Having a bit of debt on your shoulders or a lower credit score shouldn’t stop you from purchasing a home. But finding the right financing can be difficult. That’s often where an FHA loan steps in. This type of mortgage makes it easier for a broader range of people to afford a new home.
But what is an FHA loan, and how can it help you? Read on to find out whether an FHA loan is the ticket to your future home.
An FHA loan is a home loan backed by the Federal Housing Administration and the U.S. Department of Housing and Urban Development (HUD). It is provided through an FHA-approved mortgage lender.
The HUD oversees the FHA, which provides mortgage insurance to FHA-approved lenders. Because this insurance protects said lenders against loss, they’re able to offer loans with favorable terms to low-income individuals with less-than-perfect credit scores or debt.
FHA loans usually have lower credit requirements and income limits when compared to conventional loans, which makes it easier for first-time homebuyers to secure financing.
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Conventional mortgages and FHA loans function a little differently.
A crucial difference is that the government doesn’t usually back conventional loans. Instead, private lenders fund them, using stricter eligibility requirements. So, they can be harder to obtain.
For example, you may qualify for an FHA loan with a score as low as 580. In contrast, a conventional loan requires higher scores, starting around 620. Conventional loan borrowers also are required to make a slightly lower down payment.
However, if you can’t pay a 20% down payment on a conventional loan, you must pay private mortgage insurance (PMI). PMI can be removed once you hit 20% equity. In contrast, you pay a compulsory MIP on an FHA loan.
Borrowers with lower credit scores, smaller funds and debt may prefer an FHA loan due to competitive interest rates and similar loan limits.
Borrowers must meet certain requirements to qualify for an FHA loan. Here are a few worth noting.
Although it is possible to qualify for an FHA loan with a FICO® Score as low as 500, it may not be the best course of action.
For example, you’ll need to pay a minimum down payment of 10%. Additionally, you will probably receive unfavorable terms with a high interest rate.
Lenders vary, though. Rocket Mortgage®, for instance, requires a minimum credit score of 580 for an FHA loan.
A down payment is an upfront expense you will face when buying a house – usually one of the largest. Future homeowners must pay a portion of the home’s purchasing price as, essentially, a good-faith deposit on the property. Then, your mortgage covers the rest. So, the less you pay on your down payment, the more you must borrow from your lender.
The minimum down payment you need to pay on an FHA loan depends on your credit score. Generally, holding a credit score of 580 or higher requires a minimum down payment of 3.5%. A lower score (500 – 579) will require a larger down payment of 10%.
The good news is that you don’t need a specific income level to qualify for an FHA loan. However, you must prove you have a history of steady employment, usually two years at minimum.
When your lender goes to verify your income, they will ask for certain documents. The lender you work with might have a unique list they require for verification. Some of the more common forms you will need include pay stubs, federal tax returns, W-2s, and bank statements.
Borrowers of conventional loans and VA loans face similar guidelines when it comes to their loan limits. But FHA loan limits are slightly more complex.
The FHA determines your loan’s limit depending on two factors: location and property type. The potential home’s location matters since the limits change between counties. Low-cost areas have a lower “floor,” whereas high-cost areas experience a higher “ceiling.”
You can research specific FHA mortgage limits in your area using the FHA Mortgage Limits page.
And, secondarily, the type of property also matters. Renting a multi-unit property comes with a higher lending limit than you would find with a single-family home.
The FHA wants to ensure they help people finance homes that are safe to live in. Thus, they require the property to meet strict standards to ensure there are no major hazards on the property.
If you apply for an FHA refinance or buy a home with an FHA loan, you’ll need to hire an FHA-approved appraiser. This appraiser reviews standard appraisal factors, but FHA appraisals focus on safety standards more.
The HUD recommends a professional home inspection, too. During a home inspection, you can expect the professional to look over major structures and features, like foundation, plumbing, electrical systems and more.
If the appraiser or inspector finds problems, you can ask the seller to make repairs, choose an FHA 203(k) loan or pursue a conventional mortgage.
Your FHA loan comes with compulsory mortgage insurance premiums (MIP). This is an insurance policy borrowers pay both upfront (UFMIP) and regularly with their monthly mortgage payments. This additional fee protects your lender’s financial interests in case you default.
The UFMIP equals 1.75% of the loan’s amount, and annual premiums sit between 0.45% to 1.05%. The amount depends on how much money you borrow, how much you put down, and your loan’s term.
FHA loans require MIPs even after you’ve reached an LTV (loan-to-value) of 80%, so to avoid continued MIP payments, you’ll need to refinance from an FHA loan to a conventional loan.
There are different types of FHA loans out there. The version you choose will depend on the home you buy and how you wish to use the financing. Here are a few to keep in mind.
Like the name suggests, a fixed-rate mortgage maintains the same interest rate the whole time you repay it. You receive your rate when you first secure the loan and then pay that for the loan’s term. This is the most common type of mortgage among U.S. home loan borrowers.
A fixed-rate FHA loan works much the same way: you receive a rate that continues throughout the loan’s life.
The FHA also backs its version of adjustable-rate mortgages, or ARM loans. With an FHA ARM loan, you have a fixed rate at the beginning of the loan. The fixed rate lasts for a predetermined period, usually 5, 7, or 10 years.
After the fixed period ends, you receive a new interest rate based on the margin and index. Your lender discloses the margin at the loan’s beginning, and the index figure fluctuates based on the Constant Maturity Treasury (CMT) index. There are caps and floors in place which limit how much the rate changes.
Since lenders don’t have to project inflation with an ARM loan, borrowers usually receive a lower initial rate than a comparable fixed-rate loan.
Over time, you gain equity in your home. You do this by paying down your mortgage principal. Or, you can also earn equity when your home increases in value. A cash-out refinance takes advantage of that built-up equity and allows you to convert it into cash.
Essentially, you replace your current loan with a larger mortgage and then pocket the difference as a lump sum. You can use the resulting money for anything you wish.
So, it’s different from, say, a second mortgage which requires you to pay an additional monthly payment. Instead, your new mortgage takes the place of the old one. And your present mortgage does not have to be an FHA loan to apply for an FHA cash-out refinance. But you will need at least 20% equity in your home before applying.
The FHA streamline refinance allows anyone with an existing FHA loan to lower their monthly mortgage payment or change their terms. Borrowers can use this program regardless of how much existing equity they have in their home. However, you do need to be current on your loan.
It’s a quick process compared to some other financing measures since you may even be able to skip appraisals during closing. Unlike a cash-out refinance, you can’t take out any cash with an FHA Streamline, though.
Sometimes referred to as a mortgage rehabilitation Loan or an FHA Construction Loan, FHA 203(k) loans fill a specific niche for potential home buyers.
Have you ever wanted to purchase a fixer-upper? Often, lenders refuse to approve loans for properties that require major repairs, such as a home sold as-is. But a 203(k) rehab loan makes it possible to obtain financing or refinancing for a home that needs work. It does this by rolling the cost of renovations or upgrades into the overall price. This allows you to pay them down along with the mortgage.
You may still have questions about FHA loans. Here are some answers to the most common concerns homeowners have.
FHA loans usually come with lower APR and interest rates than conventional loans. This is because of their federal backing, which makes lending less of a risk for the lender. However, a range of factors can impact your mortgage rate, such as your credit score, the location of your home, the loan amount, and the size of your down payment.
A better credit score will likely result in a lower interest rate. But if you have a less than stellar score, you may want to consider the FHA loan. A conventional loan’s interest rate will probably be higher with a lackluster score.
Even though you may have various real estate goals, FHA loans only apply to primary residences, so you’re limited in how many FHA loans you can have at one time. You cannot qualify with a second home or an investment property.
Yes, you can get a cash-out refinance with an FHA loan. This allows you to exchange your current mortgage with a new, larger one. Then, you can put away the difference as cash to spend on financial needs like home improvements. The amount you receive through refinancing depends on your home’s equity and value, though.
For an FHA cash-out refinance, borrowers need at least 20% in home equity. In addition to paying off your current loan, finding out your home’s value through an appraisal will help you pinpoint the equity in your home.
Remember: conventional loans do not receive government backing. They’re offered through Freddie Mac and Fannie Mae, which are government-sponsored entities that provide funds to private lenders. They come with strict requirements that may be difficult for low-income, poor credit score-holders to meet.
However, they may be more attractive to sellers due to typically shorter closing periods. When choosing the right loan for you, consider both the terms and the additional costs you face, such as closing costs and maintenance.
If you’re interested in buying or refinancing, get started with Rocket Mortgage today.
Ashley Kilroy is an experienced financial writer. In addition to being a contributing writer at Rocket Homes, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.