If you think of an FHA loan only as a first-time homebuyer’s loan, you could be missing out on a great loan program. The FHA loan is a great option for borrowers with less than perfect credit or little money to put down on a home.
Before you even shop for a home or try to refinance, you should know the ins and outs of the FHA loan to make sure you get the deal that works best for you.
What is an FHA Loan?
An FHA loan is a loan funded by an individual lender, but guaranteed by the FHA. This loan program has flexible loan guidelines and only requires a 3.5% down payment. In exchange for the flexible guidelines, expect to pay mortgage insurance, which is how the lenders receive the guarantee of payment should you default on the loan.
While it used to be mostly a first-time homebuyer’s loan, today it’s a loan perfect for anyone with lower credit scores or lack of a large down payment, especially as a result of the housing crisis.
Qualifying for an FHA Loan
As we talked about above, the FHA loan has flexible guidelines. In general, you will find the following:
- Minimum credit score of 580 in order to put just 3.5% down on the home; a score lower than 580 will require a 10% down payment and lender consideration
- Stable employment history of at least two years, unless you changed jobs within the same industry or have another job change a lender approves of
- You must live in the home purchased with the FHA loan as your primary residence
- Your front-end debt ratio (principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance,) must be less than 31% of your gross monthly income
- Your back-end debt ratio (above mortgage payment plus current monthly debts) must be less than 43% of your gross monthly income
- Any Chapter 7 bankruptcies must have been discharged for at least 2 years (this is not the date you filed, but the date the court discharged your bankruptcy)
- If you filed for Chapter 13 bankruptcy, you must wait 12 months, have proof of timely payments of your restructured payment plan, and have approval of the trustee of your bankruptcy
- Foreclosures must be at least 3 years ago and you must have proof that you bounced back from the situation and have a solid credit history now
The FHA does grant a few exceptions to the above rules. For example, the 3.5% down payment requirement doesn’t have to come from your funds alone. You are able to obtain a gift for the entire amount as long as you properly document the gift with a gift letter and proof of the funds’ origination.
You may also secure an exception for a higher debt ratio than the above amounts if you have other compensating factors. This is on a case-by-case basis, though, as each lender has different requirements.
The FHA Appraisal
The purpose of the appraisal for any loan is just about the same – the lender wants to make sure the home is worth the loan amount, at the very least. For an FHA loan, you must use an FHA-approved appraiser. These appraisers understand the FHA guidelines, known as the Minimum Property Requirements. They aren’t anything out of the ordinary; it’s just the FHA’s way of making sure the home is safe, sanitary, and sound.
If the appraiser finds something that doesn’t meet the FHA’s requirements, you can’t close on the loan. The only way around this is to request that the seller make the necessary changes. If they are unwilling, you can either walk away from the home or pay for the repairs yourself. This can be risky, though, since you don’t own the home yet and are putting money towards a property that is not officially yours.
FHA Mortgage Insurance
As we spoke about above, in exchange for the flexible guidelines and low down payment, the FHA charges mortgage insurance. You’ll pay two types of insurance – upfront mortgage insurance and annual mortgage insurance.
The upfront mortgage insurance is equal to 1.75% of your loan amount. If you borrow $200,000, you would pay $3,500 at the closing. If you can’t afford to pay this amount at the closing, you can wrap it into your loan amount.
In addition to the upfront MIP, you will also pay annual MIP. This insurance, which you pay 1/12th of the amount with your monthly mortgage payment, is 0.85% of your outstanding balance. On the $200,000 loan from above, you would pay $1,700 per year or $141.67 per month. The lender adds the amount to your mortgage payment to make it easy for you. This amount will decrease slightly each year as you pay your principal balance down. But, you will pay this insurance for the life of the loan.
The FHA Loan Limits
FHA loans have loan limits that differ by county. Each year the FHA publishes these limits, which must be 115% of the average home price for the area, but there are a floor and ceiling limit each year as well. In 2018, the floor for FHA loan amounts is $294,515 and the ceiling is $679,650.
All counties fall somewhere in between these two numbers. You can see the limit for your county here.
Refinancing With an FHA Loan
The FHA also offers several refinancing options including the FHA streamline loan, a standard FHA refinance, and the FHA 203K loan.
If you have a current FHA loan, you may be eligible for the streamline program. If you don’t have an FHA loan, but want one whether for a rate/term refinance or cash out, you’ll need the standard FHA refinance. Finally, if you want to refinance your loan and make home renovations, the FHA 203K loan is a good option.
FHA Streamline Loan
The FHA streamline loan is for current FHA borrowers only. This program relies on your mortgage payment history and the net tangible benefit you receive from refinancing. As long as you paid your last 12 FHA mortgage payments on time and you can prove any of the following, you are in good shape for approval for the FHA streamline refinance:
- Your payment decreases with the refinance
- You can secure a lower interest rate with the refinance
- You can refinance out of an ARM and into a fixed rate loan
- You can lower the term of your current loan
The FHA does grant exceptions for one 30-day late payment on your mortgage payment history as long as it wasn’t within the last 3 months. This may vary by lender, though, as not all lenders want to take the risk. You cannot take cash out with this loan; it’s strictly a rate/term refinance to help you lower your payment or get out of a risky loan.
You don’t need to verify your credit score, income, or home value with this loan. But, you will have to pay your closing costs and funding fee in order for it to remain a streamline loan.
FHA Cash-Out Refinance
If you don’t have an FHA loan now or you have one but you want to take cash out of the home’s equity, you’ll use the standard FHA refinance or cash-out refinance. This loan works much the same way as the FHA purchase loan.
You’ll need a credit score of at least 580, stable employment, and debt ratios near 31/43 or less. You will have to pay for an appraisal for this loan program, especially if you plan to take cash out of the home’s equity. You may withdraw up to 85% of the home’s value. For example, if your home is worth $350,000, you can have up to $297,500 in an FHA loan. If your current loan balance is $200,000, that leaves you with $97,000 to do with as you please.
You can use the FHA standard/cash-out refinance with any loan program. You can even use it if you paid cash outright for your home and now want to tap into the home’s equity.
FHA 203K Loans
FHA 203K loans are a unique program offered by the FHA that provide you with funds to purchase or refinance your home plus take out money to renovate it. There are two types of FHA 203K loans, the streamline 203K and the full 203K.
The streamline 203K loan is for changes that are non-structural. For example, a new roof, new plumbing system, or minor kitchen remodels are allowed. Any renovations that include knocking down walls or adding rooms onto the home require the full 203K loan program.
In order to qualify, you must meet the following:
- Repairs can total up to $35,000
- The new loan amount cannot exceed 110% of the after-repairs value
- The renovations cannot affect the home’s structure
- You must be able to live in the home within 30 days after closing
- The repairs must be completed within 6 months
- The work must be done by a licensed contractor approved by the lender unless they grant an exception
This loan requires one closing. The seller or current mortgage company will be paid off first. The remaining funds sit in an escrow account waiting for disbursement to the contractors. The bank will provide up to 50% of the funds upfront and the final disbursement is made once the renovations are complete and approved.
The full FHA 203K works similarly to the streamline 203K with a few exceptions:
- You can make any renovations, including structural changes. The only exception is non-permanent or luxury amenities.
- You must be able to live in the home within 6 months of closing.
- You will need to use a loan consultant that will oversee the process and be your liaison between your contractors and the bank.
- The lender will approve a disbursement schedule based upon the building plans and schedule determined by the builder.
With both options, you receive one loan and only have one closing. You don’t have to worry about paying closing costs twice or dealing with two mortgage payments. The lender must approve any contractors that will work on your home and they will decide which renovations they approve and which you cannot include in the loan.
Finding an FHA Lender
Finding the right FHA lender means doing your homework. First, the lender must be FHA approved. Then, you must do your research and/or ask the lender questions directly. Try to choose the lenders that have extensive experience with the FHA program, have a fast turnaround time, and offer the most competitive interest rates. You’ll also want to pay close attention to the lender’s overlays or additional rules to make sure you meet their qualifications.
Finding the Right FHA Interest Rates
Don’t expect to find the same FHA interest rates with each lender. As you shop around, you’ll likely find varying rates from each lender. Take your time in evaluating the rates. Your best chance at securing the lowest rates is to keep your credit score as high as possible, increase your home’s equity, have a low debt ratio, and stable employment. Each factor that makes your loan ‘risky,’ increases the rate lenders may charge you.
The FHA offers a large number of programs fit for any type of borrower. Whether you are buying, refinancing, or fixing up your home, the FHA has options for each of these situations that all require the low credit score of 580 and the high maximum total debt ratio of 43%.