Understanding FHA Loans

Here’s what you need to know about the government program

Federal Housing Administration (FHA) loans often confuse people because the FHA does not make loans. Instead, it insures the loans made by lenders it has approved. This means if the borrower defaults, the FHA, which is a government program, will cover the losses.
Historically, the FHA allows some of the most liberal lending standards in the market and is often a good fit for first-time buyers, those with small down payments and those with less-than-perfect credit. But anyone is eligible to apply.
The FHA is also not a product for everyone and not all lenders offer FHA loans. But many do and you can find FHA lenders at its
Here’s a look at the pros and cons of FHA insured loans:Pros

  • Down payment. The minimum down payment is 3 percent and the FHA allows the money to come from a family member, charitable organization or even an employer. Most conventional loans require the borrower to prove he has the down payment amount.
  • Interest rate. FHA loans usually offer a lower interest rate because it allows a smaller down payment and lower credit scores. Lenders of conventional loans see more risk in a comparable loan and, so, have a higher interest rate.
  • Weak credit: Those with credit problems, even a bankruptcy, may be able to qualify for an FHA loan. The FHA puts more emphasis on income, length of employment and job security than do lenders of conventional loans.
  • Higher ratios. The FHA allows a ratio of 29 percent — of mortgage payment to income (divide the mortgage payment by gross monthly income.) –- or 41 percent -– of all monthly debt to income (divide all your monthly debt such as auto loans and credit card payments by gross monthly income.) Conventional loans usually only allow 28 percent and 36 percent, respectively.
  • No prepayment penalty. The FHA does not allow prepayment penalties, which some conventional loans require if you pay off the loan early. This penalty is charged because lenders are trying to keep people from habitually refinancing. Usually, lenders waive the penalty if the home is sold.
  • Loans for multi-unit properties. FHA loans are not just for single-family homes and condos. They are also available for 2- to 4-unit multi-family complexes. There is also a special loan program for buying a fixer (203k) that includes amounts to make the needed repairs.
  • Closing costs. The FHA allows closing costs to be included in the loan as long as the borrower qualifies for the higher amount. Most conventional loans require that closing costs be paid for at the close of escrow and not be part of the amount loaned.
  • Canceling MIP. The FHA has specific requirements that when met will allow you to cancel you Mortgage Insurance Premium. It is usually more difficult to cancel the Private Mortgage Insurance that is charged under conventional loans with a less than 20 percent down payment.

Cons

  • Higher mortgage insurance. FHA loans require a Mortgage Insurance Premium (MIP), which is similar to the Private Mortgage Insurance charged in conventional loans with less than a 20 percent down payment. The FHA MIP requires paying 1.5 percent of the loan amount up front and .50 percent of the amount owed annually, but paid monthly. (i.e.: A $100,000 loan balance will cost $500 the first year or $41.67 per month). PMI on conventional loans is usually less expensive.
  • Loan limits. The FHA has limits on the amount that can be borrowed because the program is designed for low- to moderate-income buyers. These limits are based on where the house is located. These limits can be changed at any time, so it’s best to check the FHA Web site for the latest information on your area.
  • Must be owner-occupied. An FHA loan requires the home, or one unit in a multi-family complex, be occupied by an owner. So, this program is not for investors looking to buy property to rent out.
  • Limits lender fees. The FHA sets limits it will allow lenders to charge. If the lender charges more, the seller has to agree to pay the additional costs. This can make a prospective buyer with an FHA loan less attractive.
  • Takes more time. FHA loans require more time to complete. In hot markets or in the case of multiple offers, an offer from a buyer wanting an FHA loan may not be considered as strong as an offer from a buyer with a conventional loan.