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How Do FHA Loans Work?

Are you looking to purchase a home? Are you a first-time buyer, have a not-so-great credit score, or are considered low-income? FHA loans may be the right choice for you. Created to make housing more affordable, these loans qualify individuals to purchase a home who would otherwise be unable to. These loans are offered by many banks, credit unions, online mortgage lending companies, and more, making them accessible to most borrowers. However, there are some terms and conditions required to qualify. In this article, we break down FHA loans – what they are, how they work, and what you need to do to apply for one. Keep reading to learn more. 

What is an FHA Loan?

An FHA loan is a type of mortgage loan insured by the Federal Housing Administration (FHA), whose primary goal is to increase housing accessibility and employment rates and provide loan insurance.  These loans are insurance-backed by the FHA but loaned by approved, private lenders such as banks and credit unions. 

This FHA program was born during the Great Depression era when the rate of foreclosures skyrocketed – this program intended to protect lenders from losses. Eventually, FHA loans became geared toward people who cannot afford or qualify for conventional loans.  

FHA loans are used to purchase or refinance single and multi-family homes, condos, and in some cases, mobile homes. These loans can also be used for renovations or construction in the existing home. 

Who are FHA Loans For?

FHA loans only require a minimum down payment of 3.5% for borrowers who have a credit score as low as 580. As a result, FHA loans are typically for borrowers who are considered low-income, have little to no savings, or have issues with credit. They are also a good choice for first-time home buyers for this reason, as well. FHA loans allow many borrowers purchase homes that they could otherwise not qualify for. 

FHA Loans vs. Conventional Loans

FHA loans are easier to qualify for because they are insurance-backed by the government to protect the lenders. Conversely, conventional loans are not insured by a federal agency and typically require a higher down payment and a better credit score/history. In some cases, FHA loans require a smaller monthly premium, but this is not always true. Qualifying for conventional loans is more difficult, as lenders consider them to be riskier, but they can fit the needs of a wider group of home-buyers and properties. To summarize the differences.

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FHA Loans

  • Insured by the FHA
  • Allow a lower credit score
  • Can require a minimum down payment of as little as 3.5%
  • Ideal for first-time buyers or individuals with credit issues, little savings, or low income
  • Can be used toward purchasing a house, condominium, and in some cases, a mobile home
  • Can also be used for new construction and renovation projects in an existing home

Conventional Loans

  • NOT insured by any federal agency
  • Typically require a credit score of 680 or above, with 740 being the most ideal
  • Low minimum down payments are reserved for individuals with a credit score of 680 or above
  • Can be used for more high-end, expensive properties
  • Come with more adjustable options in regards to loan terms
  • Allow borrowers to cancel private mortgage insurance after the loan balance reached 78% of the home’s value

How to Qualify for an FHA Loan

FHA loans have more lenient conditions than those conventional loans. Despite this, there are still specific terms a borrower must meet in order to qualify for an FHA loan. According to BankRate, these terms are as follows:

  1. If the borrower’s credit score is between 500-579, they must put 10% down
  2. If the borrower’s credit score is 580 or above, they can put as little as 3.5% down
  3. The borrower must have a stable employment history of at least two years
  4. The borrower’s income must be verifiable through pay stubs, federal tax documents, and bank statements
  5. The loan must be used to finance a primary residence
  6. The borrower’s front-end debt to income ratio must be no larger than 31% of their gross monthly income
  7. The borrower’s back-end debt to income ratio must be no larger than 43-50% of their gross monthly income
  8. If the borrower has filed for bankruptcy, they must wait at least 2 years before applying for a loan (exceptions apply)
  9. If the borrower has foreclosed on their home, they must wait at least 3 years before applying for a loan (exceptions apply)

How to Apply for FHA Loan

FHA loans are insured by the government but are available through approved private lenders. The first step is finding an authorized lender, which should be relatively easy as most banks, credit unions, and mortgage companies offer FHA loans. However, before you purchase an FHA loan, it is important to outline your budget and calculate your estimated monthly payments. Consider all your monthly expenses and be straightforward and honest about what you can afford. 

Once you have completed this step, you’ll need to compile all your necessary documentation. This includes,

  • 2 years’ worth of tax returns
  • Two recent paystubs
  • ID
  • Full statements of your assets (checking accounts, saving accounts, retirement accounts, etc.)

Applying for an FHA loan can be a long process, so it’s good to come prepared with all the required documents. It is also a good idea to get preapproved with multiple lenders – this way you can compare rates across all lenders to make sure you’re getting the best deal possible! 

Conclusion – How Do FHA Loans Work?

Now that you have a better understanding of FHA loans and how they work, are you ready to apply for one and purchase a home or start a renovation project? FHA loans are relatively more accessible and affordable than conventional loans, making purchasing a home more feasible for low-income families, individuals with poor credit, or first-time home buyers. Offering potentially lower monthly premiums and a minimum down payment of 3.5%, FHA loans are a great option for a big group of individuals and properties. See if an FHA loan is right for you today.

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