FHA loans are mortgages insured by the Federal Housing Administration, the largest mortgage insurers in the world. The FHA was established in 1934 after The Great Depression and its continuing mission is to create more homeowners in the US. Therefore, it is plain obvious that the popularity of FHA loans comes from their ability to extend mortgage loans to almost anyone trying to buy a home. It is important to remember that the FHA doesn’t lend money, but insures lenders instead.
Mortgage Insurance Premiums
To qualify, the FHA charges single upfront mortgage insurance payments (MIP) along with annual mortgage insurance premiums. The upfront MIP are the same for all, which is 1.75% of the loan amounts and can be financed directly into the mortgage loans. Remember, payment for mortgage insurance from borrowers are mandatory in order to protect lenders from losses in instances of defaults on loans. The annual MIP varies based on the loan term, loan amount, and the loan-to-value (LTV) ratio. Use the tables below to figure out proper MIP rates.
2020 FHA Annual MIP Rates
Loan Term—Longer than 15 Years
Loan Term—15 Years or Less
- No requirement for large down payment. FHA loans are famous for requiring down payments as low as 3.5%. This might be the single biggest contributing factor to FHA’s importance in helping to realize the dreams of home ownership to less-than-qualified households.
- No requirement for high credit scores. As a matter of fact, the FHA approves loans for households with credit scores of 580 or even lower.
- No prepayment penalties.
- No expectation for income must be met. As long as borrowers can show that they can repay the loan (either through history of payments or large savings), even the lowest income households can qualify.
- Certain scenarios where FHA loan borrowers are allowed to spend up to 57% of their income on all monthly debt obligations, which can be considered exceedingly high compared to the debt-to-income ratio requirements of other mortgage loans.
Not only do they have very appealing incentives for borrowers, but for certain mortgage lenders also; because they are a federal entity upheld by tax dollars, FHA loans basically guarantee the ability to take over any remaining loan payments when borrowers happen to default.
With as many benefits as they come with, there are reasons why they haven’t been adopted as the universal method for mortgage loans.
- The MIP and subsequent payments contribute to why FHA loans tend to be more expensive than conventional. Also, unlike the latter, FHA insurance premiums cannot be canceled once 20% of home equity is reached; this is a very expensive and important cost to account for. When people speak the good virtues of FHA, it is usually coupled with the ‘catch’ afterwards – the insurance payments. FHA insurance is often unavoidable without paying off the loan entirely.
- They hand out relatively smaller loans than otherwise. People seeking more expensive home purchases may want to look at conventional loans instead.
- Borrowers with excellent credit are more likely to get better rates from conventional loans.
- There are certain limitations to properties that can qualify for FHA loans because they must meet standards such as basic health and safety.
- As a general assumption, potential buyers that finance using FHA loans may raise eyebrows from sellers. As compared to conventional mortgage loans, FHA loan borrowers carry rash generalizations associated with low income demographics.
The Department of Housing and Urban Development (HUD) is the organization that sets specific guidelines for FHA debt-to-income ratios, formulas used to manage the risk of each potential household who borrows FHA loans for home purchases. To determine house affordability of an FHA loan, please use our House Affordability Calculator. In the Debt-to-Income Ratio drop down selection, there is an option for FHA loan.
It becomes immediately apparent that FHA loans have the most stringent debt-to-income ratio requirements. After all, the FHA was essentially created to absorb the risk inherent in handing out many loans that could be defaulted at any time.
However, there are exceptions that can be made for borrowers who cannot adhere to the front or back-end ratios of 31% and 43%, respectively. The HUD can give mortgage lenders leeway to approve borrowers as long as lenders give evidence of significant compensating factors. One or more is typically sufficient to qualify borrowers. These compensating factors include:
- A higher down payment than the minimum requirement of 3.5%, which most FHA loan borrowers take advantage of.
- Applicants showing dutiful mortgage payments in the past equal to or greater than the new potential loan.
- Excellent credit scores (however, people with great credit scores will probably get more enticing offers from conventional loans).
- Proof of substantial savings, usually three months’ worth of mortgage payments in the bank.
Quick Tip: As with any other big financial decision, take the time to evaluate all options. While FHA loans are a viable choice, conventional loans may be better for some people, such as when down payment is over 20% or they have excellent credit scores. Veterans and similarly applicable individuals should consider VA loans. Compare rates offered by different lenders.
There is no prepayment penalty for FHA loans, so it can make financial sense for some FHA borrowers to supplement an FHA loan with additional payments. However, we recommend it only when the financial situation allows for it, and our calculator can help. Inside the More Options input section of the calculator is an Extra Payments section to input monthly, yearly, or single payments. Use the results to see how much the length of the loan is cut short.
FHA 203K Loans
FHA 203k loans carry many of the same aspects as their originals, such as ease of qualification for loans, high insurance premiums, and a small ongoing fee. but with the additional benefit of borrowing money for home improvement costs. Because the Federal Housing Authority (FHA) is involved, properties that otherwise wouldn’t receive such unprofitable treatment get improvements in their build and value because they have suddenly become profitable in the eyes of lenders. However, completion of improvements must be finished within six months. FHA loan funds are transferred into an escrow account and paid to contractors as improvements occur.
A minimum of $5,000 must be borrowed and maximum limits are set by the FHA that differ according to locations. Borrowers are generally given enough to finance 110% of any home’s projected value after improvement set by appraisers. Similar to regular FHA loans, they tend to be enough for most families purchasing a home that aren’t decked-out mansions. Borrowers can expect to pay about 1% higher than standard loans.
There also exists a mini version of the FHA 203k called the Streamlined FHA 203k made specifically for lower borrowing amounts that are processed much more easily.
Quick Tip: Only owners, occupants, and nonprofit organizations may use FHA 203k loans, not investors. They were generally created for one to four unit properties, but can also apply to condo and townhomes that direly need construction.
Funds can also be used for temporary housing while improvements are being made for up to six months.
Quick Tip: Probably the most irritating thing about FHA loans are the stacks of paperwork involved to get everything in writing. Borrowers who tend not to follow lots of guidelines carefully may want to start doing so to avoid penalties. There is also time involved between processing of paperwork; keep this in mind when buying properties competitively in constrained periods.