The FHA home loan program can be a fantastic option for first time home buyers looking for a mortgage with a low interest rate and down payment. This article provides a simple overview of the FHA home mortgage program to help you make the right decision when purchasing your first home.
What is an FHA Loan?
FHA home loans are mortgages issued by FHA-approved lenders which allow home buyers to purchase a property with as little as 3.5% down payment. Additionally, FHA loans usually have lower interest rates than conventional mortgages.
Generally, this home loan program is designed for home buyers who do not qualify for conventional mortgages. Home buyers can usually qualify for these loans with a lower credit score, higher debt-to-income ratio, and less money as a down payment.
“FHA” refers to the Federal Housing Administration, which is the government body who insures these mortgages given out by FHA-approved lenders. The goal of this program is to promote home ownership in the United States by allowing borrowers who cannot meet higher standards and requirements of conventional mortgages.
What are the FHA Loan requirements? Here’s how to qualify:
- FHA loans must be used for the purchase of your primary residence. You must live in the property for at least 1 year after buying the home. This means you cannot use an FHA loan for the purchase of an investment property. However, the property may be held as an investment property after that 1 year period.
- Must have a credit score above 580 to qualify for the 3.5% down payment. To qualify for an FHA loan, your credit score must be above 500. However, if it’s below 580, you will be required to put 10% of the home price as a down payment.
- The home must be in decent condition. All the basic systems of the home like plumbing, gas, and electrical should be in working condition.
- Loan limits based on the region the home is in. This simply means that the home price should be within 80-150% of the median home value in that area.
- Debt-to-income ratio below 43%. Debt-to-Income Ratio (DTI) is one of the main factors banks look at when qualifying and approving you for a home loan / mortgage. To calculate your DTI, you would divide your monthly debt payments (including the mortgage) by your gross monthly income (household). (e.g. $3000 debt payment/ $7000 gross monthly household income = 43% DTI)
- You must pay Mortgage Insurance Premiums (MIPs). MIPs are insurance premiums added to the borrower’s monthly payment insuring the lender in case the borrower defaults on those monthly mortgage payments.
How are Mortgage Insurance Premiums (MIP) calculated?
These premiums are calculated based on a fixed rate of the base loan amount. They can also be paid as a lump sum, but most FHA borrowers elect to pay monthly.
To calculate the monthly payment, simply multiply the base loan amount by 0.85-1.25% for the annual payment amount, then divide that by 12 for your monthly payment. (e.g. $300,000 loan x 1% = $3000/year –> $250/month)
With FHA loans, the Mortgage Insurance Premiums are paid over the entire life of the loan, regardless of your equity. To stop making these Mortgage Insurance payment, you will have to refinance into a different loan once you have at least 20-25% equity in the home.
Mortgage Insurance Premiums vs Private Mortgage Insurance
Mortgage Insurance Premiums (MIP) are often conflated with Private Mortgage Insurance (PMI). Most people think they are one and the same but they are actually very different. I recently made a video about PMI vs MIP, explaining the key differences between these two loans, but here is a basic overview:
Most notably, Private Mortgage Insurance (PMI) is for Conventional loans with less than 20% as a down payment, while Mortgage Insurance Premiums (MIPs) are specifically for FHA loans.
PMI payments with conventional loans are removed from your loan after you have reached 20-22% equity in the property, lowering your overall monthly payment. MIP payments with FHA loans continue over the entire life of the loan. Therefore, it’s worth refinancing out of the FHA loan at some point or considering a conventional loan from the start. It all depends on your situation.
Another key difference is the way they are calculated. As mentioned above, MIP payments are calculated based on a fixed rate. However, PMI payments are calculated based on your overall risk as a loan applicant. The bank and insurance companies insuring the loan would look at your credit score, credit history, income, expenses, and more to determine your level of risk. Lower risk would mean lower premium payments.
Now you know all about the basic guidelines for FHA loans. Keep in mind that every lending situation looks a bit different. These are the basic guidelines the loan should conform to but ultimately the details of your loan depend on your lender and financial situation. It’s advisable to compare multiple loan options to see which one is best for you.
Reach out to me if you’re looking for a quality team of real estate agents to represent you or would like us to put you in touch with an FHA-approved lender in your area.
Best of luck with your home purchase! 🙂