Paperwork

In comparison to conventional loans, FHA borrowers must sign a few extra forms, many of which serve to protect the borrower. Doing so adds several minutes to the application process, but the protections associated with some disclosures are probably worth it. For example, the FHA Amendatory Clause changes the purchase contract to allow the buyer to cancel a home purchase if the property does not appraise for at least the sales price.

FHA Appraisal

The FHA’s appraisal includes typical items a home inspector might look for. FHA-financed homes must meet minimum safety and livability standards to be eligible for financing. This means that not all home appraisers are qualified to perform FHA appraisals, and FHA appraisals usually cost a little more. The FHA is careful to disclose that its appraisal does not replace a home inspection.

Harder for Condos

Not all condominiums can be financed with FHA home loans. In fact, the National Association of Realtors says only about 30 percent of condo projects are FHA-approved. To secure approval, the homeowners’ association (HOA) or board must submit an application package to HUD. Not all HOAs are willing or able to undergo the scrutiny. For example, FHA-approved projects must be at least 51 percent owner-occupied, no more than half of the units can be financed with FHA mortgages, and at least 85 percent of units must be current with their HOA dues.

CAIVRS

CAIVRS — the Credit Alert Interactive Voice Response System — is a federal database all lenders must check before approving government-backed loans. It tracks people who owe the government money, people who have incurred federal liens or judgments, and people who have defaulted on government-backed loans. CAIVRS is not an issue for those not listed. If an FHA applicant turns up on CAIVRS, however, he or she is ineligible for financing. The applicant must resolve the listing either by entering into a repayment plan, resolving reporting errors, or getting the entry removed.

Ranking FHA Mortgage Lenders

FHA home loans can be obtained from any FHA-approved provider, including banks, credit unions and mortgage companies. The table below shows which providers are doing the most FHA business nationally and in your area. You can sort by average loan amounts and interest rates. Knowing what nearby “going rates” are can help you evaluate the offers you receive.

Find Lenders in your Area
Banks Volume of Mortgages Number of Mortgages Market share Avg. Interest Rate
Wells Fargo Bank NaAnchorage, Alaska $670,448,426 3,881 2.62% 3.967%
Quicken Loans IncAnchorage, Alaska $537,090,668 3,748 2.10% 3.910%
Academy Mortgage CorporationAnchorage, Alaska $480,304,333 2,643 1.88% 4.119%
Primelending A Plainscapital CompanyBirmingham, Alabama $344,856,138 2,034 1.35% 4.063%
Guild Mortgage CompanyAnchorage, Alaska $332,012,510 1,702 1.30% 4.145%
Everett Financial IncBirmingham, Alabama $307,143,473 1,861 1.20% 4.150%
Fairway Independent Mortgage CorporationBirmingham, Alabama $273,084,413 1,648 1.07% 4.126%
Prospect Mortgage LlcAnchorage, Alaska $259,162,634 1,154 1.01% 4.137%
Pinnacle Capital Mortgage CorporationBuckeye, Arizona $256,089,258 1,036 1.00% 3.916%
Primary Residential Mortgage IncAnchorage, Alaska $253,539,800 1,409 0.99% 4.159%

Source: U.S. Dept. of Housing and Urban Development, 2015

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FHA Mortgage Must-Knows

With their special requirements and terminology, FHA mortgages can be a little confusing and intimidating. These loans are a bit different from conventional mortgages because they are government-backed. Knowing these differences can help you avoid mortgage mishaps and get better deals for your financing. Here are some quick tips. Click on the links to explore topics more in-depth.

Before FHA: A Nation of Renters

Homeownership has long been considered the cornerstone of the American Dream. The majority of U.S. citizens are homeowners, and for many, property is their main source of wealth.

Yet, before the FHA was created in 1934, the United States was a nation of renters. To get a mortgage, homebuyers had to come up with a 50 percent down payment and they had just three to five years to pay the loan off. These requirements made it difficult for most people to own homes.

The FHA was created to help the U.S. emerge from the Great Depression and to help Americans buy homes. In 1965, it became part of the U.S. Department of Housing and Urban Development (HUD).

Over the years, the real estate and mortgage industries have changed significantly, and FHA programs have continued to evolve to support American homebuyers and homeowners. Here are some fast facts about the FHA today.

Average credit score for FHA borrowers in Q2 2015
Average 2014
loan amount
$171,954
Percentage of FHA purchase loans
to first-time buyers in 2014
81%
total outstanding loans insured by the FHA
$1.05 trillion
Total number of FHA loans outstanding
7.6 million
total number of FHA loans endorsed in the last three months 289,642

Sources: FHA Single-Family Origination Trends Report, May 2015; FHA Annual Mgmnt Report, 2014

FHA Loans Over the Years

FHA underwriting guidelines, eligibility requirements and insurance premiums change all the time — the agency must balance the needs of homebuyers with a mandate to protect taxpayers from losses. The characteristics of FHA borrowers and loans also change. For example, in early 2008, before the financial crisis, nearly half of the approved FHA loans went to borrowers who had a FICO score below 620, according to the FHA’s 2014 annual report to Congress. The Great Recession and mortgage foreclosure crisis have pushed that percentage down to less than 5 percent of approved borrowers, as you can see in one of the charts below. These charts show you how FHA loans and borrowers have changed over the years.

FHA’s Market Share Since Year 2000

Source: Federal Housing Administration 2015

FHA Borrowers Credit Score Distribution

Source: Federal Housing Administration 2015

How Do You Stack Up?

You should understand that average credit scores are just that — averages. FHA lenders look at the entire application package — payment history, income stability, assets, down payment and more. Lower scores are not always the result of poor credit, and lenders recognize that. Applicants with credit blemishes and low scores can compensate by making a larger down payment. Applicants with higher debt-to-income ratios, smaller down payments or other weaknesses usually need scores that exceed the bare minimums.

Alternatives to FHA Mortgages

The FHA program is not the only option for people with small down payments who want to buy homes. Here are other options you can explore.

Conventional Loans With 3 Percent Down

Both Fannie Mae and Freddie Mac offer 97 percent mortgages to eligible first-time homebuyers. Like FHA mortgages, these loans offer flexible underwriting guidelines. However, they have a few advantages over FHA loans:

  • The down payment is just 3 percent.
  • There is no upfront mortgage insurance, and the annual premiums are lower.
  • Borrowers can request mortgage insurance cancellation when the loan balance drops to 80 percent of the original home value.

If you have owned a home in the last three years, you don’t qualify for this loan but you may still be able to get a conventional loan with a 5 percent down payment. It’s important to compare which loan type makes more financial sense for you.

Seller Financing

Some home sellers are willing to finance their own properties. The buyer may be able to avoid lender fees and other homebuying costs like title insurance. Sellers may be more willing than mortgage lenders to overlook credit or income issues. However, buyers of owner-financed homes should have an appraisal done to avoid overpaying for the property. Inspections and title insurance are still a good idea for the buyer’s protection, and it’s wise to hire a real estate lawyer to review the loan terms. Individual sellers don’t have to play by the same rules as licensed mortgage lenders, which means that borrowers have fewer protections.

USDA and VA Home Loans

FHA is not the only government mortgage program. VA and U.S. Dept. of Agriculture (USDA) home loans offer a number of advantages over FHA loans for those who are eligible. The U.S. Department of Veterans Affairs insures mortgages for eligible service members, veterans, and in some cases family members. These loans don’t have down payment requirements, and borrowers don’t have to pay monthly mortgage insurance. Often provided in rural areas, USDA loans allow qualified borrowers to get a mortgage without a down payment when they buy a home in an eligible area. About half of all U.S. citizens live in neighborhoods eligible for USDA loans. USDA mortgages have funding fees (2 percent), which can be financed, and require annual mortgage insurance, but the premiums are lower than FHA insurance.

FHA Loans Questions and Answers

Is an FHA loan really the best option for a first-time homebuyer?

The FHA mortgage was designed to meet the needs of homebuyers who have smaller down payments — it doesn’t matter how many homes they have owned. A buyer with decent credit and a down payment of at least 10 percent is probably better off with a conventional (non-government) mortgage. A buyer with a smaller down payment might still be better off with a conventional loan — it really depends on the total package. Homebuyers should compare the total costs of conventional and FHA offers from competing lenders to make sure they are choosing the lowest-cost option that best meets their unique needs.

Are FHA loans cheaper?

It depends. Both FHA and conventional mortgage rates are set by private lenders, not the government. Costs and rates vary among mortgage lenders by an average of 0.25 to 0.50 percent. Rates and terms can change frequently. Mortgage insurance costs also change over time. Homebuyers with less than 20 percent down should compare both conventional and FHA loans when they shop for mortgages.

How do I know if an FHA loan is for me?

The very basic rule of thumb for FHA loans is that they are more appropriate for those with smaller down payments, lower credit scores, or higher debt-to-income ratios. There is no hard-and-fast rule because FHA home loans are made by private mortgage lenders, and they set their own rates and fees. FHA lenders may also impose higher standards than the FHA requires — these standards are called overlays.

How hard is it to qualify for an FHA loan?

FHA mortgage underwriting is some of the most forgiving in the business. You need an acceptable credit history, which means no serious derogatory events in recent years, a credit score above 579 (for a 96.5 percent loan), verifiable income that is ongoing, sufficient and stable, funds to cover the down payment and closing costs, and a debt-to-income ratio that doesn’t exceed 43 percent. Those are the basics. Applicants who exceed these minimum qualifications have a much better chance at loan approval, and those who barely meet guidelines may have to work harder to get a loan.

How long does it take to close on an FHA loan?

Well-prepared applicants can usually close quickly if the applicant supplies the lender with a complete and accurate application, proof of income and asset documentation, and there are no credit or employment issues. Most home loans (including FHA) are underwritten with automated underwriting systems (AUS), which deliver decisions in seconds. Those with less common circumstances including no reported credit history, all-cash down payments or identity theft must be underwritten manually, which can take longer. On average, home loans close in about 40 days. Experts recommend buyers get preapproved before shopping for homes to make closing easier.

Is it harder to buy a house if I’m using an FHA loan?

Only if the seller’s agent has an inaccurate view of FHA loans. Some think that FHA requires higher property standards and requires sellers to pay buyer’s costs — not true. Others don’t like the FHA Amendatory Clause, which allows buyers to cancel a purchase if the home does not appraise for at least the sales price. This is not an issue unless the property is overpriced. Some perceive FHA borrowers as borderline and harder to approve — an impression that can be overcome by getting loan approval before shopping for a home.

Is an FHA loan more expensive long-term?

One disadvantage of FHA home loans is that borrowers cannot drop FHA mortgage insurance coverage, even when the loan-to-value ratio drops below 80 percent. If a homebuyer keeps an FHA loan for an entire 30-year term, it could be expensive. However, typical homebuyers under 50 keep their houses between five and eight years, and many refinance sooner than that. Very few homeowners keep a mortgage for 30 years.

Why is my lender pushing me into an FHA loan?

The loan officer or mortgage broker doesn’t earn more for selling an FHA loan (federal law prohibits basing compensation on loan terms). Chances are, he or she feels that it’s the best loan for your situation, or the one most likely to result in approval. However, a good lender should be able to explain the reasoning behind a recommendation, and no one should feel pushed into a product. Ask your loan professional why he or she is so gung-ho on the FHA loan, and see if that explanation makes sense to you. You should probably speak to more than one lender about your options and compare mortgage quotes from several before committing.

Where do I get started if I want to get an FHA loan?

First, you should obtain a few FHA mortgage quotes from competing lenders — by checking online, contacting companies by phone or visiting them in person. Next, get back to a couple of the lenders with the most competitive quotes and speak to the loan officers. This lets you judge the lender’s service and make sure you qualify for its FHA program (individual lenders can add stricter requirements to FHA’s basic underwriting restrictions, so it’s good to ask about this upfront). Finally, your loan pro should walk you through the application process — most lenders interview applicants, compete the forms online, submit the application electronically and have a decision in a few minutes. You’ll then get a list of items needed to finalize the approval.

Do I have to be a U.S. citizen to get an FHA loan?

FHA loans are available to foreign nationals who are lawful permanent resident aliens or qualified non-resident aliens working in the U.S. Unlike many conventional programs, which require noncitizens to make down payments of 30 percent of more, FHA allows qualified buyers to put just 3.5 percent down.

Can I qualify for an FHA loan with bad credit?

That depends on how bad your credit is. The FHA insures loans for people with a bad credit history if it was not their fault, or if they have overcome their financial difficulties and re-established a positive credit history and an acceptable credit score. The FHA says:

The lender must document the analysis of delinquent accounts, including whether late payments were based on:

  • A disregard for financial obligations
  • An inability to manage debt
  • Factors beyond the borrower’s control

If a borrower’s credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments and delinquent accounts, significant compensating factors, such as a higher down payment, will be necessary to approve the loan.

Who should consider getting an FHA loan?

Those with smaller down payments, credit issues or higher debt-to-income ratios should probably include FHA when comparing mortgage programs. People who want to purchase a fixer-upper should look into the FHA 203(k) program, especially if they don’t have a lot of money for repairs. Foreign nationals who don’t want to make high down payments should also consider FHA loans. Finally, homebuyers who want an assumable loan should put FHA at the top of their lists.

Updated: July 27, 2017