FHA Loan Programs
There are many types of FHA loan programs. People are usually surprised to learn that they’re not just for first-time homebuyers. In fact there are FHA loan programs for reverse mortgages, loans to save money by improving the energy efficiency of a house, loans for manufactured homes and refinancing programs that require little paperwork (a.k.a. streamline).
FHA-insured programs typically have a “conventional” counterpart. Conventional loans are not insured nor guaranteed by the government. Rather, their mortgage guidelines are set by Fannie Mae and Freddie Mac which have more rigid borrower requirements.
FHA loans have more accommodating borrower and property requirements than conventional mortgages. Meaning, they are easier to get. For example, a 30-year fixed rate conventional loan typically requires a 5% down payment. Whereas a similar FHA loan only requires a 3.5% down payment. We’ll be comparing FHA and conventional programs throughout this article.
In general, FHA programs:
- Have requirements and guidelines set by Federal Housing Administration, a subsidiary of HUD.
- Loans are made by HUD-approved lenders, not every bank or credit union or bank participates.
- Lenders set the interest rates, not the FHA.
- Dwellings must be owner occupied – you can’t buy it and immediately rent it out.
- Dwellings must be 1 to 4 units – you buy can be a house, duplex and house up to four total units but no more than that.
- Fees for certain loan charges by lenders and others involved in the transaction are capped, which protects you from excessive costs.
- These programs are not just for first-time buyers.
Here are more in-depth descriptions of the various FHA programs.
FHA Fixed Rate Mortgage – The “Basic” Loan
Your average, everyday basic FHA loan is referred to as the FHA 203(b). You will hear 203(b) pop up in conversations with realtors and loan officers and it will appear in the rest of this article. This is the loan program most people think of when they here “FHA loan.”
It’s a very popular with first-time home buyers. One reason for that is that It’s often easier to qualify for a 203(b) than a conventional loan. A FHA down payment can be as low as 3.5% versus conventional loans which typically require at least a 5% down payment.
Furthermore, it’s OK to receive that down payment as a gift from family members, employers, government housing grants or FHA-approved charitable organizations. You can’t do that with a conventional program.
The 203(b) comes in two flavors: 30 year fixed rate (lower payments, longer term loan) and 15 year fixed rate (higher payments, shorter term loan).
When you start combining these features, you can see why the 203(b) is more flexible and accommodating for the widest number of borrowers.
You may also hear people talk about the FHA 203(k) which is a renovation loan that we’ll cover below. For now, just remember that the 203 with the letter “b” at the end is the “basic” loan.
Adjustable Rate Mortgage (ARM)
ARMs have been around for many decades starting in the 1960s but gained popularity in the early 1980s when interest rates were very high. ARMs have lower initial interest rates which makes mortgage payments lower. Historically, this helped more people qualify for a loan during times of super high interest rates.
But just as the name implies, rates can (and will) periodically adjust. And both ways: up or down. When your interest rates changes, you will receive a 25-day notification. That’s not a very long lead time for borrowers to adapt. So you can see this creates a level of uncertainty about what your mortgage payment is going to look like in the future.
For this reason, one should be careful about ARMs. When interest rates were at historic highs in the early 80s, part of the “bet” borrowers made when taking out an ARM was that interest rates had peaked and would eventually edge their way down. In fact, that is what happened. Here’s a look at the Treasury Rate Index (an underlying component of interest rates) from 1962 to onward.
An interest rate for an ARM has two components, an Index and a Margin. When you combine the index and margin, you get the Full Indexed Rate, which is the rate at which the borrower pays:
Index + Margin = Fully Indexed Rate
The index is the “adjustable” part of the note rate and is tied to an underlying market index such as the London Interbank Offered Rate (LIBOR). An index like the LIBOR is controlled by a third-party, not any lenders. So when index rates go up, the ARM’s rate that is tied to it goes up. When the index rate goes down, the ARM’s rate that is tied to it goes down.
The margin represents the lender’s profit. Margins are added to the index, typically 1% to 2%. Most ARM margins stay constant for the life of the loan.
Now you might be asking, “If I get an ARM, when would my interest rate change?” Good question. ARMs are structured in a way that includes two cushions against big interest rate swings, the Initial Period and Interest Rate Caps.
The start rate is a lower interest rate that is held steady the initial period of the mortgage, say few months or even years. Sometimes you’ll hear this called a Teaser Rate. After this initial period, the loan start rate will reset higher to the Index + Margin.
Another feature of ARMs that help buffer against payment shock are interest rate caps. There are two kinds of caps. Annual Rate Cap, which controls how far your rate can change within a given year. And the Lifetime Rate cap, which the maximum or minimum rate your loan can ever be.
Mark and Alison get a 3/1 ARM which is a 30-year loan with the rate fixed for 3 years. Their ARM includes a 2/2/6 rate cap structure. 2% initial adjustment, 2% annual adjustment each year after that and lifetime cap of 6%.
Let’s be clear, ARMs are generally a questionable choice for most borrowers. While they can be good for a small number of borrowers in special situations, most seasoned financial planners would advise caution or recommend staying away from ARMs completely.
That said, you might consider an ARM if:
- You only plan to live in your home a few years
- You expect an increase in your earnings
- Current interest rates are really high
FHA Rehabilitation and Repair Mortgage – 203(k)
If you love the idea of buying a fixer-upper, a 203(k) might be the ideal kind of home financing for you. This type of loan allows you to buy or refinance a property and simultaneously remodel it – all through a single mortgage. Folks commonly refer to the 203(k) as a “rehab loan”.
In that past most banks would not make a loan on a fixer-upper until repairs were completed. This presented a problem for folks who needed money up front to cover the cost improvements and repairs.
You can use a 203(k) for smaller rehabs as little as $5,000 or for major reconstruction of an existing property – including demolishing the existing structure as long as the foundation is kept in place. There’s quite a bit of latitude here.
This is how it works: If you qualify and are approved for a 203(k), a portion of the total loan amount pays off the seller (or in the case of a refinance, it pays off the existing loan). Next, a Repair Escrow Account is created. Escrow accounts are third-party accounts that disburse funds based on pre-set, contractual conditions. Funds placed in it and are drawn down to pay for repairs and upgrades. For all you DIY type folks out there, sorry but all work must be completed by a third-party contractor.
Repairs or upgrades must be started within 30 days of the loan closing completed within 6 months. 50% of the funds go to the contractor within 15 days of the loan closing and the remaining balance is paid upon completion of the work and final inspections by a HUD 203(k) consultant. Any remaining funds are rolled into the loan’s principal balance.
There’s also a smaller cousin to the 203(k) called a Limited 203(k) for smaller repairs up to $35,000. For example, you might use the limited version for a kitchen upgrade.
Borrowers can convert a non-FHA loan (such as a conventional loan) into a FHA mortgage as long as they meet the current FHA requirements. Borrowers need to be “current” on their existing mortgage, meaning no recent late or missed payments.
Here are some typical scenarios folks chose a FHA refinance:
- Cash out (up to 85%)
- Reduce the interest rate
- Consolidate debt
- Payoff existing loan (for example divorce or property settlements)
FHA Streamline Refinance
If you already have a FHA loan and meet current FHA requirements and are merely looking to change the rate and term (not pull money out), the Streamline Program could be your ideal option.
It’s called ‘streamline’ because the underwriting process has fewer required steps. For example, there’s no appraisal requirement (though it can be mandated if the new loan amount exceeds the original loan amount). Streamlines typically don’t require credit reports (unless there’s an open bankruptcy).
As you might suspect, you’ll need to have good track record of paying your current mortgage on-time and in-full.
Here are some reasons folks chose a FHA Streamline:
- Add or remove people from the title
- Change from 30-ear to 15-year term (or vice versa)
- Change from ARM to Fixed Rate Mortgage (or vice versa)
- Reduce interest rate on the note
FHA Energy Efficient Mortgage (EEM)
Looking to save money on your utility bills? Did you know the money you save from improving the energy efficiency of an existing home (refinance) or new home (purchase) can help free up some cash for you? With a FHA Energy Efficient Mortgage (EEM), your monthly savings can help you qualify for a larger mortgage. The basic premise of an EEM is that energy efficient homes cost less to operate (lower monthly energy bills) which is kind of like giving yourself a pay raise. You essentially have more money to spend each month on your mortgage.
Your new mortgage will be based on the value of you home plus the projected costs from the energy efficient improvements.
Now, in order for this to work, the energy savings must first be determined by conducting an energy assessment. You can’t waive your finger in the air and make up a number. The savings must be determined through by a Home Energy Rating System (HERS) or through an energy inspection ($200 of the cost may be rolled into the mortgage) conducted by a qualified consultant.
EEMs are not a second mortgage, it’s something you add to another FHA mortgage; there’s no additional lien on your property. EEMs also do not require additional approval. For example, if you qualify for a 30-year fixed rate FHA loan – the 203(b) — there’s no separate approval for adding the EEM to it. You can add EEMs to Streamline Refinances as well.
Here are some popular energy efficiency improvements:
- Energy efficient HVAC
- Adding double pane windows
- Replacing doors
- Insulation in attic, around air ducts and water pipes, in crawl spaces
- Adding solar panels
These are EEM-eligible properties:
- 1 to 4 unit dwellings
- New construction
FHA Home Equity Conversion Mortgage (HECM)
Perhaps you’ve spent an afternoon delayed at an airport and noticed reverse mortgages advertisements playing on a nearby TV monitor? There’s a reason those ads run during the day; they’re targeted to retired people. Reverse mortgages allow homeowners 62 years old or older to convert some or all of the equity of their home to cash.
The Home Equity Conversion Mortgage (HECM) is the long name for a federally-insured reverse mortgage.
They’re called a reverse mortgage because money flows in the opposite direction of a regular mortgage. Instead borrowers paying a lender every month, the lender pays the borrower. There are several options of how the funds may be disbursed. HECM payment options include:
- Single disbursement – cash all at once, available only with a fixed rate loan
- Term – cash advances for a defined period of time
- Line of credit – you choose the amount to draw down and at any time
- Tenure – cash advances as long as you live in your home in equal payments
- Modified Tenure – combination of monthly payments and line of credit
HECM program details:
- Borrower keeps the title to the home
- No income restrictions
- No medical restrictions
- Must be owner occupied
- Proceeds are typically tax free
- Can be fixed or variable rate loans
The loan must be eliminated (repaid or title transfer) when:
- The last surviving borrower dies, sells the home or no longer lives in it as a principal residence
- The borrower no longer occupies the property for 12 consecutive months
- The home is not maintained in an acceptable condition
Reverse mortgages tend to be costlier than other programs if the borrower stays in the home a short period of time because fees are paid up front (as opposed to being spread out over time).
And things add up; you’ll owe more over time as the interest accrues on the outstanding amount you’ve extracted from your home’s equity. The interest is not tax deductible each year but can be written off when the loan is paid off, or partially paid off.
It’s not an excuse to let your house go to pieces. Borrowers must maintain the home, pay taxes and keep it insured or the lender can call the loan which means it must be paid back immediately.
As stated, to apply you must be 62 years of age or older and first meet with a HUD-approved HECM counselor from an approved agency. Government-approved counselors will help explain the implications of taking out a reverse mortgage as well as the costs associate with it. There is a small fee for counseling and no one will be turned away if they can’t pay it. The fee can be paid back from the loan proceeds should it go though. Given all the details and stipulations above, you can see why some counseling is a good thing. Plus, it’s actually required.
Reasons folks might want a FHA reverse mortgage:
- Supplement retirement income
- Pay for healthcare expenses
- Finance a home improvement