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What Is an FHA Loan and How Does It Work?

What Is an FHA Loan and How Does It Work?

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An FHA loan is a type of mortgage that is insured by the Federal Housing Administration, a subsidiary of the Department of Housing and Urban Development (HUD).

FHA loans are issued by private lenders but backed by the federal government. This allows lenders to offer more favorable loan terms to first-time and low- and moderate-income homebuyers.

Table of contents

  • How do FHA loans work?
  • Types of FHA loans
  • FHA vs. conventional loans
  • Additional factors to consider
  • How to qualify for an FHA loan
  • How to apply for an FHA loan

How do FHA loans work?

The FHA provides mortgage insurance on home loans issued by FHA-approved lenders. These mortgages can be used to purchase single-family or multifamily homes, residential care facilities and hospitals.

According to , FHA mortgage insurance protects lenders against losses. For example, if a borrower fails to pay back the mortgage, the FHA will cover a portion of the unpaid principal balance. This minimizes risk for lenders and allows them to offer borrowers more favorable loan terms.

To qualify for an FHA-backed loan, you must meet specific requirements, including a minimum FICO score determined by the down payment amount. Borrowers must also pay mortgage insurance premiums (MIP), collected via lenders and used to fund FHA mortgage insurance programs.

Types of FHA loans

The most popular FHA-backed home loans are traditional mortgages, also known as Basic Home Mortgage Loan 203(b). You can use this type of loan to purchase or refinance a primary residence.

With a 203(B) loan, you can finance up to 94.5% of the home’s value, so your down payment could be as low as 3.5% of the purchase price. Compare that to the typical conventional mortgage, which requires a 20% down payment if you want to avoid private mortgage insurance (PMI).

  • Home Equity Conversion Mortgage (HECM): A reverse mortgage allows seniors to convert their home equity into cash. To qualify, you must be 62 or older and your home must meet FHA property standards. You must also pay MIP on this loan.
  • 203(k) Rehabilitation Mortgage: Lets homebuyers add up to $35,000 to their mortgage loan amount for home repairs and upgrades. The FHA must approve the improvements, but these could even include reconstruction if the original foundation is in place.
  • Title I Home Improvement Loans: Insures home improvement loans. The maximum loan amount for a single-family home is $7,500 for unsecured loans or $25,000 for loans secured by a mortgage or deed payday loans Waterville Ohio of trust. Manufactured homes are also eligible.

FHA vs. conventional loans

Conventional mortgages are home loans that are not insured by the federal government. Most conventional mortgages are conforming loans, which means they meet the funding guidelines of government-sponsored mortgage enterprises Fannie Mae and Freddie Mac. Since a government agency does not insure conventional conforming loans, their credit and income qualification requirements are stricter.

On the other hand, FHA home loans have more flexible qualification criteria, including lower interest rates and down payment, credit, and income requirements. In addition to monthly mortgage payments, FHA borrowers must pay both upfront and annual mortgage insurance premiums.

Additional factors to consider

While FHA loans are great for prospective homeowners who do not meet the credit and down payment requirements for conventional mortgages, these types of loans have limits and features worth going over in more detail.

FHA loan limits

The FHA restricts how much you can borrow depending on the median sales price of houses in your jurisdiction and the number of units in the home.

The FHA mortgage limits database offers information about loan limits by county. For 2021, the limit for a one-unit home in a low-cost real estate area is $356,362, while the ceiling in high-cost areas is $822,375.

Mortgage Insurance Premiums

The upfront mortgage insurance premium (UFMIP) is due at closing – or can be folded into your monthly payments – and will equal 1.75% of the loan amount. The annual MIP amount ount, down payment and loan term.

How to get rid of MIP on FHA loans

According to The Mortgage Reports, if your FHA loan originated between , you may be eligible to cancel MIP once your loan balance reaches a 78% loan-to-value ratio (LTV).

To discontinue your MIP, your lender may require you to be up to date with mortgage payments or to have paid MIP for at least five years.

If you are not eligible for MIP cancellation, the only way to get rid of mortgage insurance premiums is to refinance your FHA loan into a conventional mortgage – or a VA loan if you are an eligible veteran.

Before refinancing, discuss your options with your lender to make sure that is the best decision for someone in your situation.

How to qualify for an FHA loan

For most borrowers, qualifying for an FHA loan can be easier than qualifying for a conventional mortgage, but there are a few requirements to keep in mind.

Keep in mind that although FHA loan requirements are the same everywhere, some lenders may have additional credit score requirements for approval.

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