FHA loans are mortgages insured by the Federal Housing Administration (FHA) and offered by private lenders. These loans make buying or refinancing a home easier for people who have middle incomes, less than perfect credit, and less money for a down payment. Because the FHA protects lenders against the risk of borrowers defaulting on their mortgages, lenders can offer favorable terms to customers who might not otherwise be approved for a home loan.
How does an FHA loan work?
You apply for an FHA loan with a lender just like you would any other type of mortgage. The FHA isn’t lending you the money for your new home. They are just insuring the loan that your lender provides. However, you do pay the FHA for backing your loan in the form of an upfront mortgage insurance premium (UFMIP) and annual mortgage insurance premium (MIP).
- UFMIP – An upfront fee of 1.75% of the purchase price of the house, which can be paid when the loan is issued or added to the total amount of your mortgage. You also pay UFMIP when you refinance. With refinancing, the 1.75% upfront is based on the principal balance of your new mortgage.
- MIP – An annual premium ranging from of 0.45% to 1.05% of the loan amount. Most borrowers who pay with a small down payment on a 30-year loan will on average pay 0.85%.
FHA loans can be used to buy or refinance detached and semi-detached houses, multiplexes, townhouses, and condominiums. FHA loans aren’t limited to first-time homebuyers. If you are buying your second home, you can use an FHA to purchase it, even if you used an FHA to buy your first home. The only catch is that the home you are buying must be your primary residence.
What are the pros and cons of FHA loans?
FHA loans are an attractive option for first-time buyers because their down payment and credit score requirements are easier to meet than conventional loans. Let’s take a closer look at the advantages of FHA loans.
- Low down payment. In most cases, you’ll only need to make a down payment of 3.5% of the purchase price. For a $200,000 loan, that’s a down payment of just $7,000. By comparison, a conventional loan can have higher down payment requirements. If you want to avoid paying for private mortgage insurance on a conventional loan, you’ll need to make a 20% down payment.
- Low minimum credit score. You may be able to qualify for an FHA loan with a credit score as low as 540. A credit score below 580 will increase your minimum down payment to 10% however.
- Easier debt-to-income ratio requirement. Homebuyers with a debt-to-income ratio as high as 43% can still be approved for an FHA loan, compared to conventional mortgages that often require a ratio of no more than 36%.
- Gifted money for down payment. You can use money that’s been given to you as a gift from a friend or family member toward the down payment and/or closing costs of your new home.
- Competitive interest rates. You may be able to get an interest rate for your FHA loan that is competitive to the rate you might receive with a conventional loan.
- Refinancing option. If you already have an FHA loan, you can use an FHA streamline refinance to lock in a lower interest rate or better terms depending upon market conditions, all while enjoying less paperwork and a fast closing.
There are a few drawbacks however, so let’s examine the disadvantages of FHA loans.
- Limited borrowing power. There is a limit on how much you can borrow to purchase your home. The limits vary but are based on the median price of homes by county. As of 2021, the current maximum is $356,362 but can be as high as $822,375 in areas where the home prices are much higher. The home must also be your primary residence, so you cannot purchase a vacation home, rental property, or investment property with an FHA loan.
- Insurance premiums. As mentioned previously, FHA loans require you to pay two kinds of mortgage insurance premiums – UFMIP equal to 1.75% of the loan amount and a monthly MIP that varies based on the size of your down payment, mortgage amount, and term. If you put less than 10% down, you’ll need to pay mortgage insurance for the life of your loan.
FHA loan applications
If you’re considering an FHA loan for your next home purchase or refinance, there are a few checklist items you’ll want to consider first.
- Check your credit – Your credit score is used to determine whether or not you qualify for a purchase or refinance and will factor into the interest rate you receive. Check your credit report for errors and find ways to improve your score before submitting your mortgage application.
- Calculate how much can you afford. Use our affordability calculator to help you figure out a price range of the homes you should consider based on your down payment, interest rate, and the loan term.
- Consider your options. Are you a veteran or current service member? A VA loan might be better option as it offers several advantages like 0% down payment and no mortgage insurance. Have enough money saved for a 20% down payment? A conventional loan might be a good option, especially if you want to avoid paying the insurance premiums associated with FHA loans.
Once you’re ready to apply for a mortgage, contact us by visiting our Get Started page or calling 877-220-5533. Our friendly loan advisors are here to help you learn more about all the options Freedom Mortgage offers homebuyers. Freedom Mortgage is the #1 FHA lender1 in the United States.
1. Inside Mortgage Finance, 2020