FHA Loan: Do You Need One?

FHA loan mortgage loans

Can You Afford an FHA Loan?
Photo courtesy Custom Home

Are you considering an FHA Loan?  One major decision that comes into play when an individual or family is purchasing a home is which type of mortgage to choose.  Since most people do not have the option of purchasing a home outright with cash a mortgage lender is necessary.

There are two main types of mortgage loans that may be used by people in the market for a home purchase.  A conventional mortgage loan and an FHA Loan.

Certain factors may cause a person in the market for a lender to decide in favor of an FHA loan.  Conventional loans typically have more strict credit standards and higher interest rates than those of an FHA loan.  Conventional loans often require a minimum down payment of 5% of the purchase price of the home as well.   Nearly 80 years ago the Federal Housing Administration (FHA) began helping individuals purchase homes at cheaper interest rates, lower down payments, and in recent times less than perfect credit scores.  Having the ability to use an FHA loan has made it possible for many people to enjoy the dream of home ownership.  But, have the times changed, and is it still right for you to purchase your home with an FHA loan?

Using An FHA Loan

It may be more difficult than 5 – 10 years ago to use an FHA loan because of changing regulations.  Congress requires the FHA to maintain a cash balance in an amount equal to 2% of all of its outstanding loans as mortgage insurance reserves.  These reserves are similar to a bank, which holds money in reserves to cover the percentage of loan defaults that inherently occur.  Due to the amount of loan defaults in recent years, the FHA is having difficulty complying.  This factor is causing an increase in fees charged to borrowers to make up for the deficit in funds on what is normally a cheap FHA Loan.  Rises in fees are seen in mortgage insurance premiums.  Now some first time homebuyers are not able to afford the mortgage insurance costs.  This makes an FHA loan impossible.  In addition, now FHA loan mortgage insurance remains through the life of the loan and cannot be canceled.

Historically, once the FHA loan principal was less than 78% of the home’s value, the mortgage insurance was canceled automatically.   In comparison, typical conventional loan mortgage insurance can be canceled once the loan principal is less than 75 -80% of the home’s current value.

FHA Loan Financing

FHA loan financing

Can an FHA Loan Still Save You Money?

If you have a credit score of 640 to 680 and cannot obtain cheaper financing through conventional means, you should consider an FHA loan.  You will want your mortgage broker or bank to give you a “good faith estimate” of all the fees to compare if you are able to obtain both conventional and FHA financing.  With an FHA loan you can have a higher DTI (debt to income ratio) compared to conventional loans.  FHA lenders use two separate DTI calculations to help them determine an individual’s ability to repay a loan.

MORTGAGE PAYMENT EXPENSE TO EFFECTIVE INCOME

Add the monthly mortgage principal and interest payment, escrow deposits for taxes, hazard insurance, mortgage insurance premium, and homeowners’ dues.  Next, take that amount and divide it by your gross monthly income before taxes.  In order to qualify this number should not be higher than 31%.

TOTAL FIXED PAYMENT TO EFFECTIVE INCOME

Add up all monthly installment debts such as student loans, car payments, credit card bills, etc. along with the monthly mortgage principal and interest payment, escrow deposits for taxes, hazard insurance, mortgage insurance premium, and homeowners’ dues.  Then divide that total amount by your gross monthly income before taxes.  To qualify for an FHA loan the amount should not be higher than 43%.

These two debt to income ratios are not the only tools used by FHA lenders to determine if a person qualifies for an FHA loan.  Nonetheless, in addition to job history and credit scores these two ratios can give a good financial picture to the lender.

Lastly, FHA does not deal directly with the public so much care should be taken in choosing from an approved list of FHA lenders.  Getting the right lender that will help you understand the process and explain any fees will make all the difference.  Do you have a horror story or something about your FHA loan experience that you can comment on?

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