The Federal Housing Administration (FHA) oversees the FHA home loan program and issues guidelines lenders use for the FHA approval process. The FHA does not approve loans or otherwise handle them in any way. The program was introduced in 1934 as an integral part of the National Housing Act of 1934 as just one of the efforts the federal government undertook to help the economy recover from the throes of the Great Depression. Prior to the introduction of this important home loan, banks would require sizable down payments from home buyers, requiring a down payment of 30, 40 or even 50 percent of the sales price. Besides the large down payment, typical loans would be for a relatively short term of say three or five years before the note was due in full.
Basic Guidelines for FHA Approval
Today, the FHA loan only needs a down payment of just 3.5 percent of the sales price of the home with loan terms ranging from 10 to 30 years. The program carries a guarantee to the lender should the loan go into default. This guarantee is financed with two separate mortgage insurance policies. There is an upfront policy that is included in the final loan amount and an annual one whose premium is paid in monthly installments. If the loan does go into default, the lender is then compensated for the loss.
Income is verified by reviewing copies of the most recent pay check stubs covering a 30 day period. FHA loans require a minimum two year employment history which can be verified with a written request by the lender or by providing copies of the last two years of W2 forms. Self-employed individuals will provide the last two years of federal income tax returns along with a year-to-date profit and loss statement. The lender will average the last two years of qualifying income and P&L. Lenders may also use income from those who will not occupy the property yet still be on the application. A parent or relative can agree to be included on the loan and responsible for repayment.
The FHA loan program does not limit the amount of income the applicants may have. The FHA loan can also include income from non-occupying co-borrowers such as a parent or relative to help qualify. In addition, the borrowers will sign a form 4506-T which gives the lender permission to request the last two years of federal tax transcripts from the IRS. This income is compared to the income listed on the application.
Qualifying monthly debt includes any installment or revolving debt that may appear on a credit report such as an automobile loan, credit cards or student loans. Day care and family support payments are also tallied. The lender will add up all qualifying debt and compare that amount with gross monthly income to arrive at a percentage referred to as the housing debt ratio. The suggested housing debt ratio for FHA loans is 31. This means the housing payment which includes the principal and interest, property taxes, insurance and mortgage insurance should be approximately 31 percent of qualifying income. Only the income from those on the application can be used.
The secondary ratio is the total debt ratio. This amount includes the housing payment along with the additional monthly credit obligations. The suggested total debt ratio should not exceed 43 percent of qualifying monthly income. The lender is able to approve an FHA loan with higher ratios given other positive factors in the loan file.
Given other positive factors in the file, referred to as compensating factors, debt ratios can be even higher. The housing ratio can be as high as 46.99 and the total ratio 56.99. Lower debt ratios are suggested when the scores fall below 640.
FHA loans are a bit more forgiving compared to other low or no-down payment loans. FHA allows for credit scores to be as low as 500 accompanied with a down payment of 10 percent or more. The qualifying credit score will be the middle score of the three received. The lender will request a credit score from each of the three main credit repositories of Equifax, Experian and TransUnion. If there are two borrowers on the application the lender will use the lower of the two middle scores.
FHA loans are the most popular choice for first time buyers primarily due to the low down payment required and relaxed credit standards. This can mean the buyers do not yet have an established credit history or have three reported scores. With an FHA loan, “alternative” credit can be used. This type of credit includes other monthly payments made such as a utility bill or phone service.
The FHA loan can only be used to finance a primary residence and is not eligible for a rental or investment property. The home can be a single family residence or a 2-4 unit property such as a duplex or fourplex as long as the borrowers occupy one of the units as a primary residence. FHA loans can be used to finance a single family home as well as a condominium unit as long as the condominium project has received FHA approval.
FHA loans are available in both fixed and adjustable rate programs with terms ranging from 10 to 30 years.