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FHA loans: What You Need To Know

FHA loans are mortgage loans which are insured by the Federal Housing Administration (FHA). Buying a home can be a costly investment which usually requires financial help from a lending institution. FHA loans are very popular among home buyers because they have requirements that are less stringent than other mortgage loans. These requirements include accepting borrowers with low to fair credit scores, which is why many opt for FHA loans instead of conventional loans. However, there are also disadvantages to FHA loans, including higher interest rates and mandatory mortgage insurance.

It's important to know the types of FHA loans available, including the rates to expect and limits on the size of the loans themselves.

FHA Loans Types

There are several types of FHA loans currently available for potential homeowners. Each loan caters to home buyers or owners in a specific stage of home ownership.

The first is the FHA 203(b), the Mortgage Insurance Loan. It is an ideal option for first-time home buyers who have poor credit and cannot afford a large down payment. Because this type of loan caters to borrowers with a poor financial history, there are conditions attached that protect the lender's investment, such as mortgage insurance.

Second is the Home Equity Conversion Mortgages (HECM), these are generally geared toward borrowers who are 62 years of age or older. With this loan, home owners use the equity they have built on their home to obtain a loan from lenders. An HECM loan is ideal for homeowners who want supplemental income to use for personal use or reinvest in the home.

Another type of FHA loan is the 203k loan, or Rehabilitation Loan Mortgage Insurance. This loan allows home owners to renovate or repair their home. The 203k rehab loan works in two ways: a portion of the loan will go toward the home purchase while the rest goes to the cost of repairs and/or upgrades. However, these costs must be pre-approved and meet certain eligibility requirements. The FHA Title 1 loan, or Property Improvement Loan Insurance, is another similar loan that helps homeowners finance the cost of improvements to their home.

The 203(h) Mortgage Insurance for Disaster Victims loan benefits individuals who have lost their home due to a natural disaster or similar incident. As one of the FHA disaster relief loans, it provides funds to borrowers to rebuild their home or purchase another. 203(h) loans are different from other FHA loans, as they have a limited window for individuals to submit their application following a disaster.

FHA Manufactured Home Loan Insurance is a loan type for individuals who want financing for their mobile homes.

FHA Loan Limits

Lenders have limitations they must adhere to regarding the FHA maximum loan amount a borrower may receive. These FHA limits can vary from one state to the next as several factors, namely local home prices and cost of living, influences how they are set. There is a national cap set by the Department of Housing and Urban Development (HUD) that applies to high-cost areas:

Maximum loan amount for a one-person family is $679,650
Maximum loan amount for a two-person family is $870,225
Maximum loan amount for a three-person family is $1,0151,875
Maximum loan amount for a one-person family is $1,307,175

On top of state-specific factors such as home prices in each area, the type of unit also plays a role in determining the loan limits. Every year there is a new set loan limit to reflect changes in the housing market and other factors.

FHA Loan Rates

Borrowers can choose between two types of FHA mortgage rates: fixed and variable.

Fixed refers to interest rates that stay consistent throughout the entire loan lifetime. Many borrowers choose this type of rate as it creates a predictability and security. It is also beneficial when making financial decisions and budgeting.

Variable-rate loans can increase or decrease over time. Also known as Adjustable-Rate Mortgages (ARMs), variable-rate loans often come with a limited fixed rate period and then make changes depending on the national average. The benefit of having a variable-rate loan is that borrowers may have some lower monthly payments if the interest rate decreases. However, the risk with a variable-rate loan is that there is no way to know ahead of time how rates will fluctuate over time.

FHA loan rates typically range between 3.5 and 5 percent. While this is the average rate, lenders consider several factors before determining a loan rate for a borrower. This includes the home price, the borrower’s financial and credit history and the geographic location. Most important to remember is that HUD helps protect consumers from experiencing sudden spikes in their interest rates by setting a cap for FHA interest rates. For instance, a 1- and 3-year ARM can only increase up to 5 percent during the entire loan term.

Qualifying For an FHA Loan

Applicants must meet certain FHA loan requirements to qualify for an FHA loan. FHA loans tend to be more flexible in their requirements while still having some strict guidelines that every FHA-approved lender must adhere to. The first and perhaps most important factor is the borrower’s credit score. A credit score is a three-digit number that reflects a borrower’s entire credit history. Scores range from 300s to 800s, with 800 being an excellent score. An FHA loan typically requires that the borrower has a credit score of at least 500. This score is lower than the requirement for most conventional loans, making FHA loans options for borrowers with poor credit.

Following FHA guidelines, lenders will also evaluate an applicant’s debt-to-income ratio (DTI) to determine if they can afford the loan. Lenders calculate the ratio by dividing an applicant’s total liabilities, such as credit card payments and student loans, by their total monthly income. If an applicant’s DTI ratio percentage is over 43 percent, then he or she may be ineligible for an FHA loan. A low DTI percentage indicates that the borrower is not financially overextended and can afford to take on another liability.

Borrowers must also be able to provide a down payment to qualify for a FHA loan. Standard down payments are 20% of the home’s sale price. FHA loans have much lower FHA down payment requirements at about 3.5 percent. However, this does not come without certain conditions. A low down payment typically entails a higher monthly interest rate and mandatory mortgage insurance. Mortgage insurance protects lenders in case a borrower defaults on his or her payment.