How do FHA Loans Work?

By Geva Lester

Ready to buy but don't have much for a down payment?

If you’re ready to buy a house but you’re struggling to find conventional financing, you’ve probably heard about Federal Housing Administration (FHA) loans a time or two. These loans are provided by many different lenders, much like conventional mortgages, but they’re backed by the FHA. This means that, in the event of a default by the buyer, the FHA will be responsible for getting the lender its money back, which provides an extra level of security to your choice of financial institution.

As a result of backing from the FHA, an agency of the United States government, lenders will be more willing to make larger loans to individuals who would otherwise struggle to attain financing. While certainly a great option in some cases, FHA loans aren’t without drawbacks of their own. Let’s take a look at how FHA loans can benefit your home search, particularly if other financing options aren’t readily available.

FHA loans are a great option for a lot of home buyers, but they aren’t for everyone. This type of loan program is most beneficial for people who meet a few basic qualifications. According to Loansafe, FHA loans are ideal for first time home buyers with a decent credit history, prospective buyers who have been turned down for a conventional loan and individuals who can only afford a small down payment.

These loans normally require a down payment of at least 3.5%, which is much lower than the typical range required for conventional loans at approximately 10%-25% of the total purchase price. In addition, FHA loans allow for the use of gifts for down payments from family members, and sellers can pay up to 6% of the loan amount towards buyer’s closing costs, if you happen to be shopping in a buyer’s market. For buyers with a lack of savings, FHA loans can be a great option.

Qualifying for an FHA loan is relatively easy, especially when compared to other types of home financing solutions. Even if your financial history has a few dings, talking to an FHA approved lender is worth your time. Because they’re designed for first time home buyers and insured by the government, it is much easier to qualify for FHA loans than conventional mortgages.

According to About Money, these loans feature no income limits, so you can qualify whether you’re a lower income borrower or are fortunate enough to have a higher income. Lenders will, however, require a reasonable debt to income ratio in order to approve a loan request. In general, a ratio of at least 29/41 is required for loan approval. FHA lenders will also check your credit report for major issues. While minor issues shouldn’t be a big deal, you’ll need to show that you do at least a fair job of managing your various financial obligations.

In exchange for its backing, the FHA charges home buyers an upfront fee, which is added on to the total amount of the loan. This is one area where this mortgage solution can become more costly than its conventional counterparts. This is where FHA loans can get expensive. These home loans have an extremely rigid mortgage insurance structure, which requires 1.75% of the loan paid up front with an additional 0.45% to 1.55% annually over the life of the loan. The actual amount of mortgage insurance you’ll need to pay depends on the individual characteristics of your loan. How long with the loan last? What is your loan to value (LTV) ratio? These are questions that will be very important to discuss with FHA lenders before committing to a mortgage. While conventional loans typically require private mortgage insurance until a predefined equity in the home is attained, prime mortgage insurance fees persist for the life of the loan. FHA loans are designed to serve a basic need for long-term home buyers, so they don’t come in many varieties. As such, there are a number of drawbacks to consider if other financing options are available.

Since FHA loans are aimed at home buyers who are searching for a long-term residence, they don’t come with a great deal of options. To protect the lender from losses, buyer-friendly features such as option ARMs are omitted, while negative amortization, where interest fees cause you to owe more after making a monthly payment, is a distinct possibility. If you’ve got options for financing, the drawbacks of FHA loans may be enough to make you turn your attention elsewhere, but, for home buyers with limited options, FHA backed mortgages could provide the sole opportunity to buy a home.

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