Understanding FHA Loan Requirements, Down Payments & More

Federal Housing Administration (FHA) loans help people with imperfect credit histories qualify for home loans. The FHA promises to repay the lenders if an FHA borrower defaults on a loan. Backed by the promise of the federal government, FHA lenders are willing to overlook blemishes in loan applications that would otherwise stymie a loan.

The FHA guaranty comes at a cost. Borrowers must pay an upfront mortgage insurance premium (UFMIP) at the start of the loan and an annual mortgage insurance premium (MIP), which is split into 12 payments and added to the monthly mortgage bill. The FHA mortgage insurance premiums make FHA loans more expensive than conventional loans, Veterans Affairs (VA) loans, and U.S. Department of Agriculture (USDA) loans. This is not to say FHA loans are bad loans - just realize FHA loans often cost more than other home loans.

Lenders must follow four main requirements when approving an FHA loan. The FHA intends for its loan requirements to minimize the chances a borrower will default on a loan by ensuring he can afford to repay the loan.

The FHA requires you to make a down payment when buying a home with an FHA loan. The minimum down payment is 3.5 percent of the home's purchase price.

If your FICO credit score is less than 580, you might be required to make a 10 percent (or more) down payment, according to some FHA lenders. This is something the lender generally determines, as it is not necessarily an FHA requirement. The FHA allows FICO credit scores as low as 500. However, lenders rarely approve loans with scores that low. A large down payment is called a compensating factor in the mortgage lending world. You can use compensating factors to overcome a deficiency, such as a low credit score.

State and local down payment assistance programs can help you meet the down payment requirement. Check with your local or state's housing authority to see if they offer any types of down payment assistance programs. Down payments can also be gifted from your parents, a spouse, a domestic partner or another relative, but not a friend. The rules state that it must be a gift and not a loan. The FHA will not allow you to borrow to get further into debt.

You must show proof of the gifted down payment by asking the donor to provide a letter with a statement that the money is a gift without expected repayment. The donor will also need to provide proof of the account from which he withdrew the funds. You cannot receive the gift in cash. Cashier's check and money order are the preferred method, with a copy of both sides of the check and the bank statements showing where the money was taken from and deposited to.

You must document the source of any large sums of money deposited to your account recently, other than your regular paycheck. What the lender considers a large sum might be as little as $500.

The FHA allows sellers to pay up to 6 percent of the sales price to cover buyers' closing costs. In some cases, the FHA allows only 3 percent. Either way, the help takes pressure off the borrower to come up with the cash for a large down payment.

The FHA limits the maximum mortgage amount. The limits vary by county and can be up to $726,525 in high-cost areas.

You must show lenders you have the means to make your monthly loan payments consistently.

Lenders use several tools to assess your ability to repay a loan. One of the most important is a number called the debt-to-income ratio (DTI). Your DTI ratio is the total of all of your debt divided by your gross monthly income. The lower the ratio, the less of a debt load you carry.

The FHA wants to see that you can afford all your bills with enough left for other expenses. Lenders view borrowers who have low DTI ratios as more likely to pay their mortgages every month.

The FHA sets the maximum DTI ratio for borrowers, but lenders are free to set lower thresholds. Under FHA rules, borrowers can qualify with a 43 percent DTI ratio. Lenders for non-FHA loans usually set the bar at 36 percent, but the exact number varies by lender. Some lenders allow a DTI ratio of up to 45 percent if the borrower has a higher score and down payment.

There are two ways to calculate a DTI ratio. Most loan officers call one the front-end ratio and the other the back-end ratio. The FHA uses different terminology to express the same ideas. Your loan officer might use either set of terms to describe your DTI.

Conventional or conforming lenders call the typical maximum ratio the "28/36 rule." For FHA loans, it's the "31/43 rule."

Once you submit these documents, your lender takes the total amount of your mortgage expenses, plus all your recurring monthly revolving and installment debt and weighs that against your pre-tax income. The FHA's rule of thumb is that your total fixed payment expenses should be no more than 43 percent of your gross monthly income.

You can exceed the FHA's 31/43 rule if you have compensating factors, such as a high credit score or a large down payment. Expect that if you have a DTI above 43 percent and a credit score below 620, you will undergo additional underwriting scrutiny.

You must disclose all debts and open lines of credit on your loan application. You might wonder why you need to describe your open line of credit. These can become debt if the homebuyer goes on a shopping spree before closing, so the FHA directs lenders to keep an eye on open lines of credit.

Let's start by calculating a back-end DTI ratio with example numbers.

The FHA calls the back-end ratio the total fixed payment expense DTI Ratio. Disclose your college loans, balances on your credit cards, auto loans, and how much you'll pay in both auto insurance and homeowners insurance. Include any personal loans from family, and other debts.

Spousal and child support obligations are considered debt to the person required to make the payments.

Now let's use the same numbers to calculate a front-end DTI ratio:

The FHA calls the front-end DTI ratio the total mortgage expense DTI Ratio.

You credit score and credit history are different but related sources of information lenders use to decide whether to approve your loan application. Your score is a predictive statistic and guess at your likelihood of repaying a loan.

When it comes to credit scores, bigger is better. Why? Lenders offer the best rates to borrowers who have the highest FICO credit scores.

The FHA minimum credit score is 500. However, if you want a loan with a 3.5 percent down-payment, then you must have a credit score of 580 or higher.

If you have a FICO credit score between 500 and 579, you are still eligible for an FHA loan. Borrowers with low scores must come up with a 10 percent down payment.

The 580 credit score standard is a bit deceiving in practice. It is common for lenders to place the bar higher and require a 620, a 680 or even higher score. Lenders may not go below the FHA's minimum credit score, but are free to require higher scores.

These higher standards are known as lender overlays and they vary from lender to lender. Lenders add overlays as a precaution, especially on credit score requirements, because borrowers with low credit scores are more likely to default. Lenders worry about their overall FHA default rate. Lenders with high default rates are not allowed to stay in the FHA program and may receive financial penalties for making too many bad loans.

If at first you are not approved, try again. Since each lender uses different overlays, loan requirements differ by lender. One lender may say no to giving you a loan, while another will say yes to the same loan.

Your credit score is just a three-digit number. Your credit history details your payments for each of your debt accounts.

Lenders look for red flags in your credit history that might indicate you will not repay the loan. Occasional, infrequent late payments on a credit card, for example, will not raise a concern if you can explain why they occurred.

Collections and late payments are evaluated on a case-by-case basis. Lenders may overlook occasional late payments on your cable bill or clothing store credit card. A serious delinquency in these types of accounts would reflect negatively on your credit score. However, lenders are more concerned about late payments on your rent or mortgage. Lenders see a history of late rent and mortgage payments as a sign you may default on future home loans.

If you defaulted on a federal student loan or have another unpaid federal debt, you will be required to come up to date and have the debt either paid off in full or be current for several months. Similarly, judgments against you must be paid. Sometimes credit issues are beyond your control. The FHA realizes this and creates programs that take into account how one's credit history may not reflect that person's true willingness to pay on a mortgage.

If you experienced a bankruptcy, short sale, foreclosure or a deed in lieu of foreclosure in the last two years, check out this foreclosure page to learn about your mortgage options.

If you have other dents on your credit history, see this page to learn how to answer your lender's requests for information about your problematic debts.

To be eligible for FHA home loans or any other government-backed mortgages, applicants are required to pass a Credit Alert Interactive Voice Response System (CAIVRS) check. It's pronounced "cavers," and it's the federal government's deadbeat database.

Any federal agency that grants direct loans or provides insurance for loans must pre-screen all applicants. For most people, the check causes no problems with their loans.

However, those who appear on CAIVRS and don't qualify for exceptions can't get FHA mortgages. They must pay off the debt, prove that they're listed in error, or bring the past-due account current under a repayment plan. If the repayment plan is approved, the reporting agency can then clear the applicant's name from CAIVRS.

Federal IRS tax liens may remain unpaid as long as the IRS is willing to subordinate the tax lien to the FHA mortgage.

Not everyone on CAIVRS is ineligible for FHA financing. These three exceptions may apply:

• Someone assumed your government loan and defaulted.
• Your divorce decree awarded property and loan payment to your ex-spouse, who defaulted after your divorce.
• A government-backed mortgage was included in a bankruptcy that was caused by circumstances beyond your control.

It's not uncommon for consumers to appear on CAIVRS by mistake, and it's nothing to be ashamed of. The lender can divulge which agency reported the information, and the borrower can then sort out the problem. To speed up the mortgage process, it's better if the applicant provides proof that that the debt was paid to both the lender and the reporting agency.

The CAIVRS check happens very early in the mortgage process, so errors don't necessarily delay closing if cleared right away. Of course, this is just one more reason homebuyers should get preapproved for their FHA mortgage before home shopping.