You may have heard the term FHA before, it stands for the Federal Housing Administration. It’s a loan type that is backed by the government to help buyers get into the housing market and most of the time buy their first home. Here is an explanation of what FHA Loans are and how they differ from a Conventional loan product.
The Federal Housing Administration (FHA) is an agency within the U.S. Department of Housing and Urban Development (HUD) that was established back in 1934 to facilitate home financing and responsible for the construction of lending standards for home purchases.
All FHA loans are insured by the FHA which provides private lenders greater security when offering loans. You can only obtain an FHA loan from FHA approved lenders.
FHA Loan Benefits
FHA loans tend to be more accessible because the requirements are more geared towards borrowers with lower credit scores or smaller down payment funds available. FHA loans are great mortgage products especially after PMI was dramatically lowered a few years back.
The minimum required down payment for a FHA loan is only 3.5% of the purchase price. Gift funds can be used for the down payment so they don’t necessarily need to be the borrowers own funds. The donor will be required to provide a Gift Letter confirming that the money is a gift and not a loan. These funds like any down payment funds will still need to be sourced. There are no rules about how much of the down payment are gift funds so a generous relative’s gift could make up 100% of the down payment needed.
Borrowers with a history of a foreclosure, short sale or bankruptcy might be considered for a FHA loan. Only 3 years needs to pass for either a short sale or foreclosure.
FHA loans are attractive to first time buyers as the requirements are more lenient and remove a number of barriers for entering the home ownership market. Higher debt ratios allow a buyer to typically qualify for a higher purchase price than other loan amounts. FHA loans typically have lower interest rates than conventional loans as well. PMI rates also do not vary with credit score; something found true in conventional financing.
FHA Loan Disadvantages
A FHA loan requires an additional charge for Mortgage Insurance Premium which also includes an upfront charge with an annual premium included in the monthly payments.
FHA only finances primary residences so it cannot be used for a second home or an investment property. These loans are for those seeking assistance to get into the housing market. Someone looking to finance a second home is not deemed to need that extra financial support.
The amount that can be borrowed against a FHA Loan is limited and depends on which county the borrower plans to purchase in. The limits are typically adjusted annually and usually reflect the changes in the housing market.
If you are legally married and purchasing in a communal property state your spouse’s debts have to be taken into account by pulling their credit if they are not planning on going on the loan with you.
If you are purchasing a condo it must be FHA approved.
FHA and Mortgage Insurance Premiums
FHA borrowers are required to pay for mortgage insurance, which protects the lender from a loss if the borrower defaults on the loan.
Mortgage Insurance Premiums (MIP) have 2 parts. The first is an upfront charge of 1.75% of the loan value. Some agreements include the MIP in the loan payment or when the loan is completed. The second part of the MIP is the monthly MIP fee that is included in the monthly mortgage payments.
Be aware that down payments less than 10% will require the MIP to be paid for the life of the loan. If you put down 5% or more it will however drop the MIP from .85% to .80%.
FHA Streamline Refinance Program
An additional benefit for a FHA loan is the ability to reduce loan rates and ultimately the monthly repayments in the long term through the FHA Streamline Refinance Program. There are some conditions applied to be able to take advantage of this program, the most important is a track record of on time mortgage payments for the last 6 consecutive months. What the FHA Streamline Refinance Program offers is a minimal application process that does not always require a full credit check.
The conditions for applying for the FHA Streamline Refinance Program:
- The new loan must not be larger than the original amount borrowed
- The mortgage being refinanced must be current
- The current mortgage must be FHA insured
- The current mortgage must be for a minimum of 210 days and made a minimum of 6 payments
- The interest rate must not be higher than the original interest
The process of applying for the FHA Streamline Refinance Program is much quicker than the original FHA loan application. There Streamline refinance does not require an appraisal, income verification or a Debt-to Income ratio to be met.
A conventional loan is a mortgage that is not backed by any Government agency such as the Federal Housing Administration (FHA), Veterans Administration (VA) or USDA Rural Housing Service. A conventional mortgage adheres to the guidelines set by Fannie Mae and Freddie Mac. There is an array of private finance companies with some variations in their offers.
Conventional Loans Benefits
The most common misconception about a conventional loan is that it requires 20% down, which is most cases is untrue. Based on your situation the minimum requited down payment can be as little as 3% of the purchase price.
There are no restrictions on property or occupancy type when purchasing with a conventional loan. However larger down payment requirements are necessary for investment or second home purchases.
A conventional loan works well for borrowers with credit scores over a 680 with 5% down or a 640 with 20% down. Conventional loans have higher loan limits in most areas when compared to FHA mortgage loan amounts. PMI rates with excellent credit are very very low with conventional financing; even with just 5% down. As someone with a 760 credit score or higher pays less than $50/mo in many cases on a $300,000 loan; when only 5% is put down.
Conventional Loans Disadvantages
Conventional loans typically have lower debt to income ratio requirements and higher minimum credit score requirements than other loan types. PMI rates are highly affected by credit scores. Higher credit score borrowers are definitely the target beneficiaries for this type of financing.
Private Mortgage Insurance
PMI charges are based on a number of factors:
- Down payment percentage – the charges change depending on the amount deposited and the charges are connected to tiers, i.e. a 3% will incur the greatest PMI charge. The down payment tiers are at 3%, 5%, 10% and 15%
- Credit score – again the PMI is linked in tiers but in tiers of 20 with a credit score of over 760 incurring the least charge, a credit score of between 720 and below 740 will incur a slightly higher PMI charge and so on.
- Debt to income ratio (DTI)
- Property occupancy
To fully understand different loan options it is prudent to get advice from a mortgage expert to understand what loan type would be most beneficial. You are able to fully discuss your plans to buy, your current commitments, work out the finances and you will be in a better position to make decisions about your plans to buy a home. The Modern Lending Team is one of the top mortgage teams in the country and are hear to answer any questions you have.