What Is an FHA Loan?
FHA loans are mortgages insured by the Federal Housing Administration (FHA), meant to boost home ownership among low-to-moderate income individuals. FHA loans require a lower down payment and lower credit score than conventional mortgages. However, FHA loans can only be processed through an FHA-approved lender.
FHA Loans Explained
FHA loans are mortgages that are backed by the FHA, which offers the lender a guarantee that even if the borrower defaults the money will be paid back. Because of this, key requirements—notably credit score and down payment—are more lax for FHA loans. FHA loans require the borrower to pay Mortgage Insurance Premium (MIP), which helps protect the lender against default.
FHA loans can be used to purchase one-, two-, three- or four-unit residences. While FHA loans often help first-time homebuyers, you don’t have to be a first-time homebuyer to qualify for an FHA loan. Borrowers of FHA loans must occupy the residence, however.
FHA Loan Requirements
One of the major draws to FHA loans is that they can be obtained with a down payment that’s as low as 3.5% of the mortgage (compared to the typical 20% for conventional mortgages). Notable key requirements for FHA loans include:
- Borrowers must occupy the residence and live in the property for one year
- No short-term rentals are allowed
- Borrowers can only have one outstanding FHA loan at a time
- Mortgage Insurance Premium (MIP) must be paid upfront and monthly
Qualifications for an FHA Loan
- FICO score of 500 or above:
- FICO score of at least 580 to qualify for a 3.5% down payment
- FICO score between 500 and 579 to qualify for a 10% down payment
- Debt-to-income ratio of less than 43%
- Proof of employment and steady income
- Mortgage Insurance Premium (MIP) is required
- Home must be the primary residence of the borrower
FHA Loan Limits
When it comes to taking out an FHA loan, there are limits to the amount of mortgage that can be obtained. The limits vary based on where the property is within the U.S., with there being a floor (low-cost areas) and ceiling (high-cost areas). Examples of cities in low-cost areas include Lafayette, LA and Gettysburg, PA, while Washington, D.C and San Francisco, CA qualify as high-cost areas.
For 2019, the FHA loan limits are:
The Department of Housing and Urban Development (HUD) offers a search tool for finding FHA-approved lenders. The list of approved lenders is fairly expansive, including major banks, credit unions, and online-only lenders. For example, included on the list of FHA-approved lenders are Bank of America, Navy Federal Credit Union, and Quicken Loans.
Advantages and Disadvantages of FHA Loan
The obvious advantages of an FHA loan are a lower down payment and lower credit score. However, there are a few disadvantages, which includes having to pay MPI. MPI for FHA loans is higher than other programs, such as PMI. The MPI is required for the life of the FHA loan if you put down less than 10%. If your down payment is 10% or more, MPI can be dropped after 11 years.
One of the overlooked disadvantages of FHA loans is that they might be looked down upon by agents and sellers. That’s because FHA loans require their own appraisers, which remain with the property for four months and can’t be simply replaced by hiring a new appraiser.
FHA Loan vs. Conventional Loan
Conventional loans have no protection for lenders, i.e. are not backed by the FHA. To qualify for a conventional mortgage, borrowers generally need a credit score of at least 620. While the down payment requirement is lower for an FHA loan, the borrower of an FHA loan must pay an upfront mortgage insurance premium.
The annual premium is 1.75% but it can be rolled into the financed amount, meaning it isn’t an upfront cash outlay. FHA loans also require an annual mortgage insurance premium of between 0.45% and 1.05%, which is paid monthly. MIP is similar to private insurance; however, unlike PMI, there are no ways to avoid paying MIP.
Thus, given a lower down payment and the MIP, the monthly mortgage payment is higher for FHA loans, but interest rates are usually similar.
Amy is looking to purchase a home but her credit score is below 600, making it difficult to get a conventional loan. Her credit score is 592, however, meaning she qualifies for a 3.5% down payment. Upon being approved for a $150,000 FHA mortgage, her down payment is $5,250, versus the typical 20% down—or $30,000—she would have had to put down with a conventional mortgage. Amy’s monthly mortgage payment for an FHA loan would be $1,073, while the conventional loan payment would be $764.
Notice that while the cash-on-cash returns will be more appealing, given the lower the down payment, the monthly payment for an FHA loan will be noticeably higher than a conventional loan. That’s in part due to the MIP, but also because you’re financing much more given the reduced down payment.
FHA Loans for Real Estate Investors
Although FHA loans can’t be used for investment properties, they can be used for owner-occupied residences. You don’t have to be a first time homebuyer and can buy one-, two-, three-, or four-unit properties, meaning real estate investors can leverage FHA loans for “investment” properties.
Investors can buy a multiple-unit property, live in one of the units and rent out the other(s). As well, a consumer can buy a single-unit and take on roommates to help cover the mortgage. The FHA loan works well for investors that are strapped for cash or those that need to keep as much cash available for renovations or rehabs after purchasing the property. Speaking of, investors that are willing to take on fixer-upper properties can get a special FHA loan known as a 203(k) loan, which allows the financing of both the purchase price and the cost of renovations.
Amortization is the gradual process of an outstanding loan balance dropping over time as the borrower makes monthly payments.
A cash-out refinance allows homeowners to take out a new mortgage and receive additional cash, which can be used for renovations or debt pay-off.