FHA Loans: A Complete Guide
What are FHA Loans?
FHA loans are mortgages backed by the U.S. government, specifically the Federal Housing Administration (FHA) which is a subsidiary of the United States Department of Housing and Urban Development (HUD).
“Backed” is the key word in the preceding paragraph. To be clear, the US government doesn’t make the loans. They are not a lender. What they do is insure loans made by private lenders (banks, credit unions, mortgage companies, etc.) If borrowers have difficulty making payments and default, the lender has a federally-insured backstop. Yep, government insurance will cover the lender’s loss. It’s a pretty clever arrangement; FHA’s insurance program stimulates broad economic activity by providing an umbrella for private lenders. Pretty sweet.
A few very important things come from this government/private partnership. First, with the risk spread around, lenders take on less of it and can offer financing to a broader pool of potential borrowers.
Second, the backing of the US Government means less established borrowers (vis a vis lower credit scores) can get a loan with competitive interest rates, keeping monthly mortgage payments smaller.
Third, FHA mortgages require a smaller down payment. People of more modest means can own a home.
Home ownership in America wasn’t always as easy. In fact, prior to the creation of the FHA it was less common and pretty hard. History is a favorite subject around here; hopefully you find the quick timeline below interesting, too.
How FHA Loans Got Started
During the Great Depression, the Roosevelt administration took a very experimental approach with the role of government in American life called the New Deal. Several government programs and agencies were created to help Americans survive a pervasive, crushing level of poverty as well efforts to kickstart the economy.
Part of the Roosevelt Administration's plan to boost the sluggish economy was the implemention of a government-backed insurance pool that would lower the barriers to entry to home ownership. The biggest challenge at the time, for would-be homebuyers, was saving up enough for a down payment. Thus, the Federal Housing Administration (FHA), a subsidiary of HUD, began their mortgage insurance program which allowed borrowers a way to buy a home with less money down.
Note: FHA doesn’t lend money. Instead, the agency operates an insurance pool that gives lenders the confidence to make more loans to people. When you pay FHA mortgage insurance, it is paid to the FHA.
The FHA “experiment” has been wildly successful, insuring over 40 million properties since its inception in 1934. Today, there are over 4.7 million single family mortgages in the FHA portfolio. About 1 in 10 home loans are backed by it. If you get a loan backed by the FHA, you’ll be joining a popular and long-held American tradition (of sorts).
FHA Loan Requirements
When you apply for a FHA Loan, your loan officer will ask you for several documents (bank statements, pay stubs, W2s, etc.) all of which builds a complete financial picture of you. The documentation is bundled up and sent to a loan underwriter for evaluation. The job of an underwriter is to assess risk and predict a borrower's ability to repay a loan. They also make sure that all the pieces of the puzzle fit within FHA guidelines.
Mortgages are obviously very large loans so lenders take a close look at applicants from many angles. However, understanding how mortgage underwriting works can be simplified by categorizing FHA loan requirements into three buckets: Capacity, Credit and Collateral. You may hear someone refer to these as the ‘Three Cs’.
Underwriters simply want to know: Do you have the means to repay your debts? The answer will come from the proof you provide of your employment and income and how they compare to your debts and assets.
Steady work history is better than spotty work history as you might suspect. Working for the same employer in the most recent two years is ideal but not mandatory. Being self-employed is fine but requires more documentation (underwriters will want to see P&L statements, etc.) Avoid changing jobs if you plan on applying for a loan. It's not the death knell for an application, but it will create an extra hurdle and you will definitely need to supply a "good" reason for the change (like a promotion).
Income can come from several sources, but it must be verified over a two-year timeframe.
- Wages (W-2s)
- Disability, retirement, social security or public assistance income
- Can come from child support or alimony
- Self-employed borrowers will provide tax returns and/or your business balance sheet instead of W2s
- Your income should be expected to continue for at least three years
- When income fluctuates like sale commissions, overtime or bonuses, it is averaged over two years as documented in the borrower’s tax returns
- Income from part-time jobs is allowed, but also is subject to a two-year review
- Interest and dividends can be included
- VA income
- Rental income
- Trust income
Based on anti-discrimination laws and regulations, you cannot be turned down based on income from public assistance programs.
Lenders want to know all of the applicant's liabilities in order make sure there's ample money at the end of each month to make a mortgage payment. Underwriters don't really drill into things like utilities, food, clothing and such. They're interested in installment and revolving debt such as:
- Minimum monthly credit card payments
- Car payments
- Student loan payments
- Child support
Debt to Income Ratio (DTI)
Now that all the cards are on the table, two fundamental Debt to Income (DTI) ratios are calculated. DTI help predict a borrower’s ability to repay a loan. FHA guidelines for DTI ratios change periodically. Your loan officer will have the most recent ratios at his or her fingertips. For now, we’ll explain the front and and back end ratios.
The Front End Ratio (sometimes called Housing Ratio) compares your income to mortgage payments. The calculation is straightforward; divide your potential monthly mortgage payment and by your gross monthly income and then multiply by 100.
Monthly Mortgage Payment ÷ Gross Monthly Income x 100 = Front End Ratio
There are a few pieces that form the total monthly mortgage payment. Add up:
- Principal and interest portion of the anticipated monthly payment
- Property taxes
- Mortgage insurance
- Homeowner's insurance
- HOA fees
The Back End Ratio (sometimes called Total Debt Ratio) adds one more piece of the equation by factoring in your other recurring monthly debt payments (installment and revolving). Combining all monthly debt payments creates a new formula looks like this:
(Monthly Mortgage Payment + Monthly Debt Payments) ÷ Gross Monthly Income x 100 = Back End Ratio
Putting It All Together: DTI Limits
For FHA loans, the acceptable limits are 31% for the front end ratio and 43% for the back end ratio. Lenders use a shorthand for this: “31/43”.
If you’ve demonstrated a long history of timely mortgage payments, stellar credit or significant cash reserves, a case may be made for an exception to the DTI rules. It doesn’t happen very often, but these “significant compensating factors” can sometimes be factored into the loan underwriting process. If a borrower’s ratios exceed the FHA limits, more often than not you will be need to apply for an alternative mortgage product, not an FHA loan.
IMPORTANT: Don’t make any big purchases like a car if you are in the process or are going to apply for a loan soon; it'll change your DTI. Also avoid buying furniture for a home you do not own yet. Keep your spending patterns within a normal range.
FHA Reserve Requirements (Multi-Unit Properties)
Reserves are funds (cash) that remain after the down payment and closing costs are paid. A lender may impose reserve requirements on borrowers who buy multi-unit properties. For 1-2 unit properties, one month of reserves is required. For 3-4 unit properties, three months of reserves are required.
IMPORTANT: Don’t move between banking account before applying for a loan. Lenders will look backward at your banking activity (via your bank statements) and will want to see how all money in your account got there. Lenders will look for sourced and seasoned funds. "Sourced" identifies where the money came from and "seasoned" means the money has been in the bank for a specified period of time. So, if your aunt Martha (source) transferred $10,000 to your account last month (not seasoned), it will look suspicious. Why? Because lenders want to know that Aunt Martha wasn’t firing money into your account on a short-term basis (or worse a short-term loan to you that you aren’t going to report as an additional debt). Be very, very careful about moving money around before applying for loan.
Eligible reserve assets:
- Checking/savings (bank accounts)
- Investments and retirement account (brokerage)
- Existing real estate holdings
- Gifts from family applied to down payment
- Seller contributions
- Money made from illegal activity
- Sweat equity
- Cash on hand
- Unsourced and/or unseasoned funds
- Unsecured funds (e.g. credit cards)
Underwriters want to know: Do you have a track record of paying your debts?
The answer to that question is found by evaluating borrowers' credit reports which contain a history of accounts, timely payments to those accounts and a summarizing credit score. Your credit history and corresponding score help predict whether you will make your mortgage payment on time and in full.
If you’ve had a few financial bumps in the road in the past, all is not lost. You may still qualify for a loan. Here are some guidelines for borrowers with an imperfect track record:
- Two years since bankruptcy and re-establishment good credit
- Three years since Foreclosure or Deed In-Lieu of Foreclosure and re-establishment of good credit
- No outstanding judgments or delinquent on any federal debt (i.e. student loans, tax liens)
- Late payments on any debt are not specified by the FHA, but individual lenders will have policies, typically involving late payments within the last 12 months
FHA Credit Score Requirements
You’ll need a good (but not perfect) FICO score. As mentioned previously, FHA changes its guidelines every so often which is why it’s best to talk with a loan officer to get current FHA requirements. The example below shows how down payments change based on a borrower's FICO score.
- Credit scores from 500 to 579 require a 10% down payment
- Credit scores at 580 or better require only 3.5% down payment
Depending upon other aspects of your financial situation (your income, cash reserves, etc.), lenders sometimes have more leeway. In other words, they will look at the whole picture of you as a borrower.
IMPORTANT: Don’t apply for a bunch of credit cards before or during your loan application. Opening new lines of credit harms your FICO Score. In fact, closing a bunch of credit accounts can impact your FICO score as well. This is the time to be overly cautious.
Lenders want to know if they will be sufficiently protected in the case of foreclosure. The two primary elements that determine the level of protection are the home equity (created when you make the down payment) and the property itself.
Down Payment / Equity
Simply put: The down payment creates owner's equity in a home which acts as a buffer against a lender losses should a borrower default on a loan. As discussed in previous chapters, FHA loan allow a smaller down payments than conventional loans. That's because lenders are protected by FHA-backed (and borrower paid-for) insurance when the equity is less than 20%.
Clearly, the lender needs to know what the house is worth. That is accomplished with an appraisal, a professional, third-party report of a home’s value. It’s an opinion. But a very well-informed one.
HUD sets Minimum Property Standards every home under consideration must meet. Why? Two reasons. Because the property is the loan collateral so if a borrower defaults, the lender will want to sell the house to recoup as much of the loan as possible. Secondly, the FHA provides the insurance and they don’t want to insure a dud as insuring many duds would increase the costs of overseeing the insurance pool. Simply put, a dump is obviously not worth as much.
What’s unique about the FHA process is that it combines an appraisal and inspection of the property. Also, the appraiser must be FHA-approved.
Appraisers look ‘under the hood’ so to speak to make sure everything works.
- Properties must meet FHA standards: Safe, sanitary and structurally sound
- Properties that don’t meet FHA standards may mean that a seller will need to pay for repairs - or the borrower will pay for them at closing (with funds held in escrow until they are complete)
- Repairs must be made by contractors (not the buyers or seller)
- Check major systems like heating, appliances, foundations, etc
Appraisers produce a Uniform Residential Appraisal Report (URAR). Appraisals cost about $400 to $500 and can take a couple days. The cost can be rolled into the loan as long as the LTV remains within guidelines. Here's the core of what you get in a URAR:
- Compares the property under consideration to three similar properties
- Establishes fair market value
Sometimes underwriters will want to know how the property will be used. In the case where part of a primary residence also includes a business purpose, there will limits. Business use is often okay as long as a maximum of 25% of total residential square footage is used for it. An example would be doggie day care.
Other FHA Rules
Borrowers must be lawful residents in the U.S., have a valid Social Security number and be of legal age to sign a contract (mortgage) within his or her respective state. In most states the legal age is 18 years-old.
All told, FHA guidelines establish the way underwriters evaluate the financial profile of the borrower using the "Three Cs." Underwriters weigh also consider the lender's guidelines. FHA and lender guidelines don’t always match up 100% because lenders are sometimes more restrictive or more forgiving based on their risk profile. When lender’s guidelines are added on top of FHA guidelines, they are called an “overlay.”
FHA Loan Limits
An FHA loan limit is maximum loan amount for that the FHA will insure. The limit is placed on the loan amount, not the purchase price of the home. FHA programs are primarily designed to encourage home ownership among moderate to low income Americans. So in the spirit of that mission, FHA sets lending limits (they can't be used to buy mansions in Beverly Hills). You'll be happy to know that most homes in the United States qualify for FHA backing.
How are FHA Loan Limits Determined?
FHA loan limits are set annually by its "parent" the Department of Housing and Urban Development (HUD). Since no loan amounts that exceed the limit will be insured, it’s a very important benchmark to know. The FHA uses three key ingredients to determine the maximum loan values they will insure. They are:
- Median home prices
- Type of dwelling
The first ingredient is price. While HUD and its subsidiary, FHA, don’t care how much income you have, they do care about the size of the loans they insure. HUD/FHA looks at the current state of underlying median home values or the House Price Index (HPI), a broad measure of single-family house prices. As mentioned, It’s adjusted annually to account for market conditions which nearly always move up or down. For what it's worth, sometimes the HPI can even stay the same.
The next ingredient is location - home price data for each state and county in the United States (and US territories) is factored. The core unit of location is a county, but in some case counties will get sliced up a little further into metropolitan areas. You know, because a home in Burbank will typically cost less than in Pasadena even though both cities are in Los Angeles County. Regional adjustments are made to account for high-cost areas where median home prices are -- you guessed it -- higher. This leeway helps low and moderate income borrowers afford an ‘average’ home in cities. The FHA sets maximum loan limits in higher-cost areas (know as a ceiling) and minimum loan limits in lower-cost areas (known as a floor).
The last ingredient is the type of property; single-family residences have different limits than FHA approved condos and so on. There are four types of dwellings that fit within FHA guidelines. They are:
- One unit (single family home)
- Two units
- Three units
- Four units
So HUD/FHA mashes up home prices, locations and types of dwellings and when blended all together you get a tidy little chart that shows the maximum loan amounts they'll insure.
Current FHA Loan Limits
|Units||Low-Cost Area “Floor”||High-Cost Area “Ceiling”|
Now that you know how the "Floors" and "Ceilings" work, you can look up the FHA mortgage limits for your county (or metro) in the United States using HUD's online tool. Special rates apply to Alaska, Hawaii, Guam, and the U.S. Virgin Islands. Rates in those areas tend to be higher. Loan limits are a key feature of all government-insured mortgages (i.e. VA and USDA loans).
FHA Mortage Insurance
If you put less than 20% down when purchasing a home - a very common situation for first-time homebuyers - lenders need extra assurance that they’ll get their money back in case of a loan default. (A default is when a borrower can’t pay back the loan and the bank takes back the property.) That's what mortgage insurance does; it protects lenders from losses if borrowers can't repay their loans.
Mortgage insurance is the norm among government mortgage programs including USDA, conventional and VA loans. Conventional (non-government backed) loan programs like Conventional 97 and HomeReady are similar. They, too, require mortgage insurance. But, in the case of conventional programs, the backing comes from private mortgage insurance (PMI) companies instead of government agencies.
The good news, regardless of the loan program, is that borrowers can buy a home with less money down. In the case of FHA loans, you can acquire a home with as little as 3.5% down. But that's the rub. If you use the FHA loan program, you’ll be required to carry mortgage insurance. There are two kinds of insurance used for FHA loan transactions.
Upfront Mortgage Insurance Premium (UFMIP)
UFMIP is a one-time fee paid at closing. If you don’t have enough cash to pay the upfront fees, FHA guidelines allow you to finance it into the loan amount, thus reducing your out-of-pocket expenses.
Annual Mortgage Insurance Premium (MIP)
The Annual Mortgage Insurance Premium is calculated yearly but broken up into monthly payements. Borrowers pay the MIP along with the principal and interest portion of the monthly mortgage payment. MIP is paid for the life of the loan.
However, after a few years of owning your home and paying down the principal balance, you’ll eventually reach a point where the loan-to-value (LTV) reaches 80%. Since FHA loans do not need to have this extra insurance when the LTV is 80% or lower, borrowers can take steps to get rid of it (FHA mortgage insurance doesn’t go away on its own) by refinancing into a new mortgage or selling the home.
FHA Upfront Mortgage Insurance Premium (UFMIP) Example:
Upfront FHA mortgage insurance is 1.75% of the loan amount. Pretty straightforward.
- $300,000 purchase price – 3.5% down payment ($10,500) = $289,500 FHA base loan amount
- $289,500 FHA base loan amount x 1.75% = $5,066.25 FHA UFMIP
FHA Annual Mortgage Insurance Premium (MIP) Example:
Annual FHA mortgage insurance premiums (MIP) scale up and down based on your situation. You can catch a break on the percentages depending upon the loan term (number of years over which the loan is repaid, the loan amount and the resulting loan-to-value after your down payment is applied.
The annual MIP charts below apply to purchase transactions and streamline refinances.
FHA Annual Mortgage Insurance Premiums for Terms > 15 Years
|Base Loan Amount||LTV||Annual MIP|
|≤ $625,500||≤ 95%||80 bps (0.80%)|
|≤ $625,500||> 95%||80 bps (0.80%)|
|>$625,500||≤ 95%||100 bps (1.00%)|
|> $625,500||> 95%||105 bps (1.05%)|
FHA Annual Mortgage Insurance Premiums for Terms <= 15 Years
|Base Loan Amount||LTV||Annual MIP|
|≤ $625,500||≤ 90%||45 bps (0.45%)|
|≤ $625,500||> 90%||75 bps (0.75%)|
|> $625,500||≤ 78%||25 bps (0.25%)|
|> $625,500||78.01% to 90%||70 bps (0.70%)|
|> $625,500||> 95%||95 bps (0.95%)|
Continuing with the example loan amount, and using the chart above, we can figure out how much you’ll pay each month for the annual FHA mortgage insurance premium.
- 30-year fixed mortgage
- FHA base loan amount of $289,500 x annual fee (chart above) .80% = $2,316
- $2,316 ÷ 12 months = $193 monthly FHA mortgage insurance
To summarize: If you have a down payment less than 20% of the purchase price of a home, FHA loans provide a time-tested way to acquire a property. With a down payment as small as 3.5%, you could be in position to be a homeowner. In this regard, FHA loans represent a tremendous opportunity for you.
Just be sure that you understand that the very tool that enables you to buy a home, FHA mortgage insurance, comes at a price. Many homeowners have decided it’s the right move for them.
FHA Loan Summary
FHA loans have been around a long time, In fact, millions of homeowners since 1934 have taken advantage of this government-backed insurance program and are happier for it. FHA loans are one of the easiest ways to finance a home purchase; borrowers need only to come up with 3.5% down. Part the reason that low barrier-to-entry exists is due to UFMIP and MIP which reduce each lender's risk.
Many people assume that FHA loans are only for first-time home buyers. What a lot of people don’t know is that the FHA insures a broad array of loan products available for all kinds for borrowers, including:
- Senior citizens who want to stay in their homes and use their existing home equity to help pay their bills (FHA Reverse Mortgages)
- Current borrowers who want to refinance for a better rate or term (FHA Streamline Refinance)
- Borrowers who want to refinance and cash out a portion of their home’s equity (FHA Refinance)
- People who love fixer-uppers who want a home improvement loan, including the ability to finance energy-saving upgrades (FHA 203k Loans)
- And, of course, first-time home buyers