What is an FHA Loan and its Requirements?

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An FHA Loan is a mortgage that is backed or insured by the Federal Housing Association that is available to home buyers with downpayments as low as 5% or a low credit score. FHA loans are a form of federal assistance that allows all Americans the opportunity to become home-owners. Different types of homes such as single-family and multi-family homes are eligible to be insured by the FHA.

What is an FHA Loan or FHA Insured Loan?

The Federal Housing Administration (FHA) offers mortgage insurance on loans aimed at low income earners through FHA approved lenders. It is important to understand that FHA does not provide the loans itself; it has a list of approved lenders which provide the loan while the FHA guarantees the loan, hence the name “FHA insured loans.” They require a lower minimum down payment of 3.5% and a minimum credit score of 500, making them easier to get than many conventional loans. FHA loans come in fixed and adjustable rates with a term of 15 or 30 years only. These factors make FHA loans a very attractive option for first-time homebuyers who do not have enough saved for a large down payment, have a low credit score or have even been bankrupt in the past.

FHA Loan Limits

FHA loans have limits and cannot be used for all loan amounts, the loan limit varies by county. The loan limit in 2021 ranges from $356,362 to $822,375. For example, the upper limit for FHA loans on single-family homes in Yukon County of Alaska is $356,362. Whereas, in San Francisco County, California the upper limit is $822,375. All FHA loan limits can be found on the Housing & Urban Developments website.

Are there Adjustable-rate Mortgages (ARM) or Variable Rate FHA Mortgages?

An adjustable-rate mortgage (ARM) has an interest rate that changes periodically over time, usually once a year. Most ARM loans taken today are ‘hybrid loans’ that start off with a fixed interest rate for a definite period of time, after which it will begin to adjust each year.

Annual and lifetime rate caps: The FHA limits how much your interest rate can adjust each year and over the lifetime of the loan. These adjustment caps are there to protect borrowers from overwhelming spikes in their monthly payments.

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

What is an FHA 203k Loan?

The FHA 203k loan is provided by the Federal Housing Administration to incentivise low- and moderate-income earners to purchase homes that are in need of repairs and maintenance. FHA 203k loan is also known as an FHA Rehab Mortgage Insurance because the loan has two purposes, home purchase and home renovation. The total amount that is borrowed not only includes the price of the home, but also the cost of renovation such as material and hired labor. The cost of the renovation and rehabilitation must be between $5,000 and $35,000.

FHA Loan Requirements

There are certain requirements to quality for an FHA home loan such as:

A credit score of 500 or above

Credit score of 580 and above will allow for a minimum down payment of 3.5%.

Credit score between 500 and 579 will require a minimum down payment of 10%

FHA loans are one of the few mortgage loans that allow for such low credit scores making them the only alternative available for some borrowers. It is also important to note that with a lower credit score, there will be less negotiating power when the interest rate is being determined by the lender of the FHA insured loan.

A credit score is a number between 300–850 that depicts a borrower's creditworthiness. A higher score signifies a better ability to repay lenders and debtors in a timely manner. A credit score is based on several factors such as number of open accounts, total levels of debt, and repayment history etc. The most common credit score in the US is the FICO credit score.

MIP (Mortgage Insurance Premium) is required

MIP (Mortgage Insurance Premium) is required to protect the lender in the case of default. The FHA MIP is divided into an upfront fee and an annual fee as described below. FHA MIP is NOT impacted by your credit score, therefore, even if you have a lower credit score you will not pay a higher MIP rate.

Debt-to-Income Ratio < 43%

To qualify for an FHA loan you must have a debt-to-income (DTI) ratio of less than 43%, that is your total monthly debt cannot be greater than 43% of your monthly pre-tax income.

The Debt-to-Income (DTI) Ratio is the ratio that measures the monthly debt payments including principal & interest payments such as a mortgage, student loans, credit cards, and other debt to your income. To calculate monthly debt payment as defined by Fannie Mae, it is the sum of the monthly payments for auto loans, student loans, and mortgages, plus the minimum required monthly payment for credit cards. For example, if your monthly debt payment is $1,500 and your monthly pre-tax income is $4,000 then your debt-to-income ratio is 37.5% ($1,500/$4,000).

The home must be the borrower‘s primary residence

The FHA loan must be used as the primary residence by the home buyer. If the house is not the primary residence, the FHA loan will not be approved. This is to ensure that FHA loans can go to low-income families to buy their house and not used for investment purposes.

The borrower must have a steady income and proof of employment

The borrower must show proof of employment as in most cases income from employment is the primary source to pay back the monthly mortgage. You must also have two established credit accounts such as a credit card, car loan or student loan.

FHA Loans vs. Conventional Loans

FHA loans are provided from institutions which have been approved by the FHA and are guaranteed by the Federal Housing Administration whereas conventional loans are provided by private institutions.

Conventional loan interest rates are typically a little higher than FHA mortgage rates. That’s because FHA loans are backed by the Federal Housing Administration, which makes them less risky for lenders and allows for lower rates. Today’s average FHA rates are as low as 2.25%, while conventional rates are as low as 2.875%. However, if you have a great credit score (above 680, in most cases) you might qualify for a lower conventional rate. You also have to consider the annual mortgage insurance rate with each loan. Depending on your credit score and down payment, conventional mortgage insurance rates could be higher or lower than FHA insurance rates. This will affect which loan is cheaper overall.

The following table highlights the key differences between FHA loans and conventional loans.

FHA LoanConventional Loan
Minimum Credit Score500At least 620
Down Payment3.5% if credit score is greater than 580
10% if credit score is between 500 and 580
At least 20%
Loan Terms15 to 30 years10, 15, 20, or 30 years
Mortgage InsuranceUpfront FHA MIP + Annual Variable MIPIf down payment is less than 20% otherwise none
Mortgage Insurance PremiumUpfront: 1.75% of loan Annual: 0.45% - 1.05%PMI: 0.5% - 2% of the loan amount
Down payment Gifts100% of down payment can be a gift100% of down payment can be a gift
Down Payment Assistance ProgramsYesYes

There are advantages and disadvantages to both loans as shown in the table.

The major advantage and benefit of FHA loans is that it is available to consumers with a minimum credit score of 500, whereas conventional loans require at least 620 otherwise the application is not considered.

The next advantage of FHA loans is that the minimum down payment is 3.5% if credit score is 580 and above. However, if your credit score is even lower then you must be able to provide at least a 10% down payment. This allows low income earners or first-time buyers the flexibility to purchase a house. Whereas, for conventional loans the minimum down payment is 20%, unless you choose to buy insurance (PMI). Conventional loans also have introduced new loans such as Conventional 97 which require down payment as low as 3%.

A disadvantage of FHA loans is that it requires all homebuyers to buy insurance or FHA MIP. The FHA mortgage insurance premium (MIP) is divided into an upfront cost and an annual premium. Conventional loans only require insurance or private mortgage insurance (PMI) if the down payment is less than 20%. PMI can be cancelled if your Loan-to-Value (LTV) ratio falls below 78% or when the loan balance reaches 80% of the home’s original value.

The FHA MIP has an upfront expense of 1.75% of total loan amount, with an annual fee ranging from 0.45% to 1.05%. Conventional loans have an annual fee of 0.5% to 2% of loan amount.

In order to provide flexibility to home buyers the FHA allows for the entire down payment to be funded as a gift. For conventional loans, 100% of the down payment can come in the form of a gift as long as the home is the primary residence of the borrower and it is a 1-unit or single-family home.

What is gift money regarding mortgages?

It is money that is provided by friends and family for the use of purchase of a home. The most important requirement is that it can be proven that the money is sent by them. Gift money can also come from the government such as programs designed to help first-time low-income buyers such as the Homeownership Voucher Program.

As the FHA is a government agency it does have down payment assistance programs, for conventional loans, there is no formal program in place, it will depend on the lender. FHA loans also allow more flexibility in terms of refinancing as the appraisal process does not need to be conducted again and there is minimal paperwork, this is known as the FHA Streamline Refinance.

FHA Loans vs. VA Loans

VA loan, or Veterans Affairs (VA) home loan, is a mortgage where a portion of the loan is backed by the US Government through the Department of Veterans Affairs. In order to qualify, a Certificate of Eligibility (COE) is required. The borrower must be a service member or veteran or a spouse of a military service member/veteran. It is similar to the FHA loan because both of these home loans are guaranteed by the government and are provided by pre-approved financial lenders. VA loans also have an additional cost known as a VA funding fee which ranges from 0% to 3.6% in 2021. The fee changes depending on several factors such as the type of VA loan, amount of down payment, and the number of times you have used the VA program. Find the lowest mortgage rates on the VA loan rates page and in order to determine your monthly mortgage payment use the VA loan calculator which includes the VA funding fee.

VA loans have limits that are varied by county and price of the house, these limits can be found on the Department of Veterans Affairs's website. VA loans also have an additional cost known as a VA funding fee which ranges from 1.4% to 3.6% in 2020. The fee changes depending on several factors such as the type of VA loan, second time use of VA home loan and whether there's a down payment.

FHA Loan VS VA Loan

FHA LoanVA Loan
Minimum Credit Score500No Minimum
Down Payment3.5% if credit score is greater than 580 10% if credit score is between 500 and 580No Minimum
Loan Terms15 to 30 years15 or 30 years
Mortgage InsuranceUpfront FHA MIP + Annual Variable MIPNo Insurance required
Mortgage Insurance PremiumUpfront: 1.75% of loan Annual: 0.45% - 1.05%N/A
Debt-to-Income (DTI) RatioLess than 43%Less than 41%
Use of Gift Money100% of down payment can be a giftYes

The minimum credit score for FHA loans is 500, which will require a minimum down payment of 10%. Although VA loans do not have a required minimum score, most VA backed institutions look for a credit score of at least 620. The average credit score of VA purchase borrowers in 2019 ranged from 706 to 713.

FHA loans require a down payment of 10% if the credit score is between 500 and 580, if the score is at least 580, down payment can be as low as 3.5% of purchase price. VA loans do not have minimum down payment requirements, however, there are certain restrictions such as:

  1. If the appraised value of the home exceeds the market value of the home, the difference will have to be paid
  2. If the home loan exceeds the VA county limit, then a down payment will be required

What is Market Value and Appraised Value?

The Market value of a property is determined by how much potential buyers are willing to pay in the current market environment. It is essentially the final purchase price negotiated between the buyer and the seller for the property. Market value can often be influenced by the buyer because the property is only worth what the buyer is willing to pay. For example, if the seller lists the price for $350,000 and the buyer places a bid for $325,000, the seller accepts the offer resulting in the final purchase price of $325,000 making that the market price.

Appraised value has less variance as compared to market value because appraised value is determined by certified professionals such as an appraiser or lender. The appraisal process is not arbitrary such as the market value, as the appraiser takes several factors into consideration such as the property’s dimensions, utilities, surrounding neighbourhood, value of similar construction houses, and schools etc.

While we try our best to get your the best rates, we cannot guarantee that they are always accurate. Casaplorer assumes no liability for the accuracy of the information presented, and will not be held responsible for any damages resulting from its use. Rates shown are for informational purposes only and may differ by zipcode, county, and state. Estimated payments do not include taxes and insurance. Some state and county maximum loan amount restrictions may apply. Casaplorer is not endorsed or sponsored by any mortgage lender or government agency.