The FHA Loan: When It’s Perfect and When It’s Not
The Federal Housing Administration (FHA) was created way back in 1934 as a way to help an economy still struggling to climb out of the Great Depression. Prior to the introduction of the program, many lower to middle-income buyers could not afford to buy a home, not necessarily because they couldn’t afford the monthly payments, mortgage loan amounts are issued based upon gross monthly income. The mortgage payment is adjusted to make the payments affordable. The FHA Loan was created as a solution.
The obstacles back then were the various lending guidelines that banks used when evaluating a loan application. When a bank made a home loan, much of the risk in issuing the loan was offset somewhat with other factors. For example, a bank could require a down payment of say 50% of the sales price or the buyers would have to open up a bank account and deposit a certain amount of cash. The well-to-do didn’t have much problem with this arrangement but as you can easily tell, it kept most potential home buyers on the sidelines. FHA home loans weren’t available yet. Remember, back then it was common practice to discriminate when evaluating a loan application and not making loans to middle-income consumers was commonplace. The FHA changed that with the introduction of its FHA loan program.
What’s an FHA Loan
The Federal Housing Administration, or the FHA, doesn’t underwrite, approve or otherwise get involved with any individual loan application. Instead it provides the guidelines lenders are required to follow when evaluating an FHA loan application. Individual lenders must be approved by the FHA to underwrite FHA loans and is also a favorite among first time buyers. And while it’s an excellent program the program may not be your best choice under different circumstances. Let’s take a closer look.
The FHA loan is one of the three mortgage programs in today’s marketplace that are government-guaranteed. The other two are the VA and USDA programs. This guarantee is not a guarantee that the applicant will be approved for the mortgage but is a guarantee to the lender. The guarantee applies should the loan ever go into default. If it does, the lender is compensated for the loss. Remember we did mention the FHA doesn’t approve any loans, lenders do but the FHA does insure them with the guarantee. In this way, the FHA loan is more like an insurance policy instead of a mortgage, right? The loan guarantee applies as long as the lender followed proper underwriting requirements. In the case of default, the loan will be audited to make sure the lender followed proper procedures.
FHA Loans: Good Idea
So when is the FHA mortgage a better option compared to other available loan programs? One of the most popular features of the FHA mortgage is the low down payment amount needed. The minimum down payment for an FHA loan is just 3.5% of the sales price. FHA loans are also more lenient as it relates to getting a financial gift. The FHA allows the buyers to get a financial gift for the 3.5% down payment and closing costs. Conventional loans also allow for financial gifts but still require the buyers to come up with part of the funds needed to close the transaction.
FHA guidelines allow for gifts to come from a relative, domestic partner, fiancé or a charitable organization designed to help home buyers financially as well as a qualified non-profit or governmental agency that provides home buyer assistance for first timers and/or low to moderate income buyers.
FHA loans also shine as it relates to credit requirements. The FHA has established a minimum credit score and the number is 500 but most mortgage companies override that minimum and set an internal standard. A 580 minimum credit score is a common guideline. While conventional loans can also approve a loan with a lower credit score, they may also ask there be a substantial down payment involved. FHA loans are used to finance a primary residence, only, not a rental property or vacation home.
An FHA loan is also an excellent choice when refinancing an existing FHA loan. When a refinance makes sense, whether to lower the rate, switch loan terms or get out of an adjustable rate mortgage and into the stability of a fixed, replacing one FHA loan with another means the transaction qualifies for what lenders commonly refer to as an FHA Streamline. It’s called a streamline due to the massively reduced documentation requirements. Remember when you first purchased the home using the FHA program, you provide your lender with lots of financial information, income, pay stubs, income tax returns and more.
With a streamline there is no need to document income and employment which means no pay stubs, W2 forms or tax returns. No bank or asset statements are needed and there are no minimum credit score requirements. A brand new appraisal is not a requirement for the FHA streamline. The only payment history the new FHA loan requires is to make sure you are current on your existing mortgage, there are no late payments made more than 30 days past the due date within the last six months and no more than one such late payment made within the last 12.
FHA Loan: Maybe Not a Good Idea
We touched on this topic earlier but if you plan on buying a rental property, the FHA loan can’t be used. It’s only for a primary residence as are all three government-guaranteed mortgages. You can however finance a purchase and then later on in life decide to move out and keep the property as a rental with no changes to your home loan.
Another reason why an FHA might not be your best bet is when there are funds available for a down payment and closing costs. If you have a down payment of say 20%, you might think about a conventional loan instead. A conventional loan amount that is at or below 80% of the value of the property there will be no mortgage insurance premium needed.
With an FHA loan, there will be two mortgage insurance premiums. One is the upfront mortgage insurance premium that will again be rolled into your loan amount and another annual premium paid monthly. If there are funds available for a conventional loan, that might be the better choice.
If you’re not sure which way to go, that’s why we’re here. Give me a call and let’s talk about the FHA home loan and see if it’s the perfect fit for your situation.