FHA loans can be great for first-time homebuyers as they may qualify for a down payment as low 3.5% of the purchase price. And people with lower incomes and credit scores may also qualify for FHA loans. This loan type makes homeownership possible for many.
Taking out a loan to buy a home is exciting, but it’s also a big decision that takes significant time and consideration. We want to provide you with the right information to help you make the best choices for you and your family, and this guide will help you understand what an FHA loan is and how to apply for one.
What is an FHA loan?
An FHA loan is a mortgage insured by the U.S. Federal Housing Administration (FHA) and provided by an FHA-approved lender. Because it is insured by the FHA, these types of loans may allow individuals with lower incomes to be approved for loans when they may otherwise be denied.
Unlike conventional loans, FHA loans can also help make homeownership possible for people with lower credit scores, and they offer lower down payments as well. They're an affordable option for many buyers.
How do FHA loans work?
FHA loans can give people with lower incomes or those with lower credit scores the ability to become homeowners. In order to offer a more relaxed credit requirement and a lower down payment, FHA requires you to pay mortgage insurance. If you defaulted on your loan, FHA would be responsible for paying off the remainder of your loan. Mortgage insurance limits the amount of money the lender may lose.
Mortgage insurance is considered a closing cost. Closing costs are the upfront fees required when you close on a home, and they're separate from your down payment. Lenders and third parties can cover up to 6% of closing costs on FHA loans, including attorney, inspection and appraisal fees.
The borrower is responsible for paying two FHA mortgage insurance fees:
- An upfront mortgage insurance premium: 1.75% of the total loan amount, which is financed or paid in cash upfront when the borrower receives the loan.
- An annual mortgage insurance premium: 0.15% to 0.75% of the total loan amount. This premium varies with the loan term (15 or 30 years), loan amount and down payment. The annual premium is divided over a 12-month period and payments are made monthly and may be required for the entire term of the loan.
For example, let's say you take out an FHA loan for $250,000. Your upfront mortgage insurance premium would be $4,375. Your annual mortgage insurance premium would be somewhere between $1,875 ($156.25/month) and $375 ($31.25/month), depending on the term of the loan (30 or 15 years). The annual mortgage insurance premium may not be cancelled and is for the life of the loan or 11 years depending on the term of the loan.
How do you qualify for an FHA loan?
Because FHA loans are backed by a government agency, they're usually easier to qualify for than conventional loans. The purpose of FHA loans is to make homeownership possible for people who would otherwise be denied loans.
You don't need to be a first-time homebuyer to qualify for an FHA loan. Current homeowners and repeat buyers can also qualify.
The requirements necessary to get an FHA loan typically include:
- A credit score of 580 or higher (less than 580, but no less than 500 would require at least a 10% down payment)
- No history of bankruptcy in the last two years
- No history of foreclosure in the past three years
- A debt-to-income ratio of less than 43%
- The home must be your main place of residence
- Steady income and proof of employment
A credit score represents how likely you are to make payments. Your credit score will also determine your down payment amount. If your credit score is at or above the minimum requirement, you’ll likely qualify for a lower down payment of 3.5%. If your credit score is below the minimum requirement, you’ll have to pay a higher down payment of 10%. Credit score requirements vary by lender.
During your credit check, the lender will consider more than just your credit score. Lenders are looking for a good credit history of timely payments. Late payments may disqualify you from getting a loan. Additionally, you should not be delinquent on debts such as student loans or have open tax liens.
A past bankruptcy will not disqualify you, but two years will generally need to pass before you can qualify for a loan
In general, you cannot get an FHA mortgage if you had a home foreclosure in the past three years. In some cases, borrowers who can prove their foreclosure was the result of extenuating circumstances may still receive a loan.
Your debt-to-income (DTI) ratio is a number that is calculated by dividing all your monthly debt payments by your gross income. There are two types of DTI ratios to consider when applying to a loan: front-end-debt ratio and back-end-debt ratio.
Your front-end-debt ratio is calculated by comparing your monthly mortgage payments to your monthly income. Your monthly mortgage payments typically should not exceed 31% of your monthly income.
Your back-end-debt ratio includes your new monthly mortgage payment and your other debts. Each month, your mortgage payments plus your monthly debt payments should generally not exceed 43% of your monthly income.
Any home you want to purchase using an FHA loan will need to be your primary place of residence, not a vacation home or a second home. Additionally, the home must meet U.S. Department of Housing and Urban Development (HUD) guidelines. The house will also have to be appraised by a HUD-approved appraiser to determine its current market value and make sure it meets minimum property standards.
Income and proof of employment
You will need to be able to verify your employment history to qualify for an FHA loan. You should be able to provide proof of income through pay stubs, W-2s and tax returns. There are technically no income limits, but you will need enough income to have acceptable DTI ratios. Having a higher income will not disqualify you from receiving a loan.
How to apply for an FHA loan
Applying for an FHA loan is simple when you know how. Follow the steps below to get started:
- Check your credit score. Your credit score will determine whether you qualify for a loan and will also determine your down payment amount.
- Budget all homeownership costs. You’ll want to take all the costs of homeownership into account. This includes the mortgage Principal and Interest payment, property Taxes, mortgage and hazard Insurance, and homeowners Association (HOA) fees (PITIA). Make sure you can afford all of this on top of your existing debt and bills.
- Calculate your debt-to-income ratio. Take your monthly debt payments, including your new PITIA, and divide them by your income. You'll want to make sure the percentage of your income is low enough to qualify for an FHA loan.
- Save enough money. To make a down payment, you'll need anywhere from 3.5% or 10% of the purchase price, depending on your credit score. You'll also need to be able to cover the closing costs.
- Get prequalified for a loan. You'll need to work with an FHA-approved lender. If you are prequalified, you will receive a letter you can show to sellers when you make an offer on a house.
Getting an FHA loan can be easy when you understand how the process works. Though it can seem difficult to understand all the details, our Home Lending Advisors are here to guide you through each step.