Understanding FHA Home Loans

Understanding FHA Home Loans

Many first-time homebuyers will find that a Federal Housing Authority (FHA) backed mortgage makes buying a home easier, or  possible, thanks to less-rigid borrower requirementssuch as:
A low minimum down payment 
Reasonable credit expectations
More flexible income requirements
Perhaps more so than for conventional loans, providers of FHA loans are willing to look at the whole picture rather than dismissing a borrower for falling short on a particular criterion.

Still, not everyone can qualify for a FHA loan.  Thus, it can sometimes be frustrating when applying for a FHA loan.

Background
The money for an FHA mortgage is not given to borrowers by the FHA; rather, borrowers receive the funds from an FHA-approved lender, and the FHA guarantees the loan.  This is very important and is the reason for the additional fees.  

In addition, the FHA offers lenders flexibility in determining loan eligibility based on the total picture of the applicant's situation, rather than requiring strict adherence to a list of requirements.  This often allows for different underwriters to interpret the guidelines differently; one institution may give you a loan while another might reject you.  Let's review the major components that determine borrower eligibility.

Dwellings Eligible For FHA Mortgages
As a rule, a property financed with a FHA loan must be the borrower's primary residence and must be owner-occupied.  Generally, this loan program cannot be used for investment or rental properties.  Detached and semi-detached houses, townhouses, row houses and condos within FHA-approved condo projects are all eligible for FHA financing.

Maximum Mortgage Amount
The maximum mortgage a borrower can receive, assuming he or she has the required income, is the lesser of:

The statutory limit for the geographic area in which the home is located.
The maximum loan-to-value (LTV) ratio.  In addition, the limits are indexed to Freddie Mac-conforming loan limits.

Credit Score
The FHA does not have minimum credit score requirements for its loans.  That being said, borrowers with poor scores may be disqualified based on the activities that created those low scores, such as not paying bills on time.
Having no credit history is not a problem in most cases.  Instead, the lender will look at other payment-history records, such as utility and rent payments. In addition, a previous foreclosure, short sale or bankruptcy will not disqualify the borrower, as long as enough time has passed (usually three years for a foreclosure or short sale and one to two years for bankruptcy) and the borrower has established a documented ability to manage his or her finances since the negative event.

Finally, consumers who participate in credit-counseling plans are eligible for FHA loans as long as they have been in the program for at least a year and have made all the required payments on time. Consumers who have successfully completed a credit-counseling plan should be prepared to provide documentation of successful program completion.

Income and Employment
Only stable and documentable income can be considered for a borrower's mortgage eligibility.  In general, most lenders like to see at least two years of steady employment in the same line of work prior to the mortgage application, with no more than a one-month gap in employment.  In addition, the job must be expected to continue for at least three years after obtaining the loan.

For the above reason, part-time employment does not count unless it has been uninterrupted for the last two years.  Nor does a full-time contract position that will end shortly.  In addition, if you are planning to retire shortly, your current salary will most likely change and thus another reason for a rejection.

However, on the positive side, a borrower who has changed jobs frequently in order to move up in their fields and increase their income are often looked upon positively.  Also, there are allowances for those who work seasonally or have taken an extended leave of absence from the workforce, such as to raise kids or attend school.

As for self employed individuals, you will need two years of successful self-employment history, documented by tax returns and a current year-to-date balance sheet and profit and loss statement.  Applicants who have been self-employed for less than two years but more than one year can be eligible if they have a solid work and income history for the two years preceding self-employment and the self-employment is in the same or a related occupation.

Debt-To-Income Ratios
Unlike many conventional loans, FHA does not set a maximum limit for the debt-to-income ratio, though exceeding a 45% back-end ratio takes special consideration and considerable cash reserves.  In other words, the total of your debt obligations should not exceed 45% of your gross income. 

Down Payment
FHA loans offer one of the most generously low down payments.  In addition, gift funds may be contributed to the down payment if they come from an acceptable source such as a relative or employer.  However, if the gift was given in the distant past, generally three months or more for mortgage purposes, it will not need to be verified or even mentioned in the application.

Closing Costs
FHA loans allow the seller to contribute up to 6% of the purchase price toward the buyer's closing costs.  This feature of FHA loans makes it easier for cash-strapped buyers, or buyers who would simply prefer to hang on to their cash so they can invest it elsewhere or use it to remodel, to purchase a home.

Mortgage Insurance
FHA loans require mortgage insurance because of their low down payments.  Up-front mortgage insurance is due at the time the loan is taken out.  This amount is equal to 1.5% of the loan amount and is typically rolled into the mortgage so the buyer doesn't have to come up with extra cash to close.  This premium does not decrease the total loan a borrower is eligible for, however, rolling it into the mortgage does increase the monthly payment slightly.  The monthly payment will also include a monthly mortgage-insurance premium, which costs about 0.55% of the loan amount on an annual basis.  This premium is generally lower than the private mortgage insurance (PMI) would cost on a non-FHA loan with the same down payment.

FHA Inspection and Appraisal Requirements
FHA requires all the mortgages it insures to be backed by homes of a particular caliber.  Thus,  even if you qualify for an FHA mortgage, that doesn't mean you'll be able to purchase the exact home you want.  Essentially, the home must be habitable, with running water, toilets, a good roof, a stove and the other elements necessary to live in a safe and sanitary manner. thus, major fixer-uppers, while they can be a bargain sometimes, are not likely to qualify for FHA financing because of this requirement.

In addition, the property must appraise at or above the purchase price, otherwise, it cannot be purchased with an FHA loan unless the purchaser/borrower can come up with enough cash to make up the difference between the appraisal amount and the sale price.

Conclusion
The FHA-loan underwriting process offers a lot of flexibility in evaluating borrowers' ability to repay a mortgage.  If your situation is not described in this article, that doesn't mean you won't be eligible for an FHA mortgage. This mortgage program looks at the borrower's big-picture situation, and financial strengths in some areas may compensate for weaknesses in others.  If you want to know if you qualify for FHA financing, the best way to find out is to talk to an FHA-approved lender in your area.

ABOUT THE AUTHOR: 

Richard sells real estate in the San Gabriel Valley which is about 12 miles South of Los Angeles.  For more information, visit his website at http://www.westsangabrielvalleyrealestate.com