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If you are shopping around for a new home or to refinance your current residence but don’t qualify for a VA loan, you can pursue other lending options. One good option may be to apply for an FHA loan. But even though FHA loans are more accessible than conventional mortgages, there are still several loan requirements that determine a borrower’s eligibility.
7 FHA Loan Requirements for Homebuyers
- Proof of Steady Income
- Must Use an FHA Appraiser
- Loan Must Be for Primary Residence
- Meet Minimum Credit Score Requirements
- Pay Required Deposit (based on credit score)
- Pay Mortgage Insurance
- Acceptable Debt Ratio
While the average down payment on a home is around 6%, many lenders these days will not be interested in providing a home loan unless a buyer puts forward 20% or more.
Lenders who are willing to accept a down payment of less than 20% of the total purchase price often require the borrower to get private mortgage insurance. This extra insurance adds to the monthly payment on the mortgage. Financing a home can prove equally difficult, with arrangements often falling through or contracts being canceled.
How FHA Loans Can Help
Since home ownership is such a stabilizing force in the economy, the federal government has a vested interest in facilitating the success of the industry. That’s why the FHA, or Federal Housing Administration was created in 1934. To this very day, it has helped many families and individuals with low to moderate incomes purchase or refinance a primary residence.
Homebuyers might have a hard time securing a conventional loan because of their income, credit history, or lack of available financial resources. Thankfully, the FHA has partnered with certain lenders to insure these loans in the event of the borrower defaulting. This lowers the lending risk for the lender and makes it possible to extend a mortgage to such homebuyers. But keep in mind that FHA lenders still have loan requirements that the FHA borrower must meet.
FHA Loan vs Conventional Loan
People often wonder, “What’s the difference between an FHA loan and a conventional loan?”
FHA loans require a minimum credit score of 580. It’s even possible to get an FHA loan with a credit score of 500. By contrast, the minimum for a conventional loan is typically 620.
FHA loans are backed by the government and offered by a third party lender or bank. While the minimum score is 580, a lender can still have tighter requirements. The better your credit score is, the better your interest rate will be – that’s true for both an FHA loan and a conventional loan.
The debt-to-income ratio for FHA loans and conventional loans is similar. FHA loans typically have lower down payments. If your credit score is above 580, you can often make a 3.5% down payment, which means you can finance as much as 96.5% of the purchase price.
FHA loans have loan limits, which are $356,362 in low-cost areas and up to $822,375 in more expensive markets. By contrast, the loan limits of a conventional loan are set at $548,250 for most of the United States – and $822,375 in more expensive markets, just like the FHA loans.
Loans above that amount are called jumbo loans, which have stricter lending requirements and are not available to borrowers who would need an FHA loan. Another key difference is that a conventional mortgage can be used to purchase any type of home – a primary residence, vacation home, rental, or even a property that you plan to renovate and flip.
By contrast, an FHA home can only be used to purchase or refinance a primary residence, but there are still ways to use that FHA loan if you’re an investor – for example, if you buy a multi-plex and live in one of the units as your primary residence, you can lease the other units to renters.
Another difference is found in the area of mortgage insurance. Most lenders will not require mortgage insurance on a traditional mortgage if the borrower puts down 20% of the purchase price or more. This private mortgage insurance (PMI) is recalculated annually as 0.58% to 1.86% of the loan amount and paid as part of the monthly payment. FHA loans also require mortgage insurance, but they are typically not recalculated and run about 0.45% to 1.05% of the loan amount.
Where Can I Find FHA Financing?
In most cases, a homebuyer won’t need to look too hard to find an FHA insured lender. Often, the same loan officer who can provide a traditional mortgage loan can help eligible borrowers with an FHA mortgage loan.
Keep in mind that an FHA home loan is not sold and serviced by the government. Rather, it is sold and serviced by a consumer-facing mortgage lender like your bank or independent mortgage lender.
7 FHA Loan Requirements for Homebuyers
1. Proof of Steady Income
To get an FHA backed loan, you must prove verifiable employment for the last two years, at minimum. That doesn’t necessarily mean you must be an employee. If you are self-employed, you can show tax returns as proof of income, or other types of asset statements.
This employment requirement is not unique to FHA guidelines. It’s safe to assume that every loan program requires proof of gainful employment and monthly income. If you do not have the means of paying the loan back, you need to look into other housing options like renting. There are plenty of homes to rent on the market if you need more space, and HUD has programs that can assist with paying rent.
2. Must Use an FHA Appraiser
According to the Department of Housing and Urban Development (HUD), you do not need to get a home inspection with an FHA loan. This might throw you off because you’ve probably heard that certain types of FHA loans have very tight requirements around home inspections. But instead of an inspection, it is an FHA appraisal that is required. Without an approved appraisal, an FHA loan cannot be issued.
The FHA appraisal is conducted by an approved FHA appraiser to determine the home’s value. FHA appraisals may contain certain safety requirements similar to a home inspection, and FHA loans cannot proceed without addressing any safety or building violations.
3. Loan Must Be for Primary Residence
An FHA loan must be used to purchase or refinance a primary residence. HUD defines a permanent residence as “a dwelling where the Borrower maintains or will maintain their permanent place of abode, and which the Borrower typically occupies or will occupy for the majority of the calendar year,” effectively ruling out vacation homes by adding that “a person may have only one Principal Residence at any one time.”
Investors looking to use an FHA loan have two options. First, a personal residence can contain up to four units (such as a quadplex, triplex, or duplex). If you live in one of the units as your primary residence, you can use an FHA loan to purchase the property and rent out the other units for rental income.
The other investment opportunity you have with an FHA loan is that you only need to occupy the FHA-backed home for one year. If you are looking to purchase a fixer-upper and flip it, you can live in the home while you remodel, then put it on the market a year later.
4. Meet Minimum Credit Score Requirements
The minimum credit score required for obtaining an FHA loan is 580, which allows you to take advantage of the very low 3.5% down payment. However, you can still get a loan from an FHA approved lender if you have a lower credit score anywhere between 500 and 579 – you will just need to put a 10% down payment towards the home. Also, your rates will probably be less competitive.
If you are a Veteran in search of housing, you can also explore a VA loan, which has no minimum credit requirement according to the VA. However, just like the FHA loan, most VA loans are not offered through the VA. Rather, they are backed by the VA and sold and serviced by third parties like your local bank. These financial institutions will usually require a credit score of 600-620 for lenders.
5. Pay Required Deposit (based on credit score)
If you obtain an FHA loan and your credit score is above 580, you can often get away with putting down just 3.5% of the purchase price. For example, if you’ve located a home for sale and negotiated with the seller to purchase it for $200,000, your down payment would need to be $7,000. The money for your FHA down payment can come from a checking account, savings account, IRA, 401(k), cash, gifts, and the sale of personal property.
6. Pay Mortgage Insurance
One hallmark of the FHA loan is its required annual mortgage insurance premium. FHA loans are not sold by the government, they are insured by the government to protect the lender against losses. Like most insurance, there are often premiums to pay, and the homeowner is responsible to pay them.
FHA mortgage insurance premiums are an annual charge that runs anywhere from 0.45% to 1.05% of the loan amount for the entirety of the loan term. However, this means the original loan amount, and not the balance, as the premium isn’t recalculated on an annual basis.
Additionally, when you purchase a home with an FHA loan, there is a one-time Upfront Mortgage Insurance Premium (FHA MIP) that runs around 1.75% of the loan. This one-time expense is used to help fund future loans for other homebuyers. This is another instance where if you are a Veteran, one of the many types of VA loans may be of better service to you, because these loans do not require mortgage insurance. As a side note, borrowers taking out a non-FHA conventional loan, who put down less than 20% of the sales price toward a down payment, will also be asked to obtain private mortgage insurance or PMI.
7. Acceptable Debt Ratio
Debt to income ratio (DTI) is something all lenders use to calculate the risks and rewards of extending a loan and determining a loan limit. Your personal DTI is calculated by taking your total monthly debt service – how much money you pay to credit cards, a car loan, student loans, and any other type of creditor – and dividing that by your household’s gross annual income.
The FHA requires that your front end debt ratio, which is essentially your potential monthly mortgage payment, will be no higher than 31%. They also require your back end debt ratio (all your debts and your potential mortgage) to avoid exceeding 43% – although some lenders in some cases will allow it to run as high as 50%.
The lower your DTI, the better off you are, both in terms of obtaining a loan with the FHA loan limit you need and in terms of your personal finances.
It must also have been at least two years from a bankruptcy and three years from a foreclosure before obtaining an FHA loan. This is another area where a VA loan is better for veterans since you can get a VA loan two years after a VA loan foreclosure instead of the three required for an FHA loan.
What About an FHA Refinance?
You can get an FHA streamline refinance to pay off your old mortgage and take on a new one.
It is called the FHA streamline because you don’t need a new appraisal or credit check. The loan officer or underwriters will use your information from the first FHA loan. However, if you are using an FHA loan option to refi an existing non-FHA loan, you cannot use the FHA streamline option.
Is an FHA Loan Right for Me?
For many American homebuyers, the answer is yes. This is likely why 9.6% of the home loans closed in 2020 were FHA loans – and why over 83% of FHA borrowers are first-time homeowners.
First-time homeowners may not yet have a sizable income stream or large amounts of money saved up for a down payment, which is why the FHA loan can be a perfect match for their needs.
However, if you are a Veteran, you are probably better off looking at VA loan requirements since, among several other benefits, VA loans will not require you to pay an annual insurance premium. Like everything else about the home buying process, it’s important to shop around and compare all your options to make sure you are getting the best deal.
