What is an FHA Loan?
An FHA loan is a loan from the Federal Housing Administration. It is designed to be a loan for the people that the average American can take advantage of. The FHA loan is not very score conscious and has some guidelines that are a little less stringent than most other loans. For instance, on an FHA loan you can go up to 56.99% debt-to-income ratio whereas most other programs top out at 50%. FHA loans also have no minimum credit score requirements. There are several lending institutions that will state that they have a minimum credit score for an FHA loan. This is known as an overlay in which a bank adds their own set of rules over top of the FHA’s. They do this in order to protect their own standing and weed out the loans that they are not interested in by applying an arbitrary credit score requirement to it. However, the FHA has no true minimum credit score that they require and some lenders, like us, have no overlays. Our team has even been able to finance loans with 525 credit scores. Putting through a loan like this involves having compensating factors such as a significant amount of money in your 401(K) or having a low debt-to-income ratio to compensate for a low credit score. In that type of scenario, the FHA will likely come up with an approval on the loan, making it a great tool for people who do not have perfect credit but still want to buy a house and want a fair deal on their loan.
An FHA loan can be utilized for properties that have up to four units, with the loan limit being higher the more units the property has. Recently, the lending limits for an FHA loan have been raised to $420,680 for a single-unit property, $538,650 for a duplex, $651,050 for a tri-plex, and up to $809,150 for a four-plex. An FHA loan requires a 3.5% down payment regardless of the borrower’s circumstances and the number of units in the property as long as they intend to occupy the property. Since FHA loans are only for owner-occupied properties, you must live in one of the property’s units. Theoretically, one could purchase a four-plex that costs $800,000, live in one of the units, and collect rent from the tenants residing in the other three and can still be eligible for an FHA loan at only 3.5% down.
Misconceptions about the FHA loan
Although FHA loans are extremely common, there are a lot of misconceptions about them.
Most people believe that an FHA loan is only for first time homebuyers. That is absolutely not the case. An FHA loan can be used even if you have a loan on another property as long as you only have one FHA loan at a time. The FHA will only allow you to have one FHA loan at any given time unless some very specific criteria is met. For instance, if relocation for work is necessary, the FHA will allow you to purchase a new home with an FHA loan. Another circumstance is if you have had a new addition to your family and have thereby outgrown your home, you can petition for an exemption and get another FHA loan.
Drawbacks of an FHA loan
Some realtors can be a little bit less likely to take an FHA offer. Historically, this is because of property condition issues. The FHA has a requirement that is over top of a standard appraisal, where they have a checklist of items in the property that are required to be in a certain state. This includes no trip hazards such as uneven sidewalks and no peeling paint. Another item that appraisers need to ensure that a property has is a hand railing which is usually a very easy fix if it does not. Additionally, the attic must be inspected for indications of water intrusion into the home and the property must have hot water. An appraisal will not get cleared all the way through if the property has any of these issues, the seller will first need to remedy the situation. However, the fact that now the FHA has raised the loan limits significantly means that you can purchase higher quality homes that likely will not have these issues. Most $400,000 houses in the Cleveland area are well maintained properties and it is very infrequent that our FHA appraisals comes back with significant issues.
FHA Loan vs. Conventional Loan
FHA loans and conventional loans are two of the most compared loans because they have some similar elements that operate in different ways. One of which is PMI, private mortgage insurance, which covers the bank against you defaulting on your mortgage. Any conventional loan in which the down payment is less than 20% will have PMI. However, the PMI on conventional loans is risk-based, meaning it varies depending on your credit score as well as the amount you are putting down. Therefore, the lower your credit score and the less of a down payment you put down, the higher the PMI will be. On the other hand, FHA loans have a mandatory PMI that is just based on the loan amount, regardless of credit score and down payment. However, the PMI on FHA loans never goes away, it is for the life of the loan. With a conventional loan, the PMI falls off automatically once your loan-to-value ratio reaches 80%. In an FHA loan, in order to get rid of the PMI you must refinance out and be under an 80% loan-to-value ratio when you do. Just remember that while you will have PMI with an FHA loan, unless you have 20% to put down you will have PMI on a conventional mortgage regardless.
FHA loans also have what is a called a mortgage insurance premium. It is a one-time up-front fee that is charged on top of the loan amount. A mortgage insurance premium is not considered in your debt ratio, but it does get added to your loan amount at 1.75% of the loan which is $1,750 per $100,000. Thus, FHA loans are a tad more expensive than conventional in the sense that the loan amount will be slightly larger. However, if your credit score is below 680, FHA loans are a great option because they will give you about the same interest rate as someone with a credit score of 750 getting a conventional loan will have since conventional loans are extremely score-driven.
The FHA loan is not for everyone, but it exists for a reason. It is a truly great mortgage product and is the best loan option for many Americans. If you have any circumstances that are holding you back from applying for a loan, an FHA loan will likely be more favorable to you. For instance, you can obtain a loan through the FHA only two years after bankruptcy and only three years after a foreclosure, whereas you must wait 7 years to be eligible for a conventional loan in this situation. An FHA loan is the more forgiving product, and it does not take advantage of that forgiveness. It is a great vehicle to get you into your home, whether it be your first home or your tenth, and you will still be able to get a fair deal with a decent rate.
Contact us to have our mortgage experts evaluate your financial picture and help you discern which type of loan is best suited for your unique situation!