What is a Federal Housing Administration (FHA) loan?

FHA loans are like your mom or dad getting their friends to lend you money to buy a house, but asking for a bit of extra insurance...

The government — like a parent — wants to see you do well and get settled down to raise your family in a house. Your finances aren’t quite good enough to go down to the bank and get a regular loan; so dad takes on some of the risk of securing your loan, but asks you to chip in a bit of extra insurance as a show of good faith.

As with any major financial decisions, there are both advantages and disadvantages to an FHA loan. This type of mortgage might not be right for everyone. Let’s discuss some of the pros and cons of an FHA loan.

Pros

• The minimum credit score for an FHA loan is lower (minimum of 500) than for a conventional loan (typically no lower than 620), making homeownership more accessible to those who have a rocky financial history.
• The downpayment can be as low as 3.5% (compared to 5% for a conventional loan), depending on your credit score.
• FHA loans are available to help with home repairs and renovations, which may be necessary for a home you’re purchasing that is not quite move-in ready or a home you already own that needs repairs.
• FHA relief may be available to those facing financial hardship and struggling to make their minimum monthly payment.
• The interest rates for FHA loans are comparable to — and often lower than — those for conventional loans.

Cons

• Borrowers must pay an upfront mortgage insurance premium of about 1.75% to protect the lender from loss.
• Borrowers must pay an annual mortgage insurance premium for the life of the loan. You could remove this annual premium after 11 years if your down payment were 10% or more.

To qualify for an FHA loan, borrowers must meet the following qualifications:

• Credit score of at least 500 (for a downpayment of 10%)
• Credit score of at least 580 (for a downpayment of 3.5%)
• A debt-to-income ratio (the percentage of your monthly income going toward debt) of no more than 43%
• At least two years of employment history that shows you can make the minimum payments every month
• Money to cover the upfront mortgage insurance premium (usually about 1.75% of the loan amount)
• Money to cover closing costs (anywhere from 2%-6% of the purchase price)
• The home you’re purchasing with the FHA loan must become your primary residence, meaning you can’t use an FHA loan to purchase a rental property or vacation home.

When you apply for your FHA loan, you’ll have to fill out an application and share your personal and financial information. These numbers represent the minimum requirements, but some lenders may have tighter standards than others.

FHA loans differ from conventional home loans in several ways.

First of all, conventional loans aren’t insured by the government. Because of this, lenders may have stiffer requirements for who can qualify for a loan. For example, an FHA loan requires a minimum credit score of 500. With a conventional loan, you’ll probably need a credit score of at least 620.

With an FHA loan, you’ll have to pay an upfront mortgage insurance premium. This is not usually the case with a conventional loan.

Here’s a more comprehensive look at the differences between an FHA loan and a conventional loan:

There are several different types of FHA loans available to borrowers depending on their individual needs.

Fixed-rate mortgages Fixed-rate mortgages are the most common type of FHA loans. The interest rate for a fixed-rate FHA loan does not change over the life of the loan. Borrowers choose a term of either 15 or 30 years and have a guarantee that their interest rate and monthly payment will remain consistent.

Adjustable-rate mortgages Unlike with a fixed-rate mortgage, the interest rate for an adjustable-rate mortgage (ARM) may change over the life of the loan. ARMs usually start with a lower interest rate, but that rate can change over time based on the index it is tied to. Most ARMs are tied to the performance of one of three major indexes: the maturity yield on one-year Treasury bills, the 11th District cost of funds index (COFI), or the London Interbank Offered Rate (Libor).

There are safeguards in place to ensure that your rate doesn’t increase too much. FHA offers different interest rate cap structures for ARMs. According to The U. S. Department of Housing and Urban Development, this is the most your interest rate can increase, based on the length of the introductory period:

• 1 and 3-year ARMs: up to 1% increase annually, up to 5% increase over the life of the loan
• 5-year ARMs: either up to 1% increase annually and up to 5% increase over the life of the loan OR up to 2% increase annually and up to 6% increase over the life of the loan
• 7 and 10-year ARMs: up to 2% increase annually, up to 6% increase over the life of the loan

ARMs are best suited for people who don’t plan to stay in the home for the full 30 years and who can benefit from the early years of a lower interest rate. Be wary with an ARM, as you run the risk of seeing your monthly payment increase drastically over the life of the loan.

You also run the risk of what is called negative amortization. When your monthly payments are not enough to cover the interest due on a mortgage and your balance actually grows, this may cause problems if you try to sell the house.

FHA reverse mortgages FHA allows for Home Equity Conversion Mortgages (HECM), which are FHA-backed reverse mortgages available to seniors with at least 50% equity in their home.

This type of loan is different as it only applies to those who already own their homes and are 62 years of age or older.

A HECM allows borrowers to receive a monthly payment from their lender, nwhile decreasing the amount of equity they have in their home.

Energy-efficient mortgages The FHA Energy Efficient Mortgage Program (EEM) helps borrowers to make improvements to their home that increase the energy efficiency of the house and lower utility bills. Borrowers may be eligible for this type of loan either with their initial home purchase or to refinance an existing mortgage.

These improvements must be cost-effective, meaning the cost of making them is equal to or less than the money saved on energy from the improvements. The borrower must obtain a home energy assessment to identify opportunities for energy efficiency and ensure the improvements will be cost-effective.

FHA 203(k) loans The FHA 203(k) program, also known as Rehabilitation Mortgage Insurance, allows homebuyers and homeowners to finance the cost of certain home repairs and renovations, such as those identified by a home inspector or an FHA appraiser.

This can help homebuyers to make their home move-in ready, or help existing homeowners to make home improvements either for themselves or to prepare the home for sale.

You can only borrow an FHA loan from an FHA-approved lender. There are lots of lenders who offer these loans, from big banks to small community banks and credit unions. The loan terms may vary slightly from one lender to another, so it’s important to shop around.

The U.S. Department of Housing and Urban Development (HUD) has on their website a search tool to find FHA lenders available in your area.

The FHA adjusts the loan limits for FHA loans annually. The limits may vary in different regions to account for different costs of living.

In 2020, the FHA national loan limit is set at $331,760. This is the most you can borrow in low cost of living regions. The limit for high cost of living areas is $765,600.

HUD has on its website an FHA mortgage limit estimator, which allows you to find the current limit for your area.

There is a program in place to help FHA loan recipients who have faced financial hardship (such as a reduction in income) and are struggling to meet their monthly minimum payments.

The FHA-Home Affordable Modification Program (HAMP) can help borrowers by providing for a temporary mortgage forbearance agreement (a temporary halt in mortgage payments). Borrowers who are struggling may also be able to permanently lower their monthly mortgage payments to a more affordable level by lowering the interest rate or extending the payback period.