When talking about the requirements for buying a home, chances are that you’ve heard the 20% down payment requirement rule. Conventional loans often require a 20% minimum down payment in order to secure. Without it, you either won’t get approved for the loan or will pay for pricey private mortgage insurance to obtain it.
With an FHA home loan, though, that 20% rule doesn’t apply. With these types of government-backed loans, you can buy a house with as little as 3.5% down. The loose lending parameters for FHA loans mean that many more people can qualify to buy a home, even if they can’t meet the traditional downpayment or credit guidelines.
What is an FHA loan?
An FHA loan is a mortgage loan insured by the Federal Housing Administration (FHA). While the loan is backed by the U.S. government, you still obtain FHA mortgage loans through a private lender. The government backing enables the lender to take on more risk, which means it can accept a lower down payment, approve lower credit scores and provide a competitive interest rate.
What does FHA stand for?
The Federal Housing Administration (FHA) is a part of the U.S. Department of Housing and Urban Development, which is a cabinet-level department in the federal government. The FHA works to help more Americans get access to affordable housing through homeownership. The main way that the FHA does this is by providing mortgage insurance to private lenders so they can extend financing to a wider range of American homebuyers. Since the FHA’s inception in 1934, over 46 million mortgages have been backed by this federal department. COVID-19’s impact on FHA loans While the Federal Housing Administration’s requirements for borrowers are set quite low, private lenders still have the final say on approval. Meeting the FHA’s loan requirements doesn’t mean automatic approval. Private lenders still weigh the risks and can decide whether they want to approve you for a loan or not.
The economic damage caused by COVID-19 has greatly increased the concern over lending and potential foreclosures, which has injected a lot of uncertainty into the housing market. When foreclosures increase, mortgage rates and lending requirements also increase. Some lenders have tightened approval restrictions for new loans across the board, including FHA loans.
FHA loan vs. conventional loans
When you look at what an FHA loan is on the surface, it looks similar to a conventional loan — but you only need to put down 3.5%. There are some differences between the two products to be aware of, though.
Conventional loans only require private mortgage insurance (PMI) until you have 22% equity built up in your home. With an FHA loan, you’re required to pay mortgage insurance for at least 11 years to help the lender recoup losses if you default on the loan. The MIP paid on FHA loans can last for anywhere from 11 years to the life of the loan.
There’s an upfront insurance premium of 1.75% that also must be paid on FHA loans. However, many lenders will allow you to roll the cost of this fee into the total loan to limit the upfront costs. This doesn’t mean you’re not paying the fee — it’s just spread out over the life of your loan with interest in that case.
The other major difference between the two products is that FHA loans have a geographically-determined limit on the amount you can borrow. The maximums change each year, but the max loan amount ranges from $331,760 and $765,600 for 2020 depending on where you live.
Types of FHA loans
- Fixed-rate mortgage — The most popular FHA loan available is a fixed-rate mortgage. With this loan type, your mortgage payments and interest rate are fixed for the life of the loan. This helps borrowers know exactly what they’ll need to pay from month to month with no chance of surprises down the road.
- Adjustable-rate mortgage (ARM) — ARM loans come with a low introductory interest rate that is in place for a fixed period of time. Once that period is over, the rate can adjust to be higher or lower once per year based on the economic climate. While this type of loan may seem attractive due to the low intro rate, it can create problems if the interest rate increases because your payment size could drastically change.
- 203(k) mortgage — This type of FHA loan gives homebuyers the ability to purchase a home that needs renovations. In addition to covering the cost of the home, the loan gives you access to the cash you need to make the renovations to the home. The terms of this loan are particularly nuanced, so make sure you fully understand the stipulations and requirements before choosing to go this route.
- Section 245(a) loan — Known as the graduated payment mortgage, a section 245(a) loan is designed for borrowers who expect their income to rise over time. The plans start with low monthly payments that slowly increase with time to match your growth in income.
How to qualify for an FHA loan
Qualifying for an FHA loan happens at two levels — with the FHA and with the private lender. The FHA only requires that you have credit score of 500 if you’re putting down 10% or a score of 580 if you’re putting down 3.5%, but most lenders won’t approve borrowers with scores that low. You’ll also need to provide income verification for two years, no recent bankruptcies and be able to meet the debt-to-income requirements.
If you meet all of the requirements by the FHA, you still need to get approved by the private lender providing your loan. Private lenders are not required to approve anyone simply for meeting the FHA’s minimum requirements — and most lenders will require much higher credit scores or down payments for approval.
Pros and cons of FHA loans
- Requires a smaller down payment
- Potential approval for lower credit scores
- Can, in some circumstances, roll closing costs into the loan to limit upfront cash needed
- Maximum loan limits
- MIP for the life of the loan (or at least 11 years)
- Upfront mortgage premium
How to apply for an FHA loan
- Gather your documents. The first step to applying for an FHA loan is to gather the necessary documents. This includes income verification, proof of assets, bank statements and other information required by your lender.
- Shop lenders. You should shop around for different lenders to see what rates and repayment terms you can get. Remember, even a fractional difference in your rate can mean tens of thousands of dollars over the life of the loan.
- Complete your application. After you’ve selected the private lender you want to work with, it’s time to fill out your application. Make sure that you stay on top of your paperwork and get it in as quickly as possible. If the lender asks you for anything, quick compliance can help increase your approval chances and speed up the process.