As a Realtor, let me tell you: Americans love open houses. Even when they’re not shopping for a house. They love to drop by, munch on free cookies and imagine what it would be like to live in a house that they most likely can’t afford.
Can you imagine how few homeowners there would be if everyone had to make a 20 percent down payment? Did you know that that used to be the reality prior to the 1930’s?
Although regulators have cracked down on some of the loose lending practices popular 10 years ago, it’s still possible to obtain financing to buy a home with less than the 20 percent required for a conventional mortgage.
The FHA loan program, for example, only requires a 3.5 percent down payment and can get home buyers approved with little or no credit history. Thanks to lenient credit requirements, the FHA program is still open to most borrowers — but fewer are taking advantage because fees have gone up substantially over the last few years.
Whether you’re thinking of buying your first home or moving up, here’s what to know about the FHA loan program today and whether it’s worth the cost.
The history of FHA loans
The Federal Housing Administration (FHA) was created by Franklin Delano Roosevelt in 1934. One of the goals of the FHA was to stimulate the economy by allowing families to afford homes with smaller down payments.
Until this time, 30-year fixed loans were rare. Instead, loans requiring large down payments and with risky balloon payments were common. Over the past 80 years, the FHA has created a huge boost both for the housing market and the general economy by allowing home ownership to become more affordable. At the same time, traditional lending has evolved to offer the 15- and 30-year fixed rate mortgages with which most of us are familiar.
As a result, the rate of homeownership in the United States has climbed from 48 percent in 1930 to 65 percent in 2013, according the U.S. Census Bureau. The homeownership rate peaked in 2005 at 69 percent.
The FHA is not a lender!
This is a common misconception. The FHA is an insurer, not a lender. The FHA insures the lenders when they make loans that conform to FHA requirements.
You still apply for the mortgage via your local bank, an online mortgage company, or an independent mortgage broker.
Anyone can apply for an FHA loan
You don’t have to be a first-time buyer to qualify for an FHA loan, and there is no income limit to use the FHA program (in other words, you can’t earn too much to apply for an FHA loan).
To qualify for the loan, you will need to earn enough so that no more than about 31 percent of your pre-tax income goes to mortgage costs and no more than 45 percent of your pre-tax income goes to combined mortgage and other debt payments. (The actual ratios used to qualify may vary by lender.) Use our home affordability calculator to see where you fall.
FHA loans are only for primary residences, however, so you can’t use the program to buy a second rental property. There are, however, FHA loans available for both multi-family units and new home construction.
FHA loan credit score requirements
FHA loans are designed to help people own homes, so FHA loan credit score requirements are lenient.
The required minimum credit score and credit history to obtain an FHA loan with the low 3.5 percent down payment is around a 580 FICO score. That said, many lenders set their own requirements higher — around 640. If your score is lower than 580 (and quite possibly, lower than 640), you may need to put at least 10 percent down. (Learn how to check your credit score and report.)
In addition to meeting the FHA loan credit score requirements, you’ll also need to have at least two credit lines on your credit report. For applicants without at least two credit lines, a substitute method of qualifying may be available.
Surprisingly, having a history of bankruptcy or foreclosure in the past few years does not necessarily disqualify you from getting an FHA loan, but you will have to:
- show your efforts to reestablish good credit
- document that you have income to pay the loan
- put down a higher down payment
FHA loan limits
There are limits to how much you can borrow with an FHA loan that vary by region. You can do a search for FHA loan limits here.
Increased FHA loan fees
In addition to paying 1.75 percent of the loan value up front, FHA loans require monthly insurance payments that are much higher than most mortgages.
When you get a mortgage and make a down payment that is less than 20 percent of a home’s appraised value, you are required to pay private mortgage insurance (PMI) that protects the lender in the event of a loan default. That’s true whether the loan is backed by the FHA or not.
But in 2010, the FHA started increasing borrower’s monthly private mortgage insurance fees in an attempt to recoup some of the losses they faced from borrowers not making mortgage payments. The current PMI payment is 1.3 percent of the mortgage balance each month, up from 0.5 percent.
Another big change on FHA loans is that PMI must be paid for the life of the loan. With FHA loans made prior to 2013 and with conventional loans, borrowers can cancel PMI once they build the necessary of equity in their home. As you can imagine, paying 1.3 percent or your mortgage balance every month until it’s paid off in full adds up to a lot of money.
Some borrowers may be able to offset these higher FHA loan fees by participating in voluntary credit counseling. The FHA announced last month that borrowers who undergo counseling before closing are eligible for a 0.5 percent break on the upfront fee and a 0.1 percent break on annual insurance premiums. Borrowers who complete counseling post-closing and maintain a timely payments for two years are eligible for a 0.15 percent break in annual premiums.
How to apply for an FHA loan
First, you’ll need to save at least a 3.5 percent down payment plus estimated closing costs and some wiggle room for the inevitable unexpected expenses that come up when you buy a home.
Your mortgage broker or an online lender can take your mortgage pre-approval application and begin to see if you qualify for an FHA loan. They may require more documentation than a simple pre-approval, including tax returns, bank statements and pay stubs. You’ll also need to authorize your lender to run your credit.
With this information lender can begin to shop your mortgage and give you a sense of exactly what rate you’ll pay, what your payment will be, and other information under the FHA program.
Is the FHA loan program sustainable?
The FHA backs millions of home loans in the United States every year and is the primary loan program for first-time homebuyers.
According to Bloomberg, the FHA was the source of over 27,000 mortgages in February 2014 alone. Yet that number has dropped significantly in recent months, a 32 percent decrease from February of 2013. The reason for the drop in FHA loans is clear: they are getting less and less affordable for first time homebuyers as the fees continue to rise.
Former FHA director Brian Chappelle explains, “When you’re asking young families to pay a couple hundred extra dollars every month in new FHA fees, you’re keeping a lot of them from becoming homeowners. Anyone who bought a house in 2005 will tell you that nobody has a crystal ball when it comes to real estate. No one knows exactly what the future will hold.
But experts predict that more people will refinance out of FHA loans to conventional loans or wait longer to buy by saving up more money, as FHA loans are becoming less and less affordable to homebuyers. This doesn’t mean that they’ll disappear completely, but simply that they will become less common.