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How Do FHA Loans Work?

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Home loans come in many shapes and sizes. From conventional loans to Federal Housing Administration loans and Department of Veterans Affairs loans, borrowers have plenty of choices to consider on their journey to homeownership. While many buyers get a conventional loan, customers with lower credit scores or a smaller down payment may fare better with an FHA loan.

What is a Federal Housing Administration loan?

The Federal Housing Administration provides home purchase opportunities for buyers who may not otherwise qualify. The loan is guaranteed by the FHA to reduce the risk for lenders, but the agency doesn’t actually issue loans. Instead, the government acts as the insurer of the loan, which is originated by a private lender. Lenders have the assurance that they’ll be paid even if the borrower defaults on the loan, and borrowers with less-than-stellar credit can get financing for their own property.

To qualify for an FHA loan, borrowers should have a credit score of at least 580 and a 3.5% down payment. Individuals with a bankruptcy in their past and/or a credit score between 500 and 579 may qualify if they have a down payment of at least 10%. Additionally, all borrowers are required to show proof of employment history and income.

When a lender looks at your income for an FHA loan, they want to know if your income is likely to continue for at least the next three years. Lenders need at least two years of income to calculate factors including hourly wage, overtime, and other earnings.

Still, there are limitations on FHA loans — for the 2018 calendar year, the Department of Housing and Urban Development decided that the maximum loan limit for an FHA loan is $679,650. This may vary based on location; more expensive areas like Hawaii or California may have slightly higher limits.

Furthermore, per HUD regulations, the total FHA loan payments should be equal to or less than 31% of a borrower’s income. If a borrower has debt, the combination of debt payments and mortgage payment should equal 43% or less of the borrower’s income. The lender may make some exceptions to this rule.

How to apply

If you decide to apply for an FHA loan, you’ll want to have the correct documents on hand before applying. Forms you’ll need to have during the loan process include:

  • Personal documents: You’ll need to provide your Social Security number, two years worth of tax returns and employment verification.
  • Uniform residential loan application: You’ll need to fill out the type of loan, property information, employment, income, and assets.
  • Sales contract: Your lender will need the sales contract for the home you purchase to send to HUD.

The FHA loan process is similar to that of a conventional loan, the primary difference being that borrowers are required to pass CAIVRS (Credit Alert Interactive Verification Reporting System). Borrowers who want an FHA loan cannot have defaulted on any government loan or owe back taxes.

A consumer won’t know they are listed in CAIVRS until they apply for an FHA loan, but this database is reserved for individuals who have defaulted on federal loans. Agencies that report to CAIVRS include HUD, the VA, the Department of Education, the Departments of Agriculture and Justice and the Small Business Administration.

Your lender will run your name through the system as part of the approval process. To read more about the forms you will receive as you move toward finalizing your FHA loan (including the loan estimate and FHA closing disclosure), go here.

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FHA appraisals.

One thing FHA loan borrowers should be aware of is that the home you purchase must undergo an appraisal (and in most cases, an inspection), as HUD will need to see documentation to verify that the sales price is equal to or less than the value of the home. If the home appraises for less than the amount you agreed to pay, the amendatory clause allows you to back out of the deal without losing money. If you choose to move forward with your purchase at the higher price, you’ll be required to come up with the difference between the home value and the sales price.

In a hurry? According to Marc Johnson, a Utah-based vice president of lending with Guaranteed Rate, the best thing you can do is to have your documents ready from the beginning.

“The loan process isn’t that hard,” said Johnson. “People will tell you horror stories, but the best thing they can do is gather all of their info and give it to the loan officer beforehand. It gets complicated if you find the house first.”

What are the benefits of an FHA loan?

If you’re thinking about getting an FHA loan, it can be helpful to take a look at the pros and cons. Here are a few benefits FHA loans offer:

  • Down payments as low as 3.5% with a credit score as low as 580.
  • Individuals with a credit score between 500 and 579 may qualify if they can provide a 10% down payment.
  • FHA loans require sellers to allow buyers to back out of a sale if the property appraises for less than the sale price.
  • You don’t have to be a first-time buyer to qualify.
  • No income limits.
  • You could qualify for an energy efficient loan, which provides financing for improving the energy efficiency of your property. FHA loans are available for more than just a traditional home purchase. Buyers can secure an FHA construction loan to fund energy efficiency projects, home construction, and rehabilitation projects (particularly on fixer-upper properties). FHA loans may be fixed-rate or adjustable, so you have options to meet your needs.

What are the drawbacks of an FHA loan?

An FHA loan may not be ideal for your situation; there are some things that could make your home purchase more difficult. These are some of the potential drawbacks of an FHA loan:

  • All FHA loans require mortgage insurance, which will increase the monthly payment. With conventional loans, buyers can stop paying for private mortgage insurance once they’ve earned enough equity. With FHA loans, this may not be possible, unless the buyer contributed at least 10% upfront.
  • FHA loans have an upfront mortgage insurance premium (typically around 1.75% of the total loan), due at closing.
  • There are loan limits — the max FHA loan in most areas is $679,650.
  • FHA loans only provide loans up to the appraised value of a home. If the sales price is higher than the appraised value, you’ll have to either walk away or come up with the difference.
  • HUD has safety requirements for the homes you purchase, so an FHA loan could be denied if an inspection reveals too many problems — which means a regular FHA loan may not be ideal for properties that need major improvements. In fact, an FHA loan can be put on hold until the owner makes repairs to items like peeling paint, loose handrails, and other safety issues.

“Buyers do like conventional loans better because there is a laundry list of stuff you can’t have if you’re selling your home through an FHA loan. A conventional loan is easier on the seller,” Dana Martinson, a real estate agent in Davis County, Utah said.

Martinson noted that while some buyers will care, others may not. “Many sellers don’t pay attention; they just want to know if you qualify, if you can close on the house by the time they want to sell,” she added.

Is an FHA loan right for me?

The only way to know if an FHA loan will work with your situation is to schedule a call with a mortgage lender or a HUD counselor. They’ll be able to review your finances and answer any questions you have about individual circumstances or properties.

Borrowers should keep in mind that while the FHA loan is usually associated with first-time homeowners, anyone purchasing a home (who meets lending qualifications) can apply for an FHA loan. Here are a few more tips to help you decide:

  • If your credit score is 580 or below, it may be easier to qualify for an FHA loan than other mortgages, including conventional loans.
  • If you have had a bankruptcy or foreclosure in your recent past, an FHA mortgage may be your best option.
  • If you are struggling to come up with a significant down payment, an FHA loan only requires 3.5% down.

If you do opt for an FHA loan, work with an FHA-approved lender who not only understands your particular financial situation but how the process works.


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