Personal Finance

FHA Loans Offer More Than Low Down Payments

Feb 28, 2019

When you hear “FHA loan,” your first thought may be “low down payment.” You are not wrong. However, FHA loans have more to offer borrowers than simply a low down payment. For borrowers with less-than-perfect credit, they are a valued option for the purchase of a home or the refinance of an existing mortgage. FHA loans can also offer a solution to borrowers with higher debt-to-income (DTI) ratios that aren’t acceptable in conventional loan programs.

Brief History of the FHA

The Federal Housing Administration (FHA) was created by Congress in 1934 — in the middle of the Great Depression. Many construction workers had lost their jobs, mortgages typically required repayment within three to five years, and a majority of the households in America were renting. The mission of this government agency was to increase home construction, reduce unemployment, and expand the options for borrowers to purchase homes.

The FHA is the only government agency that costs the U.S. taxpayers nothing. Proceeds from the mortgage insurance paid by homeowners are used to operate the entire program, including payments to lenders for mortgages that have defaulted. Although its programs have been modified throughout the years, the FHA has remained true to its primary goal of helping to put Americans into homes of their own.

How FHA Loans Work

FHA loans are offered through approved lenders. They are guaranteed by the Federal Housing Administration. And borrowers make mortgage insurance payments to the FHA for their guarantee of the loan. In turn, because FHA loans are guaranteed, lenders are comfortable offering more flexibility in their underwriting requirements, including credit guidelines and the size of the down payment. This system of guarantees, mortgage insurance, and expanded guidelines all works together to allow lenders to make home loans to borrowers who may not qualify for a conventional mortgage.

Purchase Loan Benefits

In addition to the benefit of a low down payment, FHA loans can offer borrowers relaxed credit qualifying requirements and low closing costs.

Low down payments

Traditional conventional mortgage programs will typically require a 20 percent down payment. However, saving this sizable amount may not be an attainable goal for every borrower. For many borrowers, an FHA loan provides a more affordable mortgage option with a minimum down payment requirement as low as 3.5 percent.

Easy credit qualifying

Another benefit of FHA loans is that they allow more flexibility with regard to a borrower’s credit history. They have lower credit score requirements. Generally, a borrower with a minimum credit score of 580 can qualify for a down payment of 3.5 percent. And borrowers with credit scores as low as 500 can qualify for a reduced down payment of 10 percent. An FHA loan may also allow a higher debt-to-income (DTI) ratio under certain circumstances. For borrowers with credit issues and high DTI, an FHA loan may be one of their only options to purchase a home.

Low closing costs

The allowable closing costs and fees for an FHA loan are set by the Department of Housing and Urban Development (HUD). Lenders are required to make sure the fees charged to the borrower also meet all applicable federal, state, and local laws and disclosure requirements. In general, closing costs are somewhere between 3 percent and 5 percent of the loan amount. A unique feature of an FHA loan is that the seller can pay up to 6 percent of the loan amount to cover a buyer’s closing costs. In contrast, under conventional loan guidelines, sellers can only pay up to 3 percent.

General FHA Loan Requirements

Loan is for borrower's primary residence.
Borrower has steady income and proof of employment.
Credit score of at least 580 for a 3.5% down payment.
Credit score of 500 to 579 for a 10% down payment.
Debt-to-Income (DTI) Ratio of less than 43%.
Mortgage Insurance Premium (MIP) is required.

Loan Terms

The mortgage loan term is the number of years you will make payments on the loan. Typical mortgage loan terms are 30, 20, 15, or 10 years. The FHA allows for mortgage terms of up to 30 years. Although the loan terms offered for FHA loans can vary by the lender, 30-year and 15-year terms are common options.

Interest Rate Types

Like the loan period, the interest rate type available for an FHA loan can vary among lenders. In general, all lenders will offer a fixed-rate FHA loan. It is a popular choice because the interest rate doesn’t change over the loan term. It’s a predictable payment set for the life of the mortgage.

Some FHA-approved lenders will also offer Adjustable Rate Mortgages (ARMs). With this type of mortgage, the interest rate is often fixed for a few years at the beginning of the loan term and then adjusts periodically based on a set interest rate index. ARMs are designed to save the borrower money on interest during the early years of the loan. After the fixed period ends, the interest rate could go up or down based on market conditions.

FHA Mortgage Insurance

The FHA loan program requires mortgage insurance premium (MIP) payments for all borrowers, regardless of the amount of down payment. Mortgage insurance compensates lenders against losses that result from borrowers defaulting on their home loans. FHA borrowers will pay two types of mortgage insurance —Upfront MIP and Annual MIP.

Most borrowers will pay an Upfront MIP of 1.75 percent of the loan amount. It can be rolled into the loan or paid at closing. In addition, the Annual MIP is paid throughout the year with a portion included in each monthly mortgage payment. The amount of Annual MIP varies based on several factors, including the loan amount and the loan-to-value (LTV) ratio. Payments range from 0.45 percent to 1.05 percent of the base loan amount. Most borrowers are obligated to pay this premium for the entire loan term.

FHA Loan Assumption

A unique feature of an FHA loan is that it’s assumable. With a mortgage assumption, the existing borrower transfers the FHA loan to an assuming borrower. The benefit of a mortgage assumption is that the assuming borrower will often be allowed the same loan terms as the original borrower. The lender must agree to the transfer, and the FHA has rules that outline when a down payment is required and a credit check is necessary.

Types of FHA Refinance Programs

In addition to purchase loans, there are a number of refinance programs available through the FHA. These programs can be used to refinance existing FHA loans and some also allow for the refinance of non-FHA loans. The FHA offers both No Cash-Out and Cash-Out Refinance options. Like purchase loans, an FHA Refinance will require borrowers to pay mortgage insurance.

No Cash-Out Refinance

A No Cash-Out Refinance is used to pay off an existing loan, but not to provide cash back to the borrower. Generally, the borrower can’t receive anything greater than $500 at the close of the loan. The FHA offers three types of No Cash-Out refinances:

FHA Streamline Refinance Program

An FHA Streamline Refinance requires limited credit documentation and underwriting. It is available only for the refinance of an existing FHA loan and doesn’t typically require a home appraisal. Although a credit check and income verification aren’t needed, lenders often have minimum credit requirements. Including closing costs in the new mortgage amount isn’t allowed with this program. To help borrowers avoid paying this out-of-pocket expense, most lenders have a “no cost” option where a slightly higher interest rate is used to cover closing costs.

The basic requirements of a Streamline Refinance include:

The existing mortgage must already be an FHA loan.
The mortgage must be current and not delinquent.
There must be a net tangible benefit to the borrower.
Cash in excess of $500 may not be taken out.

Streamline refinances have credit qualifying and non-credit qualifying options. There are a number of guidelines that determine which option is used by the lender. For example, a credit qualifying streamline refinance might be required if there will be a large increase in the monthly mortgage payment or a borrower is removed from the loan.

FHA Simple Refinance Program

If the borrower wants to include closing costs and prepaid items in the new loan, an FHA Simple Refinance will allow them to do so — if the appraisal supports it. Like the Streamline program, it’s an FHA-to-FHA refinance with no cash back to the borrower. An appraisal is required, and the lender will analyze the borrower’s credit, income, and assets to make sure they qualify for the new loan.

Rate-And-Term Refinancing

For borrowers who have non-FHA loans, the Rate-And-Term Refinance program is an option. The property must be the principal residence of the borrower or a HUD-approved secondary residence. As with the Simple Refinance program, closing costs can be included in the new loan amount, but there’s no cash back to the borrower. An appraisal along with a credit check is required.

A Rate-And-Term Refinance may make sense for a borrower if their credit score has declined since they obtained their non-FHA loan. The FHA program in general has more flexible credit qualification guidelines, and this holds true for their refinance programs. However, lenders are allowed to set minimum standards for qualification.

Cash-Out Refinance

If a homeowner has built up equity in their home and they’d like to access some cash through refinancing their existing loan, the FHA Cash-Out Refinance program may be a good option. It can be used by a borrower with either an existing FHA loan or non-FHA loan, as long as the home being refinanced is the borrower’s principal residence. An appraisal is required and the loan will be fully underwritten by the lender.

Borrowers will find that FHA Cash-Out Refinances often offer higher LTV and more lenient credit score requirements than other refinance programs. This may be of benefit to borrowers who have less than 20 percent equity in their home or whose credit scores are not high enough to meet the requirements of a conventional loan program. Also, an FHA Cash-Out refinance with a fixed interest rate may be preferable to a Home Equity Line of Credit (HELOC) with a variable interest rate. In this situation, a side-by-side comparison between the products can be helpful when evaluating options.

"Since 1934, the FHA has remained true to its original mission of helping Americans become homeowners"

FHA loans have their origins in the Great Depression but are still a viable option today for borrowers looking to purchase homes or refinance existing mortgages. The design of the program — borrower paid mortgage insurance, government guaranteed loans, and lender flexibility when qualifying borrowers —makes it possible for borrowers with limited down payments or lower credit scores to qualify for home loans.

To learn more about FHA loans and the other loan programs available at Axos Bank, call 888-546-2634 and speak with an experienced mortgage professional who can help you find a mortgage option that fits your individual needs.