FHA Loans
FHA loans are a common way that many low- and middle-income families buy their first homes.
From credit scores to mortgage insurance, the type of loan you ultimately choose will shape your homeownership journey. FHA loans are one more option to consider, and understanding how they work can empower you to confidently engage with lenders, evaluate loan options, and make informed decisions aligned with your financial objectives.
FHA loans can’t usually be used to directly fund investment properties, since their use is restricted to primary residencies. However, there are some exceptions that smaller or new investors can take advantage of (such as an owner-occupancy option like house hacking).
In this article, we’ll delve into the key information you need to know about FHA loans to equip you to choose the right loan for your homeownership aspirations.
What are FHA Loans?
Federal Housing Administration (FHA) loans are home mortgages that are insured by the federal government and backed by an FHA-approved lender.
Funding for these loans is not provided by the FHA itself, but rather by banks and financial institutions that the FHA approves. Because the government guarantees these loans, they become less risky for lenders. This in turn makes FHA loans easier to get approved for since FHA approved lenders aren’t responsible for the risk of borrowers not being able to make their monthly payments.
For this reason, FHA loans are generally more accessible for many people who aren’t able to meet the strict credit and down payment requirements of private conventional loans. However, borrowers with FHA loans do have to buy mortgage insurance and pay monthly premiums to the FHA.
Brief History of FHA Loans
FHA loans were established by Congress in 1934, at the height of the Great Depression. At this time, the U.S. had increasingly low homeownership rates because most Americans could not afford 50% down payments and extreme mortgage terms. The homeownership rate was less than 45% by the late 1930s, according to the U.S. Census.
To ease this problem, Congress created the Federal Housing Administration. The Federal Housing Administration, or FHA, is a government agency that promotes affordable, easy-to-qualify-for home loans. Specifically, the FHA backed mortgages to reduce the risk to lenders in creating mortgages with lower down payments and more lenient terms. As a result, more borrowers were able to qualify for loans and homeownership rates increased steadily to an all-time high in 2004 (69.2%). Today, 65.7% of Americans own their homes.
Who Qualifies for an FHA Loan?
When comparing FHA loans to conventional mortgages, you’ll notice differences in eligibility criteria and mortgage insurance requirements. The FHA loan requirements are more lenient, including lower minimum credit score thresholds, making them accessible to a broader range of borrowers. They are often suitable for home buyers with a past bankruptcy or substantial debt.
To qualify for an FHA loan, FHA borrowers must meet the following general FHA loan criteria:
- FICO credit score at least 580 for a 3.5% down payment
- FICO credit score at least 500 for a 10% down payment
- Debt-to-income (DTI) ratio ideally less than 50%
- Loan principal between the FHA “floor” and “ceiling” amounts (This is based on the property type and whether the location is a low-cost or high-cost area).
- Mortgage insurance (required, but can be canceled after 11 years with down payments of 10% or more)
- Steady source of income
- Proof of employment
Additionally, homes financed with FHA loans must be used as the borrower’s primary residence. They can’t (usually) be used for investment properties or rental properties. Homes must also be inspected to ensure government health and safety regulations are met, but they can be anything from a single-family home to a townhouse, condo, or semi-detached house.
FHA loans are designed for lower-income households. However, they aren’t restricted to this population. FHA loans can also work for someone with high income but who also has lower credit, a short credit history, high debt, or less savings for a down payment (although borrowers with good credit generally opt for conventional mortgages).
Benefits of FHA Loans
FHA loans are attractive for first-time homeowners for many reasons. Here are a few of their benefits:
- More lenient credit score requirements
- Low down payment required
- Better fixed-rate interest rates than other loans
- More flexibility in DTI ratios
- Certain closing costs may be rolled into your mortgage
- Qualifying is still possible even if you’ve had a bankruptcy or other financial issues in the past
However, FHA loans also have some cons, such as the requirement to buy a mortgage insurance premium and stricter FHA loan limits. Be sure you review both the pros and cons of FHA loans before deciding if this financing option is right for you.
Types of FHA Loans
Traditional mortgages are the most common type of FHA loan. However, the FHA also offers several other types of loans, which we’ll discuss in this section.
FHA 203(k) Loans
The FHA rehabilitation loan, specifically the FHA 203(k) loan, stands out for its ability to combine mortgage and renovation costs into a single loan, making it an attractive option for those looking to finance home improvements. An FHA 203 k loan includes extra funds for the purpose of covering repairs, renovations, and other home projects along with the purchase of a home. They are ideal for those looking to purchase a fixer-upper or renovate their current home.
To qualify for this loan, the home must be at least one year old. There are many acceptable improvements identified by the government that can be covered under this loan. Here are a few of them:
- Eliminating health and safety hazards
- Making structural alterations
- Rehabilitating, improving, or constructing a garage
- Repairing plumbing, heating, air conditioning, or electrical systems
- Improving functions and modernization
- Repairing or installing new roofing, siding, gutters, and downspouts.
- Installing or repairing fences, walkways, driveways, exterior decks, patios, and porches
- Installing new appliances
Home Equity Conversion Mortgage (HECM)
Home Equity Conversion Mortgages (HECMs) are reverse mortgages that allow homeowners at least 62 years old to tap into their home equity in exchange for cash. The homeowner retains the title to their home but may draw on their equity (usually a fixed amount each month or a line of credit) to gain additional income that can be used for repairs, living expenses, or other purposes.
Home Equity Conversion Mortgages are the only reverse mortgages insured by the federal government.
Section 245(a) Loans
The FHA also offers Growing Equity Mortgages and Graduated Payment Mortgages, also known as Section 245(a) loans. These loans are designed for young families and first-time homeowners who cannot currently qualify for conventional mortgages but expect their income to increase in the future. Growing Equity Mortgages have scheduled increases in the monthly principal you pay, leading to shorter loan terms since the principal is paid faster. Payments for Growing Equity Mortgages start low and gradually increase as the loan ages and the borrower’s income grows.
FHA Energy Efficient Mortgage
FHA’s Energy Efficient Mortgage (EEM) program helps homeowners save money on their utility bills by offering loans with funding for energy-efficient home improvements. Homes with energy-efficient upgrades like solar/wind technologies, weatherization items, and energy-efficient appliances like refrigerators, washers, and dryers.
Understanding FHA Mortgage Insurance
Similar to some conventional mortgage types that require private mortgage insurance unless you can achieve a certain down payment amount, FHA Mortgage Insurance Premiums (MIP) are a requirement for FHA loans, including both upfront and annual payments.
The upfront premium is 1.75% of the base loan amount and is either rolled into the mortgage or paid when you close on the home. The annual mortgage insurance premium ranges from 0.15% to 0.75% of the base loan amount, and the borrower is required to pay mortgage insurance each month. These costs are calculated based on the loan amount and added to your monthly mortgage payment. The funds are then deposited into an escrow account managed by the U.S. Treasury Department.
FHA mortgage insurance typically lasts for the loan’s life or up to 11 years, affecting your long-term financial commitments. To eliminate mortgage insurance, consider refinancing your existing mortgage with a non-FHA loan once you have at least 20% equity in your home.
Be aware that certain regions may have higher limits, impacting your mortgage insurance expenses.
Can Investors Use FHA Loans?
In general, no—an FHA loan cannot be used to finance an investment or rental property since the home must be owner-occupied.
However, there are some circumstances under which investors might take advantage of this loan option. For example, investors may be able to use FHA loans to finance the purchase of a multi-unit property or “house hack” a property. The key is that the investor must occupy one of the units (for multi-unit properties) or have lived in the home for at least one year (in the case of house hacking your primary residence) to take advantage of the loan.
This can be a great strategy to start out your real estate career, pay off your first mortgage, and kickstart your way into your next real estate investment. For new investors, learning the ropes by house hacking with an FHA loan can be an incredibly lucrative approach.
Conclusion
Now that you have a better understanding of FHA loans, FHA 203(k) rehab loans, and other types of mortgages offered by the FHA, you are hopefully much better equipped to navigate the home financing landscape.
