Everything You Need To Know About FHA Loans

The concept of the FHA loan was introduced in the 1930s when the United States was reeling from what would turn out to be the worst depression in American history. As the stock market crashed and the economy took a turn for the worst, defaults and foreclosures ran rampant. In response, the powers that be (the federal government) saw fit to provide lenders with peace of mind by insuring subsequent home loans. The resulting Federal Housing Administration (FHA) loans did their best to reduce lender risk and stimulate a struggling housing market, and their legacy lives on today. Not surprisingly, FHA loans are designed to promote homeownership amidst low-to-moderate income borrowers. And while we may not be facing the same financial crisis we were in the 30s, or even just a decade ago, borrowers should take solace in the fact that FHA loans are here to help.

What Is An FHA Loan?

The name says it all: an FHA loan is a mortgage issued by federally qualified lenders. Perhaps even more importantly, however, FHA loans are subsequently backed by the department of Housing and Urban Development (HUD). In other words, FHA loans are insured by the government, which begs the question: What does that really mean? Why is the federal government intent on insuring more loans?

According to Investopedia, “the government created federally insured loans that gave mortgage lenders peace of mind, reduced lender risk and stimulated the housing market.” More specifically, government backed loans awarded lenders the ability to underwrite more mortgages for buyers that were previously ignored by lenders because of the risk of default they posed. You see, once the government decided to insure FHA loans, low-to-moderate income borrowers (or those with a less than attractive financial profile) could finally get the loan they needed to buy a home without making a significant down payment. More people could transition to homeownership and, in turn, help stimulate the economy.

It is important to note, however, that FHA loans are insured for the lender, not the borrower. That’s an important distinction to make, as the FHA will assume responsibility for protecting the lender if the borrower neglects to keep their mortgage payments current. In the event a borrower does default on their mortgage, they are still at risk of a foreclosure, but the lender can rest assured, knowing full-well that the loan was insured by the government.

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FHA Loan Requirements

• A credit score of at least 500.
• Those with a credit score between 500-579 can obtain an FHA loan with a down payment of 10%.
• Those with a credit score higher than 580 can get an FHA loan with as little as 3.5% down.
• Borrowers should be able to prove a steady employment history for at least two years.
• Borrowers need to prove they are a legal citizen, of the legal age to sign a mortgage and provide a valid Social Security Number.
• At the very least, borrowers will need to put down 3.5% at the time of signing.
• FHA loans can only be used by those looking for a primary residency.
• The subject property must be appraised by an FHA-approved appraiser.
• The borrower must exhibit a front-end-ratio of less than 31% of their gross income, typically.
• The borrower must exhibit a back-end-ratio of less than 343% of their gross income, typically.
• While there are exceptions, borrowers should be at least two years removed from bankruptcy and on their way to establishing good credit.
• While there are exceptions, borrowers should be at least three years removed from foreclosure and on their way to establishing good credit.
• The property itself should meet FHA standards at the appraisal. FHA loans will only be given to properties that meet FHA guidelines.

FHA loan requirements stray from those of their conventional counterparts because they are insured by the federal government. As a result, FHA loans a specifically tailored to help those with less than perfect financial profiles. That said, FHA loan requirements are not as strict as those that have become synonymous with conventional loans. Credit scores, for example, don’t need to be perfect to qualify for an FHA loan, but instead can be as low as 500. Of course, a borrower’s credit score will impact the amount they are expected to “put down” at the signing. Those with a credit score between 500-579 can obtain an FHA loan with a down payment of 10%. Those with a slightly better score (at least 580) could get away with a down payment as little as 3.5%. In addition to credit scores and down payments, FHA loan borrowers will need to demonstrate some level of financial competency; namely, that they are at least a couple of years removed from bankruptcy and three years removed from any foreclosures.

These aren’t the only requirements to meet if you want to qualify for an FHA loan. For more information, please refer to the U.S. Department of Housing and Urban Development’s page on FHA loans.

How To Apply For An FHA Loan

1. Determine whether or not you qualify: Though they have become known for their “looser” requirements, there are still several requirements you must meet if you hope to obtain an FHA loan. Before you move forward, make sure you qualify for an FHA loan. Most importantly, make sure you have the credit score necessary to proceed.

2. Find an FHA-approved mortgage broker: Only FHA-approved lenders can offer FHA loans, so make sure you find a qualified lender. The FHA Lender finder available on the United States Department of Housing and Urban Development website is a good place to start.

3. Save up enough for a down payment: Every FHA loan will require a down payment. While your credit score will determine how much you need to put down, you’ll be expected to pay the down payment up front, so be ready. Now is the time you may want to reference a dependable FHA loan calculator, as to gain a better idea of what to expect.

4. Compile necessary documentation: Since you are looking to take out a rather sizable loan, you will need to provide the lender with your employment status, savings, credit and personal information. These are formalities they will use to decide your creditworthiness, so make sure you can find the necessary documentation. The documentation you will need is extensive and includes, but isn’t limited to job records, tax documents, and personal information.

5. Fill out the loan application: Of course, to qualify for a loan you must fill out an application, and FHA loans are no exception. Fill out the application correctly, and leave nothing to chance. Fill it in to the best of your knowledge, and look up any information you may not be absolutely certain of.

6. Have the property appraised by an FHA-approved appraiser: In order to qualify for an FHA loan, you must have the subject property appraised by an FHA-approved appraiser. If for nothing else, the home must qualify just as much as you should. More specifically, however, the home needs to comply with health and safety regulations.

7. Sign the papers at the closing table: Provided everything falls into place, you are ready to sign the closing papers. Expect additional fees at the closing table and come prepared to pay them immediately.

What First-Time Buyers Need To Know About Their FHA Loan

• The down payment is directly correlated to your credit score: First-time buyers need to understand that how much they put down at the time of signing an FHA loan will depend on their own credit score. Not surprisingly, the better your credit score, the less you’ll have to put down, as you are considered less of a risk. Those with a credit score between 500-579 can obtain an FHA loan with a down payment of 10%. However, those with slightly better scores (580 or more) may only have to put down as little as 3.5% at the time of signing. That said, it will pay to have your credit in check prior to applying for an FHA loan.
• FHA loans are meant to stimulate the housing market: As I already alluded to, FHA loans were introduced into the marketplace to stimulate the housing industry. The government decided to insure loans so that select lenders would be willing to take a shot on “riskier” lenders. And, as a result, more people would be able to fulfill their dream of homeownership. That said, FHA loans are not too good to be true, but rather a bet that more people can afford homes if they aren’t impeded by huge down payment requirements. What’s more, a lot of buyers may not realize they qualify. At the very least, you will never know until you check, so don’t write of FHA loans as an option for your first purchase.
• The government insures the lender, not the borrower: A government backed loan may sound reassuring to many first-time homebuyers, and it should, but not for the reason many assume. You see, the government isn’t insuring the loan on the borrower’s behalf, but instead they are giving the lender peace of mind. As a result, the lender doesn’t need to worry as much about a default. The borrower, on the other hand, still needs to remain current on their mortgage payments, as government insurance won’t do them any good in the face of default. That said, don’t assume a government backed loan offers you any sort of safety net; the insurance will make it easier to get a loan, but it won’t do anything for you in the event of a default.

An FHA loan is the perfect solution for buyers with less than perfect financial profiles. More importantly, an FHA home loan awards prospective buyers the ability to make the transition to ownership, as they significantly lessen the burden of the dreaded down payment. That said, nobody is simply going to give you an FHA loan; you need to do the work yourself and make things happen. If you are interested in applying for an FHA loan, mind due diligence and learn everything you can about them; only then can I recommend moving forward.

Key Takeaways

• The amount you can expect to put down for an FHA loan is directly correlated to your own credit score.
• FHA loan requirements are not as strict as their conventional counterparts, but there are requirements, nonetheless.
• The FHA home loan is specifically designed to help buyers that may have difficulty qualifying for today’s conventional loans.