What are Federal Housing Administration Loans?

What are Federal Housing Administration Loans?

Federal Housing Administration (FHA), agency within the U.S. Department of Housing and Urban Development (HUD) that was established by the National Housing Act on June 27, 1934 to facilitate home financing, improve housing standards, and increase employment in the home-construction industry in the wake of the Great Depression.

The FHA’s primary function was to insure home mortgage loans made by banks and other private lenders, thereby encouraging them to make more loans to prospective home buyers. The FHA’s approach was designed to attract support from interest groups such as the real-estate and banking industries, which were historically opposed to federal intervention in the housing arena.

Prior to the FHA, balloon mortgages (home loans with large payments due at the end of the loan period) were the norm, and prospective home buyers were required to put down 30 to 50 percent of the cost of a house in order to secure a loan. However, FHA-secured loans introduced the low-down-payment home mortgage, which reduced the amount of money needed up front to as low as 10 percent.

The agency also extended the repayment period of home mortgages from 5–10 years to 20–30 years. The resulting reductions in monthly mortgage payments helped to prevent foreclosures, often made buying a home cheaper than renting, and allowed families with stable but modest incomes to qualify for a home mortgage. In addition, because government-backed loans involved less risk for lenders, interest rates on mortgages went down.

Understanding the Federal Housing Administration (FHA) Loan

If you have a credit score of at least 580, you can borrow up to 96.5% of the value of a home with an FHA loan, as of 2022. That means the required down payment is only 3.5%.

If your credit score falls between 500 and 579, you can still get an FHA loan as long as you can make a 10% down payment.

With FHA loans, the down payment can come from savings, a financial gift from a family member, or a grant for down payment assistance.

The Bank’s Role in an FHA Loan

The FHA doesn’t actually lend anyone money for a mortgage. The loan is issued by a bank or other financial institution that is approved by the FHA.

The FHA guarantees the loan. That makes it easier to get bank approval since the bank isn’t bearing the default risk. Some people refer to it as an FHA-insured loan for that reason.

Borrowers who qualify for an FHA loan are required to purchase mortgage insurance, with the premium payments going to the FHA.

History of the FHA Loan

Congress created the FHA in 1934 during the Great Depression. At that time, the housing industry was in trouble: Default and foreclosure rates had skyrocketed, 50% down payments were commonly required, and the mortgage terms were impossible for ordinary wage earners to meet. As a result, the U.S. was primarily a nation of renters, and only one in 10 households owned their homes.5

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The government created the FHA to reduce the risk to lenders and make it easier for borrowers to qualify for home loans.

The homeownership rate in the U.S. steadily climbed, reaching an all-time high of 69.2% in 2004, according to research from the Federal Reserve Bank of St. Louis. In the third quarter of 2021, the rate stood at 65.4%.

How FHA loans work

FHA loans come in 15-year and 30-year terms with fixed interest rates. The agency’s flexible underwriting standards are designed to help give borrowers who might not qualify for private mortgages a chance to become homeowners.

But there’s a catch: Borrowers must pay FHA mortgage insurance, which is designed to protect the lender from a loss if the borrower defaults. Mortgage insurance is required on most loans when borrowers put down less than 20 percent. All FHA loans require the borrower to pay two mortgage insurance premiums:

Upfront mortgage insurance premium: 1.75 percent of the loan amount, paid when the borrower gets the loan. The premium can be rolled into the financed loan amount.

Annual mortgage insurance premium: 0.45 percent to 1.05 percent, depending on the loan term (15 years vs. 30 years), the loan amount and the initial loan-to-value ratio, or LTV. This premium amount is divided by 12 and paid monthly.

So, if you borrow $150,000, your upfront mortgage insurance premium would be $2,625 and your annual premium would range from $675 ($56.25 per month) to $1,575 ($131.25 per month), depending on the term.

FHA mortgage insurance premiums will be canceled after 11 years for most borrowers if they financed 90 percent or less of the property’s value — in other words, for those who put at least 10 percent down and stay current with their monthly mortgage payments. Loans with an initial LTV ratio greater than 90 percent will carry insurance until the mortgage is fully repaid.

FHA lenders are limited to charging no more than 3 to 5 percent of the loan amount in closing costs, and the FHA allows up to 6 percent of the borrower’s closing costs, such as fees for an appraisal, credit report or title search, to be covered by sellers, builders or lenders.

Types of Federal Housing Administration (FHA) Loans

In addition to traditional mortgages, the FHA offers several other home loan types.

Home Equity Conversion Mortgage (HECM)

This is a reverse mortgage program that helps seniors ages 62 and older convert the equity in their homes to cash while retaining the home’s title. The homeowner can withdraw the funds in a fixed monthly amount, a line of credit, or a combination of both.

FHA 203(k) Improvement Loan

This loan factors the cost of certain repairs and renovations into the amount borrowed. It’s great for those willing to buy a fixer-upper and put some sweat equity into their home.

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FHA Energy Efficient Mortgage

This program is similar to the FHA 203(k) improvement loan program, but it’s focused on upgrades that can lower your utility bills, such as new insulation or solar or wind energy systems.

Section 245(a) Loan

This program works for borrowers who expect their incomes to increase. The Graduated Payment Mortgage (GPM) starts with lower monthly payments that gradually increase over time. The Growing Equity Mortgage (GEM) has scheduled increases in monthly principal payments. Both promise shorter loan terms.

How to qualify for an FHA loan

To be eligible for an FHA loan, borrowers must meet the following lending guidelines:

  • Have a FICO score of 500 to 579 with 10 percent down, or a FICO score of 580 or higher with 3.5 percent down.
  • Have verifiable employment history for the last two years.
  • Have verifiable income through pay stubs, federal tax returns and bank statements.
  • Use the loan to finance a primary residence.
  • Ensure the property is appraised by an FHA-approved appraiser and meets HUD guidelines.
  • Have a front-end debt ratio (monthly mortgage payments) of no more than 31 percent of gross monthly income.
  • Have a back-end debt ratio (mortgage plus all monthly debt payments) of no more than 43 percent of gross monthly income (lenders could allow a ratio up to 50 percent, in some cases).
  • Wait one to two years before applying for the loan after bankruptcy, or three years after foreclosure (lenders might make exceptions on these waiting periods for borrowers with extenuating circumstances).

Pros and cons of FHA loans

Pros

  • You can have a lower credit score: If you haven’t established much of a credit history or you’ve encountered some issues in the past with making on-time payments, a 620 credit score — the typical magic number for consideration of a conventional mortgage — might seem out of reach. If your credit score is 580, you’re in good standing with most FHA-approved lenders.
  • You can make a lower down payment: FHA loans also give the option for a smaller down payment. With a credit score of at least 580, you can make a down payment of as little as 3.5 percent. If your credit score is between 500 and 579, you may still be able to qualify for an FHA-backed loan, but you will need to make a 10 percent down payment.
  • You can stop renting earlier: Since FHA loans make buying a home easier, you can start building equity sooner. Instead of continuing to rent while trying to save more money or improve your credit score, FHA loans make the dream of being a homeowner possible sooner.

Cons

  • You won’t be able to avoid mortgage insurance: Since your credit score is lower, you’re a bigger risk of default. To protect the lender, you have to pay mortgage insurance. You can roll the upfront insurance premium into your closing costs, but your annual premiums will be divided into 12 installments and show up on every mortgage bill.
  • If you put down less than 10 percent, you have to pay those annual premiums for the entire life of the loan. There’s no escaping them. That’s a big difference from conventional loans: Once you build up 20 percent equity, you no longer have to pay for private mortgage insurance.
  • You’ll have to meet property requirements: If you’re applying for an FHA loan, the property has to meet some eligibility requirements. The most important is the price: FHA-backed mortgages are not allowed to exceed certain amounts, which vary based on location. You have to live in the property, too. FHA loans for new purchases are not designed for second homes or investment properties.
  • You could pay more: When you compare mortgage rates between FHA and conventional loans, you might notice the interest rates on FHA loans are lower. The APR, though, is the better comparison point because it represents the total cost of borrowing. On FHA loans, the APR can sometimes be higher than conventional loans.
  • Some sellers might shy away: In the ultra-competitive pandemic housing market, sellers weighing multiple offers often viewed FHA borrowers less favorably.
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Federal Housing Administration (FHA) Loan Limits

FHA loans have limits on how much you can borrow. These are set by region, with lower-cost areas having a lower limit (referred to as the “floor”) than the usual FHA loan and high-cost areas having a higher figure (referred to as the “ceiling”).

There are “special exception” regions—including Alaska, Hawaii, Guam, and the U.S. Virgin Islands—where very high construction costs make the limits even higher.

Elsewhere, the limit is set at 115% of the median home price for the county, as determined by the U.S. Department of Housing and Urban Development (HUD).

Is an FHA loan right for you?

An FHA loan might be the right choice for you if you have decent credit and don’t have a large down payment saved. The fact that you can get an FHA mortgage with just 3.5 percent down puts homeownership within grasp for many people, but that doesn’t mean FHA loans are the best option for everyone.

If you have strong credit, there’s a good chance you’ll be able to qualify for a conventional mortgage even if you can’t put 20 percent down. With a conventional loan, you’ll be able to get out of PMI once you’ve built sufficient equity.

Similarly, if you have a lot of money saved for a down payment, you may be able to get a conventional loan even if you have less than perfect credit.