Owning your own home is a cornerstone of the American Dream, but the responsibility of taking on a mortgage makes achieving the dream much harder. Many mortgages come with high down payment and credit score requirements. Still, if you don’t have a lot of savings, or you do have a low credit score, you’re not out of luck. A Federal Housing Administration (FHA) loan may be the solution to your mortgage challenges.
What is an FHA Loan?
FHA loans are mortgages insured by the Federal Housing Administration and issued by a qualified lender, like a bank or credit union. The FHA insurance protects lenders in case of default. FHA loans come with a 3.5% down payment for borrowers with a credit score of 580 or above. If your credit score is below 580, you can still get an FHA loan, but you’ll have a 10% down payment instead of 3.5%. As of 2020, prospective homeowners can borrow up to 96.5% of the total home price.
While FHA mortgages are popular with first-time single-family home buyers, they can also be used for refinancing single-family homes, and buying or refinancing 2-4-unit multifamily homes, condominiums, and sometimes manufactured homes.
What is the FHA?
In 1934, Congress established the Federal Housing Administration to help stimulate the flagging housing market and overall declining American economy during the Great Depression. Mortgage terms were nearly impossible for a country struggling with deep poverty. Loans were capped at 50% of a property’s value, and the repayment schedules were punishingly short. By 1933, almost half of American homeowners had defaulted on their loans.
The first FHA loans started with 20% down payments for up to 80% of a home’s value. Today the FHA is part of the United States Department of Housing and Urban Development.
5 Common Types of FHA Loans
In addition to the basic home mortgage, the FHA offers a few other types of loans for different purchasing, construction, refinancing and renovation needs. They include but are not limited to:
203(b) Basic Home Mortgage: The most common type, a home mortgage used to finance a primary residence.
203(k) Rehab Mortgage: Finances for homes that require extensive renovations, a “fixer-upper.”
Energy-Efficient Mortgage: Finances energy efficient upgrades to homes to lower utility bills. This type requires an FHA assessment and the improvements must be deemed cost effective. For commercial properties, look into C-PACE financing.
Home Equity Conversion Mortgage for Seniors: This one is a reverse mortgage, which allows seniors 62 and up to convert their home equity into cash.
Section 245(a) Loan: This type includes a Graduated Payment Mortgage, which begins with lower monthly payments that gradually increase when a borrower’s income rises. There is also a Growing Equity Mortgage, with scheduled increases in monthly principal payments resulting in shorter loan terms.
Additional Factors to Consider
Mortgage Interest Premiums
Because the FHA insures but does not issue the loan, if you qualify for one, you’ll have to purchase mortgage insurance. FHA loans require an upfront Mortgage Insurance Premium (MIP) and an annual MIP payment for 11 years, or the life of the loan, depending on the Loan to Value (LTV) ratio and the length of the loan.
Loan Relief if Something Goes Wrong
If you already have an FHA loan and you experience extreme financial hardship, you may be eligible for loan relief. There are a few different options, including The FHA Home Affordable Modification Program (HAMP), which helps prevent foreclosure by lowering your monthly mortgage payment.
FHA Mortgages vs Traditional Mortgages
There are pros and cons to both types of mortgages. It’s easier to qualify for an FHA loan, as the credit score requirements, down payments and repayment terms are more lenient than those of other mortgages. Where you can get an FHA loan with a credit score of 500, and a downpayment between 3.5 and 10%, traditional mortgages usually require at least 620, and a down payment anywhere from 3% to 20%.
The loan terms for FHA mortgages are 15 and 30 years, while conventional mortgages have a greater range: 10, 15, 20, or 30 years. As noted above, mortgage insurance is required for FHA loans. With traditional mortgages, there is no insurance premium if you have at least a 20% down payment. If the down payment is less than 20%, you’ll pay until after the loan is paid down to 78% LTV.
100% of the down payment can be a gift for FHA mortgages, but for traditional ones, only part can be if the down payment is less than 20% of the total mortgage. As we’ll see below, the real advantage to traditional mortgages is that right now, they may be easier and faster to obtain.
Current Climate for FHA Loans
While the usual requirements of having at least a 580 credit score for a 3.5% down payment still stand in theory, in practice some lenders have stricter parameters. These limitations can make the process of getting a loan more difficult, and sometimes longer.
In 2020, FHA lenders tended to favor applicants with FICO scores of 650 or above, according to a study from ICE Mortgage Technology. Another study from the National Association of Realtors revealed that sellers were more likely to accept conventional loans than FHA loans at the start of 2021. Sellers at the time saw FHA loans as more onerous, with stricter appraisal and inspection requirements. Nerdwallet noted that in the first quarter of 2021, FHA loans were deployed in only 10% of single-family home and condo purchases.
FHA Loans Make it Easier for More Americans to Own Homes
On the plus side, FHA loans have longer loan terms, more lenient requirements for credit scores and savings, and a number of options to meet different prospective homeowners’ needs, from energy savings to renovations, and more.
On the downside, your property will likely have to meet more stringent health and safety standards than for a traditional mortgage, you’ll have to pay mortgage insurance, and the loan cannot exceed certain limits for the area you’re renting in.
Nonetheless, if you want to buy a home but don’t have enough savings for the downpayment on a traditional mortgage, or the credit score, an FHA loan can let you become a homeowner more easily and less expensively than a traditional mortgage.