Understanding FHA Loans
If you’re thinking of buying a home, you may have heard about FHA loans. Here is the scoop on government-insured FHA mortgages.
The Federal Housing Administration was established during the Great Depression when many borrowers defaulted on their loans and lenders were reluctant to approve mortgages for all but the least risky of borrowers. If this sounds familiar, today’s mortgage market has led to a resurgence in FHA loans.
The FHA does not lend money to borrowers. Instead, it insures the loans, so that if foreclosure does occur the lender will not have to cover the loss. As a result, lenders can afford to offer FHA loans to borrowers who might not qualify for conventional loans.
How FHA loans are different
Unlike conforming loans, FHA loans do not have to conform to guildelines set out by Fannie Mae and Freddie Mac for loans sold on the secondary market. (For more information on conforming loans see our article titled Conforming Loans.
FHA loans differ in the following ways:
Lower down payment
FHA loans allow a down payment of as little as 3 percent. By contrast, conventional loans generally require at least a 5 percent down payment (though many lenders price loans higher for any down payment of less than 10 percent). In addition FHA loans are one of the only programs that allow the loan’s closing costs, including the down payment, to come from a gift to the borrower.
Expanded credit guidelines
Many lenders will not approve a borrower who has a foreclosure or bankruptcy on their credit report – and those can stay on your report for up to seven years. Borrowers who’ve had credit problems such as a bankruptcy may find it easier to qualify for an FHA loan.
Larger debt-to-income ratios
This is a calculation that figures your recurring debt as a percentage of your gross income. Generally, conventional loans require that your housing expenses not exceed 28 percent of your gross income and your housing expense plus non-housing debt not exceed 36 percent. An FHA loan allows a maximum ratio of 29/41. (For more information on debt-to-income ratios see our article on Debt-to-Income Ratios.)
Lower maximum loan amounts
One downside to FHA loans is that they typically require lower loan limits than conventional loans. Loan limits vary by state and county. You can find the FHA loan limits for your area from the HUD website.
FHA mortgage insurance
Another possible downside of FHA loans is that they require a more expensive mortgage insurance than conventional loans. FHA loans typically require an upfront mortgage insurance premium of 1.50 percent of the loan amount (which can be financed as part of the mortgage) and an annual fee of 0.5 percent. A conventional loan typically requires a private mortgage insurance (PMI) premium of 0.5 percent a year.
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