FHA Mortgages and Loans

If a borrower is a first-time homebuyer with low to moderate income, and he/she is not able to meet the down payment or credit requirements for a conventional loan, than the Federal Housing Authority (FHA) may be able to help.

The FHA provides mortgage insurance to private lenders. This insurance enables lenders to provide loans to borrowers who might otherwise be deemed a poor risk.

As the table in this article shows, an FHA-insured loan helps borrowers by relaxing the guidelines for:

• Down payment amounts
• Credit history
• Closing costs
• Origination fees

Whether the borrower chooses an FHA-insured loan will depend on their financial situation. If the borrower is just starting out, and/or has low to moderate income and less than perfect credit, then an FHA-insured loan may be a preferred choice.

If a borrower is looking to buy a home but has issues with income, cash flow, and/or credit, they may need some help with financing.

The Federal Housing Authority (FHA) can help if a potential borrower meets one or more of the following criteria:

• The potential borrower is buying a home for the first time
• The potential borrower is has low to moderate income
• The potential borrower is not able to meet the down payment or credit requirements for a conventional loan

The Federal Housing Authority is part of the Department of Housing and Urban Development (HUD). HUD is the federal agency that creates national policies and programs for America's housing needs. FHA helps to underwrite home ownership for low- to moderate-income families.

This article focuses on the Federal Housing Authority helps borrowers to determine if a Federal Housing Authority Loan meets their financial needs and goals by answering the following questions:

• What is a Federal Housing Authority loan?
• How does it work?
• What are the pros and cons?

What is It?

First, a bit of name clarification is in order.

FHA doesn't actually provide mortgages per se. Rather, FHA underwrites loans by providing mortgage insurance to private lenders. This insurance helps first-time homebuyers and others who might not be able to meet the down payment or credit requirements of conventional loans to become homeowners.

By providing this insurance, the Federal Housing Authority encourages lenders to make loans that they might normally consider too risky. These loans are FHA-insured, not issued by the FHA.

FHA-insured loans take longer to process than is the case for conventional loans, because of the many rules, regulations, and procedures that borrowers and lenders must follow during the application process. If a borrower does not mind waiting a little longer to close on the loan, an FHA-insured mortgage may be a positive alternative to a conventional loan if the borrower's financial situation permits.

FHA-insured mortgages began during the Depression of the 1930s. At that time, so many mortgages were in default that many lenders had stopped issuing them. The FHA stepped in to protect lenders against default by insuring 100% of the loan, and thereby eliminating the lender's risk so they would write mortgage loans again.

Borrowers repay the FHA's insurance costs in two ways:

• An up-front insurance premium of 1.5% of the loan amount that the borrower pays at closing, and,
• A premium of 0.5% of the loan amount that the borrower pays each month as part of the monthly payment

While an FHA-insured loan may be slightly more costly than is the case with a conventional loan, it also enables cash-poor and/or credit-challenged borrowers to become homeowners.

How does it work?

An FHA-insured loan can be any fixed, adjustable-rate, or hybrid instrument. Additionally, interest rates on FHA-insured loans are comparable to those on conventional loans. As noted above, the main difference is that the FHA insures the loan and protects the lender from default.

If a borrower is interested in obtaining an FHA-insured mortgage, they need to apply to a HUD-approved lender who participates in the various FHA programs.

The most commonly used FHA programs are:

• Section 203(b) - For the purchase of new or existing one- to four-family homes. These homes can be in urban or rural areas, and can be standard or manufactured homes.
• Section 234(c) - For the purchase of a condominium.
• Section 203(k) - For the purchase and rehabilitation of a home that needs improvements (a.k.a a "fixer-upper" or "rehab" home).

The FHA also has more relaxed guidelines for borrowers than is the case for conventional loans.

These guidelines include:

• Low down payments - While conventional mortgage programs usually require a down payment that is 10% or more of the purchase price of the home, FHA-insured programs allow down payments as low as 3%. Additionally, the source of the down payment can be a gift, and the borrower does not have to verify the source of the gift money.
• Ability to finance closing costs - With most conventional loans, the borrower must pay closing costs. Closing costs are the various fees and charges associated with buying a home, and usually come to about 2-3% of the home's purchase price. With FHA, those closing costs roll into the mortgage amount, therefore reducing the up-front costs the borrower must pay to become a homeowner.
• More relaxed credit requirements - Through an FHA program, a borrower may be able to get a mortgage even if they have less than perfect credit. Many FHA programs allow the borrower to qualify even if they have filed bankruptcy.

In greater detail:

• A Chapter 7 bankruptcy discharge at least two years ago.
• A Chapter 13 bankruptcy discharge at least one year ago and the prospective borrower must show proof of satisfactory payment on the bankruptcy for that time. Additionally, some FHA programs allow use of "alternative credit" such as payment history for utilities, cable TV, auto or medical insurance, child care or school tuition, in lieu of traditional credit.
• Lower fees - FHA rules limit some of the fees that mortgage companies can charge for making the loan. For example, the mortgage company cannot charge a loan origination or processing fee that is more than 1% of the mortgage amount.

The following table summarizes these points.

In exchange for all these benefits, there is one very important limit that these FHA programs impose - the loan amount cannot exceed a certain ceiling. These ceilings vary by state. Interested applications need to check the HUD guidelines for each state to find out what the ceiling is. FHA has this loan amount limit to ensure that its programs are actually serving low- to moderate-income borrowers.

What are the pros and cons?

Prospective buyers who have low to moderate income, and/or are cash-strapped or credit-challenged may find that an FHA-insured loan may help. As with any other mortgage option, it has advantages and disadvantages.

Whether a prospective borrower chooses an FHA-insured loan will depend on the plans for their home, and on the overall financial picture.