What is an FHA loan?

An FHA loan is insured by the Federal Housing Administration and requires lower minimum credit scores and down payments than many conventional loans.

You can qualify for an FHA loan with a credit score as low as 500 with 10 percent down. To get FHA’s maximum financing of 97.5 percent, you need a credit score of 580 or higher and 3.5 percent down. FHA borrowers pay for mortgage insurance with upfront and annual premiums. The insurance protects the lender from a loss if the borrower defaults on the loan.

How FHA loans work

FHA’s flexible underwriting standards allow borrowers who may not have pristine credit or high incomes and cash savings the opportunity to become homeowners. But there’s a catch: borrowers must pay FHA mortgage insurance. This coverage protects the lender from a loss if you default on the loan.

Mortgage insurance is required on most loans when borrowers put down less than 20 percent. All FHA loans require the borrower to pay two mortgage insurance premiums:

  • Upfront mortgage insurance premium: 1.75 percent of the loan amount, paid when the borrower gets the loan. The premium can be rolled into the financed loan amount.

  • Annual mortgage insurance premium: 0.45 percent to 1.05 percent, depending on the loan term (15 years vs. 30 years), the loan amount and the initial loan-to-value ratio, or LTV. This premium amount is divided by 12 and paid monthly.

So, if you borrow $150,000, your upfront mortgage insurance premium would be $2,625 and your annual premium would range from $675 ($56.25 per month) to $1,575 ($131.25 per month), depending on the term.

FHA mortgage insurance premiums cannot be canceled in most instances. The only way to get rid of the premiums is to refinance into a non-FHA loan or to sell your home. FHA loans tend to be popular with first-time homebuyers, as well as those with low to moderate incomes. Repeat buyers can get an FHA loan, too, as long as they use it to buy a primary residence.

FHA lenders are limited to charging no more than 3 percent to 5 percent of the loan amount in closing costs. The FHA allows home sellers, builders and lenders to pay up to 6 percent of the borrower’s closing costs, such as fees for an appraisal, credit report or title search.

How to qualify for an FHA loan

To be eligible for an FHA loan, borrowers must meet the following lending guidelines:

  • FICO score of 500 to 579 with 10 percent down or a FICO score of 580 or higher with 3.5 percent down.

  • Verifiable employment history for the last two years.

  • Income is verifiable through pay stubs, federal tax returns and bank statements.

  • Loan is used for a primary residence.

  • Property is appraised by an FHA-approved appraiser and meets HUD property guidelines.

  • Your front-end debt ratio (monthly mortgage payments) should not exceed 31 percent of your gross monthly income. Lenders may allow a ratio up to 40 percent in some cases.

  • Your back-end debt ratio (mortgage, plus all monthly debt payments) should not exceed 43 percent of your gross monthly income. Lenders may allow a ratio up to 50 percent in some cases.

  • If you experienced a bankruptcy, you must wait 12 months to two years to apply, and three years for a foreclosure. Lenders may make exceptions on waiting periods for borrowers with extenuating circumstances.

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