What is the Federal Housing Administration (FHA)?
Buying a house is a major financial investment — so much so, that some people might not think they’ll ever be able to own a home themselves.
Government-insured mortgages lower the barrier to entry in the housing market so more people can qualify for loans and find a home that’s truly theirs. That’s what the Federal Housing Administration (FHA) is all about: helping people land the house of their dreams, regardless of their financial status. Since the agency’s inception, many homebuyers have turned to FHA loans to secure financing for a home loan when a conventional mortgage seems out of the question.
Let’s review this important institution and take a look at how it continues to level the mortgage lending playing field.
A brief history of the Federal Housing Administration
The Federal Housing Administration is a government agency that offers mortgage insurance to FHA-approved lenders, encouraging them to extend home loans to borrowers who might otherwise be viewed as too risky.
The FHA was created in 1934 as part of the New Deal. Its purpose: to make it easier for people everywhere to qualify for a mortgage and buy a home. By insuring the lender’s mortgage on FHA loans, the agency eases lender fears about risky borrowers defaulting on their mortgage.
Since 1965, the FHA has operated under the umbrella of the Department of Housing and Urban Development (HUD). More than ever, today’s FHA remains committed to its original mission, helping people all over the country secure financing for a new home.
What does the Federal Housing Administration do exactly?
The FHA insures mortgages for individuals who would be deemed a financial risk by lenders and, as such, are unlikely to be approved for a mortgage. That includes people with low credit scores, low funds in their bank accounts and minimal assets for collateral. Above all else, the FHA was created to give more people the chance to buy a home of their own.
What is the FHA’s role in the mortgage business?
FHA loans are very common in today’s mortgage industry. More than 8 million mortgages are insured by the FHA, with unpaid principal figures totalling more than $1.3 trillion. The FHA plays a vital role in the housing market, helping first-time homebuyers, low-income families and cash-strapped couples secure financing when other loan options are unavailable.
Who qualifies for FHA loans?
Although FHA loans support a lot of people who don’t have a strong financial history of managing debt, that doesn’t mean everyone will qualify for assistance. The FHA lays out several key criteria that you must meet to receive a government-backed loan:
- If you’re hoping to make the minimum down payment — 3.5% of the purchase price — your credit score must be 580 or higher.
- Alternatively, your credit score can range between 500 and 579, but you will need to put down at least 10% of the sale price.
- Your debt-to-income (DTI) ratio should be less than 50% — ideally even lower, say 43% — regardless of your credit score.
- You must apply the loan toward your primary residence.
Those requirements are in addition to the typical checks you would expect with any home loan, like verifying your income, place of employment and status as a lawful U.S. resident. Evidence of extreme financial distress, such as declaring bankruptcy, may hurt your chances of receiving an FHA loan.
Looking at the criteria listed above, arguably the biggest point to take away here is that your credit score will dictate how much money you need to pay up front. The higher your credit score, the less you need to put down.
Finally, it’s important to keep in mind that even with FHA financing, your lender still needs to approve your loan. Their criteria for assessing risk and determining who is mortgage-worthy may vary from the FHA’s requirements. For instance, even though the FHA may be OK with a sub-580 credit score, your lender may not approve anything lower than 620.
How much can you get from an FHA loan?
When trying to figure out how much house you can afford with an FHA loan, it’s good to know that the agency’s mortgage limits fluctuate from year to year and county to county. The FHA analyzes the median sale price for single-family homes in each market, and then sets the FHA loan ceiling at 115% of that figure.
Looking at Cook County in Illinois, for example, the current median sale price for a single-family home is $330,000. Using that information, HUD has set the FHA loan limit at $379,500. Take a look at HUD’s mortgage limit calculator to see the most you may qualify for in your housing market.
What types of residences does an FHA loan cover?
We referenced single-family homes in the example above, but FHA loans can be used for all kinds of residences:
- Single-family homes
- Condos
- Duplexes
- Multi-family homes, ranging from two to four units
- Townhouses
- Manufactured or modular homes
Keep in mind that the FHA may have different requirements for each of these types of residences. For instance, modular homes typically need to meet certain size and construction guidelines to qualify for a government-backed loan.
FHA-approved condos, townhouses, duplexes and other residences also need to be structurally sound and safe to inhabit. If you’re looking at a major teardown and rebuild, the FHA isn’t going to sign off on your loan.
What are the pros and cons of an FHA loan?
There’s a lot to like about FHA loans, especially for first-time homebuyers and low- to moderate-income families. But there are also downsides to consider, so it’s always a good idea to weigh the pros and cons before committing to an FHA loan.
Pros
- Credit score requirements are far more lenient compared with conventional mortgage loans.
- Down payments are typically much lower — Options may include 3.5% to 10% of the sale price — than industry standards.
- DTI flexibility means people with higher debt can still qualify for a home loan.
- Private mortgage insurance (PMI) isn’t tacked on to offset lower down payments.
Cons
- Mortgage insurance is still required, which the FHA will provide. But unlike PMI, FHA’s mortgage insurance will last through the entire duration of the loan, no matter what. Borrowers can cancel the PMI on a conventional mortgage once they cross a certain equity threshold — typically 20% of the purchase price. That’s not the case with an FHA loan.
- Mortgage limits restrict how much you can spend on a house, especially in counties with high variances in prices. Going back to our Cook County example, that $379,500 limit would not cut it in many of the metropolitan area's real estate markets, including various neighborhoods in the city of Chicago and several outlying suburbs.
- FHA’s safety and structural requirements may restrict your homebuying options even further. Depending on how the home inspection and appraisal goes, the FHA could block an attempt to buy a fixer-upper in a desirable location, for instance.
Another important point to consider is that FHA mortgage interest rates may vary from the rates your lender offers on conventional loans. Take the time to crunch the numbers and figure out what home loan option will cost you the least in the long run.
When does it make sense to get an FHA loan?
The purpose of FHA loans is to make it easier for anyone — low- to moderate-income families, people with low credit, individuals with high debt, first-time homebuyers, you name it — to purchase a house of their own. If you fit one of those categories, chances are you’ll have more success securing mortgage financing through the FHA.
Here’s a handy checklist to see if you may be a better candidate for an FHA loan as opposed to a conventional mortgage:
- You have a low credit score — 500 to 580.
- You have low funds available for a down payment — You’re using a down payment option that's 3.5% to 10% of your target price.
- You have high debt — lower than 50% DTI — but better bring it down to 43% to be on the safe side.
In conclusion
It may have been created in response to the U.S.’s most dire economic climate, but the FHA continues to help prospective homebuyers secure financing no matter how hot or cold the real estate market runs. FHA loans are a viable alternative to conventional mortgages, especially if your financial track record is a little spotty.
Keep in mind that even if the FHA grants you a home loan, your lender will need to sign off on your mortgage as well. Still, if you don’t have the collateral, savings or credit score that lenders typically look for in an ideal borrower, the FHA can extend you a helping hand. Review all of your mortgage loan options, including comparing expected PMI and FHA insurance costs, to find the best option when buying a home.