Understanding FHA Loans

Are you learning about the mortgage process?

Once upon a time, choosing a mortgage was easy: you just skipped down to your local bank and applied. 🏡

Today, there’s a world of loans to choose from that come in all different shapes and sizes. Where do you even start? How do you find the best rate? Who do you trust?

With millennial home buying on the rise and COVID-19 leaving everyone in murky financial waters, more millennials are finding solace in FHA loans. These government-backed loans offer low-interest rates, low down payments, and flexible qualification criteria.

But how do they stand up against conventional loans? What fees do you need to worry about? And how do you even qualify? In this guide, we’ll take you through all things FHA loans and give you our best tips to securing the mortgage you deserve.

What is an FHA Loan? 💡

An FHA loan sounds complicated, but it’s really just a mortgage backed by the Federal Housing Administration (FHA), an agency under the Department of Housing and Urban Development (HUD). FHA loans are insured by the FHA, which means that the lender is protected if the lender defaults on a loan. 

FHA loans are popular with millennials, mostly because of the low down payment requirement and flexible qualification criteria. Although the FHA loans are legally insured by the U.S. government, they are provided by lenders which have to first receive approval by the FHA. These loans come in either 15 or 30-year terms with fixed interest rates.

What is the ‘FHA’ Anyway?

The Federal Housing Administration was created during the Great Depression in 1934. During this time, the housing market wasn’t doing so well—default and foreclosure rates had peaked. Loans were capped at 50% of the property’s value, and mortgage terms were out of reach for most homebuyers. This created a nation of renters, with just about 40% of households actually owning their homes.

To re-energize the housing market, the Government created the FHA—their loan programs lowered the risk that lenders faced and made it a lot easier for borrowers to access loans to buy a home. Since then, the rate of U.S. residents owning their own homes went to 67.9% in 2020 after peaking at 69.2% in 2004.

How FHA Loans Work 🏘

FHA borrowers get their loans from FHA-approved mortgage lenders, as opposed to the FHA itself, however, the FHA insures the loan. To secure an FHA loan, those who qualify will need to buy mortgage insurance and make some premium payments to the FHA, which we’ll get into more below. 

You can apply for an FHA loan in many different ways, from large banks and credit unions to leading online mortgage lenders like Rocketmortage’s world-class experience. FHA-approved lenders generally have varying rates and costs, even if it’s for the same loan, so make sure to do some research and get up-to-date on today’s mortgage rates and fees.

Types of FHA Loans 🗂

FHA loans come in all shapes and sizes. Here are some of the more popular loans:

Fixed-Rate FHA Loan

This is a mortgage with a fixed rate over a 15- or 30-year term. With a fixed interest rate, you won’t need to worry about rising mortgage rates because your interest rate will stay the same until the very end.

Adjustable-Rate Mortgage (ARM)

ARM loans tend to come with a lower initial interest rate than most fixed-rate mortgages. The catch? It doesn’t stay like that forever—as soon as your introductory period ends, you may get hit with a higher monthly interest rate (or lower) depending on the adjustment index it’s tied to.

FHA Jumbo Loan

Jumbo loans are what you get when your loan exceeds the cap on conventional loans—$679,650 for a single-family based in San Francisco, for example. This loan is ideal for borrowers in high-cost areas looking to buy or refinance.

The downside? As jumbo loans have a larger loan limit, getting approved is more complicated than many other FHA loans: you’ll need a near-flawless credit score, a low debt-to-income ratio, and you’ll need to make a significant down payment. 

That said, if your credit is far from perfect, there are several options when it comes to mortgages for bad credit, so you won’t be left stranded.

FHA 203(k) Improvement Loan

As the name suggests, the improvement loan is the one for you if you’re looking to repair, improve or rehabilitate your home. HUD says that borrowers can use this money for anything that makes your home “basically more livable and useful”. You will need to use your home as collateral with this loan.

Energy-Efficient Mortgage (EEM)

An EEM mortgage helps to create a more energy-efficient home. EEM allows borrowers to lower their utility bills by financing the cost of adding some energy-efficient features to a new home or refinancing your current home.

Six of the Most Popular FHA Loans

FHA Loan Amount Limits 🔎

While figuring out the best loan for you, understanding the FHA’s minimum and maximum loan amounts will be an essential deciding factor. 

It all depends on where you reside but overall, loan limits for 2021 have risen. Today, mostly due to rising housing prices across the U.S., loan limits start at $356,362 and go up to $822,375, increasing by $24,602 on the 2020 limits. 

You’ll want to figure out exactly how much you’re entitled to, though. To do this, you can go straight to the HUD website and see the limits for your county. You may notice there is some disparity between high-cost and low-cost areas, as you see below.

FHA Limits (low-cost areas)

FHA Limits (high-cost areas)

How to Qualify for an FHA Loan 📄

No matter where you reside, or which loan you choose in the end, the higher your score, the better chance you have of meeting the FHA’s loan requirements. A minimum FICO score of 580 will allow you to reap the benefits of a lower down payment, so remember to treat your credit well.

If you haven’t been able to grow your credit score to 580, take a breath, there still may be a way to reach the outstanding FHA loan. First off, there are ways you can repair your credit score by paying agencies, but the top companies won’t be cheap.

You could also qualify with a lower credit score by paying a 10% down payment. This flexibility makes FHA loans particularly favorable among millennials.

Working to build your credit score might be your best option in the long run. Not only could this give you access to a lower credit score, but you’ll also sleep better at night knowing that you’re more protected with an FHA loan.

What if You Don’t Meet FHA’s Requirements?

You tried everything, and then some, but you still don’t meet FHA’s requirements? The FHA’s criteria look at a range of different factors around income and debt.

Sometimes, when a borrower fails to meet the standard criteria, the lender can do some manual underwriting. This means that if you don’t match the requirements as outlined by the FHA, the lender could still approve your loan after looking a bit closer at your overall financial situation.

FHA Mortgage Insurance Premium 💰

We all know that insurance is a necessary pain and mortgage insurance is no different: it helps protect lenders from loan money if you default on your loan. 

For this reason, borrowers will need to pay private mortgage insurance for conventional loans when a downpayment of less than 20% is made. Refinancing with less than 20% is no different—all FHA loans come with a mortgage insurance fee, regardless of the down payment amount.

How Much Does Mortgage Insurance Cost?

FHA mortgage approval will result in an initial fee of 1.75% of the total loan amount. This can be paid at closing, in cash, or it can be rolled into your loan amount, thus increasing your monthly repayments. A payment — each month — of between 0.45% to 1.05% will also be added to your monthly repayments. 

How to Get Rid of an FHA Mortgage Insurance

Borrowers can cancel private mortgage insurance once you reach sufficient equity (typically about 20%). Once your equity reaches 78% of the purchase price, the lender will automatically cancel your mortgage fee. When a down payment of less than 10% is made the insurance sticks throughout the term of the loan.

How Long Borrowers Will Pay MIP (Annually)

FHA Loan Closing Costs 💸

On top of your mortgage insurance, you will need to consider some other fees, including lenders’ fees and third-party fees. Here’s some more detail: 

Lender Fees

Like mortgage insurance, lender fees are hard to shake off. Some lenders fees you could face include:

• Document preparation fee.
• Origination fee.
• Interest rate lock fee.
• Underwriting fee.
• Supplemental loan origination fee (only for FHA 203(k) renovation loans)

You will have the option of taking advantage of discount points, i.e., the interest you prepay to lower your loan’s monthly interest rate. If a lower interest rate is something you’re keen on, there are some quality loans for lower interest out there. 

Third-party Fees

These fees are to pay for the third-party services received. Mostly, these are nothing to worry about but, all the same, ask your lender how much they will come to and work them into your overall costs. This way you’ll know exactly how much your FHA loan will cost.

• Title insurance policy premium (for the lender and an option for the buyer to purchase).
• Notary fee.
• Credit report fee—take heed of this in particular because the loans you get with good credit may give you far better rates.
• Appraisal fee—United Wholesale Mortgage (UHM) will partially refund this fee if the appraisal has not been completed within 10 days.
• Courier fee.
• Recording fees.
• Flood certification fee.
• Attorney fees.

Prepaid Items

And let’s not forget some of the fees that you will need to pay in advance—both the buyer and the seller will be responsible for some of these. Prepaid fees include: 

• Tax and insurance escrow deposit.
• Flood and hazard insurance premiums.
• Real estate taxes.
• Per diem interest.

How to Minimize FHA Closing Costs

With mortgage rates on the rise, the last thing we need is high fees. Luckily, we have a few tips to help you minimize closing costs:

✔️ Convince the seller to pay for their share of settlement expenses

✔️ Negotiate with the seller so that they take on some of the closing costs 

✔️ Use a cash gift from a friend or family member 

✔️ Research to see if you meet the criteria for a down payment or closing costs grant

✔️ Finance the closing costs

The first one is easy: ask your seller to take on some of the closing costs. After all, the seller has a responsibility to pay his share of some closing costs, like real estate commissions, which all add up.

Then, try asking the seller to pay some of the settlement costs. Don’t get your hopes up though, as this will depend on your real estate market’s activity level. A market where demand outstrips supply might leave you on the wrong side of the playing field.

Apart from asking your seller to pay some of the fees, you could try using a gift of cash from a family member or friend. FHA loans accept cash gifts from borrowers’ families, friends, or charities. Just make sure it’s legitimate because it will be thoroughly looked into by the FHA.

Some borrowers might meet the criteria for closing costs down payment grants from state housing assistance programs. Finally, try minimizing closing costs by financing some of them. Borrowers can add closing costs to their loan balance, which will take some of the heat off the upfront fees. Just watch out; financing your closing costs won’t make them disappear: you’ll pay for it with a higher monthly repayment and interest rate. 

Which is Better: Conventional Loan vs. FHA

You probably understand the benefits of an FHA loan by now. But let’s see exactly how much of a leg-up an FHA loan gives you when compared to a conventional loan.

We need to start by saying that the best loan for you will ultimately depend on your personal and financial needs. That said, an FHA loan offers more flexible qualification criteria and heightened loan limits.

Another benefit to an FHA loan compared to a conventional loan is that it offers a lower down payment. While, technically, a traditional loan boasts a down payment starting from 3% (compared to the FHA loans starting point of 3.5%), most conventional loans require a higher down payment than this. This means that, in most cases, you’ll get a lower down payment option through an FHA loan.

Additionally, an FHA loan requires a lower credit score and debt-to-income (DTI). If your credit is good enough, there are plenty of fair credit loans with good rates, which offer more flexibility than government loans. 

And finally, while there is a Mortgage Insurance Premium (MIP) fee with an FHA loan, conventional loans have mortgage insurance. This makes FHA and conventional loans pretty even-steven in this department. From what we can see here, FHA loans are worth taking a look at. Here are the stats:

The Best FHA Loan Alternatives 🏆

If this doesn’t float your boat, there are other options with low down payment requirements aside from the FHA program. Here are some ideas to explore:

Seller Financing

This is a loan provided by the seller to help you finance the property. In this case, the buyer could dodge some lender fees and some other costs like title insurance. Just make sure to have an appraisal done to be sure you don’t overpay.

USDA and VA Home Loan

Some other government mortgage programs to consider: the U.S. Department of Agriculture (USDA) and VA. These loans have several advantages for those who qualify, including no down payment requirements and no monthly insurance fee. These loans are for veterans, eligible service members, and in some instances, family members can even reap these beautiful rewards.

Applying for an FHA Loan 👨‍💻

While experts predict mortgage rates to tick up gradually, high demand is still expected, so you should probably get your house offer in sooner rather than later. Here are the steps to take to get started:

1. Apply for Pre-Approval 👍

Getting pre-approved before you do anything else will propel you ahead of the game. Pre-approval isn’t mandatory but will save you time in the long run. It’s relatively straightforward but for a better chance, try pushing up your credit.

To meet the guidelines, apply for pre-approval with an FHA-approved mortgage lender. When you’re approved, you’ll get a letter in the post informing you of the loan amount, which you can show to the property owner to secure the home. 

2. Fill out Form 1003 📝

When you find a home you want to call your own, download and fill out the Uniform Residential Loan Application (Fannie Mae form 1003). This form will ask you for the loan amount you hope to receive, along with the property address that you’re looking at buying.

On top of this, you’ll need to include some necessary information, as you would for any mortgage application process. This may consist of any debts or expenses, income details, and your history of employment. 

3. Get a Home Appraisal 🏘

Something to be aware of is that the FHA keeps a close eye on the market value of real-estate—it will play a role in whether your loan is approved or denied. To be sure the FHA is making the right decision, the agency sends a third-party home appraiser to the home to report back its estimated value.

If your loan amount request lines up with the estimated amount, your FHA application will be pushed onto the next stage. If the loan amount you requested is more than the appraisal, your lender may just cancel the whole thing if for some reason or another.

4. Follow the Underwriting Process ✒️

At this step in the process, your mortgage lender will evaluate your FHA loan application. This is where the smaller details matter, like financial history and credit score. Once everything is in order, you should be on your way to a mortgage. If any issues arise, bring them up with the lender.

5. FHA Loan Secured ✅

Once you make it through the underwriting stage, you can start getting excited about your new home. The lender should give you the financing you need to buy your home, and you can happily skip your way to the closing process, where you will gain ownership of the house.