FHA Loans: What to Know
FHA-backed loans can offer aspiring buyers a pathway to homeownership when conventional mortgages might be out of reach.
The Federal Housing Authority (FHA) works with designated lenders to provide guarantees on home mortgages. This encourages private lenders to offer financing to those who would otherwise be denied a mortgage, with the knowledge that the U.S. government will guarantee the debt in the event of a default.
FHA loans can be a great way for prospective home owners to purchase a home, as the financing terms tend to be more lenient than those of a conventional mortgage. For instance, depending on your credit score, you can purchase a home with a down payment of only 3.5% of the total price. However, there are some drawbacks, such as the requirement to purchase mortgage insurance, which will add to your monthly expenses and the overall cost of the loan.
Using tools such as the TipRanks’ mortgage calculator can help you better understand the terms of your prospective loan, regardless of whether you qualify for an FHA loan, use other U.S. governmental programs, or opt to secure financing through a conventional mortgage.
Uncle Sam Wants to Help You
The U.S. government has a long-standing policy of encouraging home ownership, dating back to the presidency of Abraham Lincoln and the Homestead Act. While the history of American economic policy is probably not on the front of your mind when you begin thinking about purchasing a house, understanding your options could make the difference between closing a deal or not.
The Federal Housing Authority was established in the 1930’s during the Great Depression to make home ownership a realistic possibility for many Americans. With so many Americans defaulting on their mortgages, banks were extremely hesitant to offer loans. The FHA was established to address the uncertainty in the market, and in the years since has helped to create a feasible path for homeownership for millions.
In addition to the FHA, there are other U.S. government agencies that offer their own loan programs, such as the VA and the U.S.D.A.
Do You Qualify for an FHA Loan?
There are a number of criteria that are part of the lenders’ assessment for whether you qualify for an FHA-backed loan.
- (1) Credit score: There are two basic levels of FHA-backed loans, which are contingent on your credit score. If you have a credit score of 580 or above, this program will allow you to purchase a home with a down payment of only 3.5% of the total cost. Alternatively, if your credit score is between 500-579, you can still qualify, but you will need to provide a down payment of 10%.
- (2) Stable employment: Even though there is less risk for the lender, it remains in their interest to provide loans to individuals capable of repaying the balance. They will want to see evidence of stable income as proof that you will be able to repay your obligation.
- (3) Primary residence: The FHA-backed loans are not designed to encourage real estate speculation. Their purpose is to encourage families to put down roots in communities and begin to accumulate home equity. Therefore, the financing must be used for housing that will serve as your primary residence.
- (4) Mortgage limits: FHA-backed loans are capped at a certain amount, which is based on the home prices in the area where you are looking to purchase and the number of housing units you are looking to buy. (You can plug-in your information into HUD’s “FHA Mortgage Limit” website to understand the ceiling in your neighborhood.)
- (5) Debt-to-Income Ratio: Lenders will look at your debt-to-income ratio, which is the amount you are paying to service your debts (including prospective ones) versus your monthly income. Unless you can demonstrate a compelling reason, you will need to have a debt-to-income ratio of 43%. This threshold includes the potential mortgage payments that you would be making assuming you are approved for an FHA loan.
Drawbacks of an FHA Loan
Receiving a much-needed boost to your home ownership goals can be a lifechanging assist, but there are costs to getting this support.
- (1) Mortgage insurance: You will be required to pay mortgage insurance on your FHA-backed loans. This includes both an upfront cost that is 1.75% of the price of your house, as well as an annual fee that most lenders will divide up and include in your monthly payments. If your down payment is 10% of the cost of the house, you will need to pay mortgage insurance for the first 11 years of your loan. If it is less, you will pay these annual costs for the entire life of your mortgage.
- (2) Maximum limits: As mentioned above, the government imposes both minimum and maximum limits to the size of an FHA-backed loan. By definition, pursuing an FHA-backed loan will restrict the options at your disposal.
- (3) Home inspection: Though it is not a drawback, a licensed-appraiser is required to conduct a home inspection to ensure that the property is “safe, secure, and sound.” (Even when this is not a requirement, it is probably a good idea to make sure that your family does not live in unhealthy environs.)
- (4) Are you prepared for debt?: Taking on a mortgage raises issues much larger than your household finances. It is really about the life you want to live, and your ability to balance long-term debt with your short-term obligations. The FHA process was designed for those lacking sufficient capital and/or with lower credit scores. These lower scores are the result of outstanding debt, late payments, or past bankruptcies, among other issues, signifying that maybe you are not ready to take on more obligations.
Conclusion: When to Consider an FHA Loan
If you believe you are ready to be a homeowner, but your financial situation would make it difficult to obtain conventional financing, an FHA-backed loan is a good option to consider.
You can use the HUD’s Lender List Search on their website to search for lenders that the FHA works with. Banks and other potential lenders will generally publicize their affiliation with FHA as well.
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