Federal Housing Administration (FHA) Loans
How FHA Loans Work
FHA loans are one of three types of mortgage loans known as “Government” loans. The other two are Veteran and USDA loans.
The Federal Housing Administration does not actually provide the funds for the loan but rather they “insure” the loan. In order to be eligible for FHA to insure the loan, it must be underwritten to FHA guidelines.
There is a misconception that FHA loans are for people with bad credit. While FHA guidelines will accept borrowers with lower scores than Conventional Fannie Mae or Freddie Mac it’s more about what specific loan type makes sense for a specific loan scenario.
For example, when purchasing a multi-unit property, say a two-unit, that will be owner-occupied, FNMA and FHLMC require a minimum 15% down payment, regardless of credit score. As long as the property will be the primary residence of the borrower FHA will accept as little as 3.5% down. This is a huge difference when someone is looking at $300,000+ two-unit buildings. That’s only $10,500 down vs. $45,000.
FHA Loan Requirements
In general, the FHA will accept lower credit scores and higher debt-to-income ratios at interest rates that are competitive and sometimes lower than Conventional financing. With lower down payments, 3.5% – 5% FHA loans are very competitive. However, FHA loans become less so when the down payment is closer to 10% or more.
While Conventional financing requires private mortgage insurance (PMI) when down payments are less than 20% (LTV > 80%), FHA loans require MI (just “mortgage insurance” when FHA) for all loans regardless of down payment or LTV. The PMI on Conventional loans will automatically drop off when the LTV reaches 78% of the original purchase price (or appraised value if a refinance) but on FHA loans the MI lasts for the life of the loan.
Additionally, there are two components to FHA mortgage insurance. There is the monthly amount that is part of the monthly payment and there is also the UpFront Mortgage Insurance when the loan is made. The UpFront portion is typically added to the base loan amount and is not an additional expense the borrower needs to have available. However, it increases the total loan amount and therefore the total monthly payment.
FHA loans are neither “good” nor “bad” but are simply different tools to be used when appropriate. I’m glad they are available and have helped many borrowers buy or refinance with FHA programs.
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