Understanding and Learning To Qualify for an FHA Loan

In 1934, Congress established the Federal Housing Administration, which became part of the Department of Housing and Urban Development in 1965. The FHA serves one primary purpose: to provide mortgage insurance to lenders, allowing them to offer mortgages to higher-risk borrowers.

Federally backed mortgage insurance protects a lender against future losses, meaning approved lenders can offer more mortgages to homebuyers. By loosening the reins on mortgage terms and qualifications, homebuyers can qualify for mortgages with lower incomes and credit scores.

Defining FHA Backed Loans

When people discuss government-backed loans or mortgages, they refer to loans insured by the Federal Housing Administration. The mortgage insurance provided by the government is not a guarantee for mortgage approval, but it allows lenders more room to negotiate.

Many homeowners who cannot qualify for conventional mortgages may qualify for a government-backed mortgage. The requirements of such loans are less restrictive, allowing applicants with smaller down payments of 3.5%, and lower credit scores, 580 or better.

Lenders grant mortgages to higher-risk applicants because the federal government promises to make good on any remaining principal balance on defaulted loans. The FHA can make repayment promises because all qualifying applicants must pay an insurance premium on top of their mortgage payment.

Learning About the Loan Process

The primary difference between the government-backed mortgage program and conventional mortgages is the role of insurance. Mortgage insurance provides assurances for approved lenders, limiting their losses and allowing them to take on greater risks.

Though less stringent, lenders and the government still set restrictions and requirements for borrowers. A down payment and a qualifying credit score are only part of the qualifying process. A borrower must also handle closing costs on the loan, including the initial upfront mortgage premium. Lenders and third parties can help with up to 6% of the closing fees and expenses.

Another critical difference between traditional mortgages and FHA loans is the allowance of gifts. Conventional mortgages may allow gifts to help cover the down payment or closing cost, but the lender typically specifies where that money can come from.

Mortgage Fees

Qualifying applicants for federally backed mortgages must pay two mortgage insurance fees: an upfront premium and an annual premium. The upfront mortgage insurance premium is 1.75% of the total loan amount, and the borrower pays it when they receive the loan. On a $250,000 property, the upfront cost is $4,375.

The annual insurance premium is between 0.45% and 1.05% of the total loan amount. The premium varies based on the loan term, amount, and down payment. Unlike the upfront premium, borrowers pay the annual premium over 12 monthly installments. Borrowers may need to pay an annual premium every year for the life of the FHA loan. On a $250,000 property, the monthly cost is likely between $93 and $220, depending on the mortgage rate.

Understanding the Qualification Process

Government-backed loans are typically easier to qualify for than conventional loans because of the guarantees they provide. The purpose of mortgage insurance loan programs is to open a pathway to homeownership, and lenders do not restrict that path to only first-time homebuyers. As long as a borrower can meet the seven requirements for approval, they can be current homeowners, first-time buyers, or repeat buyers. The mortgage value, insurance premiums, and applicant approval depend on the borrower's ability to meet standard applicant requirements.

1. Credit Score

A conventional mortgage program often requires applicants with a credit score in the 700s, despite reports that a 620 is acceptable. Even if approval is possible with a lower score, mortgage rates are often too high for lower-income homebuyers.

An FHA loan only requires a minimum credit score of 580. If a borrower's score is above or at the minimum credit requirement, they can also qualify for a 3.5% down payment. Even if a borrower's credit score is below the minimum, they may still qualify for the loan, but the down payment will increase to a minimum of 10%.

2. Payment History

Payment history plays a significant role in approval odds. A lender will usually disqualify applicants with a proven record of late or missed payments and delinquent accounts.

For a government-backed mortgage, a borrower must also show an established credit history. The definition of an established history is a minimum of two lines of credit, such as a credit card and a student loan.

A spotless credit report is unnecessary for mortgage approval. While applicants can have past indiscretions on their reports, including closed and delinquent accounts, their recent credit history of two to three years should show healthy financial habits.

3. Debt-to-Income Ratio

The debt-to-income ratio is vital to FHA loan approval. The DTI is a numerical representation of a borrower's monthly debt compared to their gross income. Lenders typically use two DTI calculations to determine an applicant's ability to pay a mortgage: front-end-debt and back-end-debt ratios.

The front-end-debt calculation divides the potential mortgage payment by a borrower's gross monthly income to arrive at a percentage. For loan approval, the payment cannot exceed 35% of a borrower's income. If an applicant makes about $3,000 per month, a mortgage payment cannot exceed $1,050.

The back-end-debt calculation divides the potential mortgage payment plus other monthly obligations by the borrower's gross monthly income. The resulting percentage must not exceed 48% of their income. For an applicant making $3,000 per month, their monthly debt cannot exceed $1,440, including the prospective mortgage. Some lenders might permit a maximum of 50%, but this is rare and not advisable for FHA applicants.

4. Proof of Employment and Income

People often assume the Federal Housing Administration puts income limits on qualifying applicants, but that is not the case. A higher income does not disqualify a borrower from the program. The primary concern is that a borrower earns enough to cover the mortgage costs and their debt without entering further financial hardship.

To ensure a borrower is ready for the financial responsibilities of homeownership, they must provide proof of employment and income. Proof refers to pay stubs, tax returns, and W-2s. Providing appropriate qualifying information allows lenders to calculate DTIs, which further helps them mitigate their risks and the government's risks on the FHA loan.

5. Bankruptcy

Bankruptcy does not disqualify a borrower from mortgage assistance but will delay the process. In most cases, applicants must wait a minimum of two years from the discharge date of their bankruptcy, not the filing date. The discharge date typically coincides with the bankruptcy closing.

The type of bankruptcy can also affect the timeline. A chapter 13 filing takes between three and five years to complete. A borrower may apply for a government-backed mortgage if they meet specific criteria:

Minimum of 12 on-time monthly plan payments
Bankruptcy is unlikely to happen again
Court approval of home purchase with FHA financing

6. Foreclosure

As with bankruptcies, a foreclosure does not disqualify borrowers automatically. However, an applicant must wait at least three years before applying for a mortgage through a federally backed program.

While a three-year waiting period is standard, a lender can make exceptions for borrowers that show the foreclosure resulted from extenuating circumstances. Acceptable extenuating events typically include the death of a wage earner or severe illness. Divorce is not acceptable as an extenuating condition.

Besides proving specific conditions, a borrower must also show good credit habits since the foreclosure, including re-establishing a good credit score. Even if a borrower can meet particular prerequisites, a lender is under no obligation to approve a loan before the established FHA waiting period ends.

7. Primary Residence

The Federal Housing Administration specifies occupancy requirements for all borrowers. Any property purchased through a government-backed loan must be a primary residence — rental and seasonal properties do not count.

The stipulations of the loan agreement require the borrower to take possession of the home within 60 days from the closing. Also, the borrower must live in the house most of the year, and they must use it as a primary residence for a minimum of one year.

For borrowers interested in purchasing an investment property through the loan program, the administration permits the purchase of multi-unit dwellings, up to four units. However, FHA eligibility requires one unit be the borrower's primary residence.

Making Assessments Before Applying for a Loan

Applying for a loan from an approved lender can feel intimidating. Thankfully, most lenders are helpful and willing to walk potential borrowers through the application process.

Still, before applying, it is wise for future homebuyers to assess their credit, budget, costs, and DTI ratios. By reviewing their credit score and report, a borrower can note any potential red-flag items and work to establish a defense, if necessary.

Also, as a mortgage application is a way for lenders to review financial ability, potential borrowers should take the time to review their expenses and assess possible homeownership costs. Reviewing expenses helps applicants determine if a mortgage is practical.

Contact a Financial Advocate for FHA Assistance

Homeownership is not a guarantee, but the Federal Housing Administration opens the possibility to many individuals and families. If you are ready to buy your first home or move to a new one, seek assistance from a financial advocate or an expert in FHA loans. Contact FHA Connection for more information.