How do FHA loans work?
Everyone has heard about FHA mortgages but why does a government financing program introduced in the 1930s work so well today, especially for first-time buyers?
The Federal Housing Administration (FHA) started in 1934 and strangely enough, it doesn’t make loans. It’s actually an insurance program.
A huge insurance program that helped more than one million borrowers last year.
There are insurance programs to help with such things as car accidents, medical bills, and flood damage.
The FHA program is similar but has an odd twist. With FHA financing you pay the premiums but if something goes wrong you can’t collect a dime. Instead, the FHA program pays off lenders, covering 100% of all losses.
How does the FHA help borrowers?
Lenders hate excess risk. A little risk is okay but too much risk is a no-no. If you want to make lenders happy then reduce their risk and buy real estate with 20% down.
The National Association of Realtors (NAR) reported that in December 2019 the typical existing home in the US sold for $260,000. That means 20% upfront was around $52,000 – a sum most people simply don’t have. In Multnomah and Clackamas Counties the average sales price is closer to $400,000. A 3.5% down payment is $14,000
Lenders are happy to substitute FHA insurance for a big down payment.
With the FHA program less down is needed, therefore it becomes possible to buy a home sooner.
In the government’s fiscal 2019, the FHA insured more than 1 million mortgages. Most of these loans – 776,284 – were used to purchase homes and of that number, almost 83% were used by first-time buyers.
Check your loan eligibility here
You likely have auto insurance and health insurance. In exchange for coverage, you pay a premium. The FHA system is similar.
With the FHA there are two types of mortgage insurance premiums (MIPs).
There is an up-front MIP and an annual MIP.
The up-front MIP is equal to 1.75% of the loan amount. Example: If you buy a $200,000 home with 3.5% down the loan amount will be $193,000.
The loan-to-value ratio (LTV) is 96.5%. The up-front MIP is equal to $3,377.
Here’s the good news. You can add the up-front MIP to the loan balance. You don’t have to come up with that in cash.
But it does add to bigger debt and higher monthly cost. Over 30 years $3,377 at 4.25% interest will increase the monthly mortgage payment by about $16.
The annual MIP for the overwhelming majority of FHA borrowers is equal to .85% of the mortgage amount. This assumes
– Less than 5% down
– Loan amount less than $625,500
– Loan term of 30 years
The FHA is very open to borrowers with imperfect credit. You can borrow with 3.5% down as long as your credit score is above 580. From 500 to 579 a 10% down payment is required.
Less open are lenders. Different lenders have different credit standards. They don’t like to originate mortgages for iffy borrowers. According to the FHA 2018 Annual Report, less than 1% of all FHA borrowers had credit scores below 579. A little more than 10% had credit scores between 580 and 619.
The bottom line is that solid credit is crucially important for any big loan. Make a point to pay all bills on time and keep your balances on credit cards at 30% or below of the high credit offered. This will not only raise your credit score and lower interest costs it will also help you avoid late fees and other charges.
Lenders are very concerned about monthly debt payments. They want to know about your debt-to-income ratio (DTI).
The DTI compares your gross monthly income (what you earn before taxes) with required monthly debt payments.
In general terms, there are two types of DTI ratios.
The “front” ratio looks at your monthly housing costs for such expenses as mortgage principal, mortgage interest, property taxes, mortgage insurance and property insurance.
The FHA will generally allow up to 31% of your gross monthly income to be spent on housing costs.
The “back” ratio looks at your housing costs plus recurring monthly payments for such things as student loans, auto financing, credit card bills and housing costs. In general, your back DTI can be as much as 43% of your monthly income.
Example: The Smiths have an $85,000-a-year household income. That’s a gross monthly income of around $7,000. The front ratio permits housing costs of as much as $2,200 (31%) while the back ratio can amount to $3,000 (43%). Lenders would describe these standards as 31/43.
There are other circumstances where a higher DTI – as much as 50% – may be allowed for borrowers with such compensating factors as strong credit scores, good cash reserves or a strong residual income. “Residual income” is the money a borrower will have at the end of the month after all required expenses have been paid.
Many renters don’t think they can ever buy a home. That is, until they check into FHA.
With lenient credit and income guidelines, FHA could be the tool that finally makes you a homeowner.
Whenever you’re ready here are 3 ways I can help you now…
#1)-Go here for an easy way to find out how much you can be bank approved for, your price range of home and what your real monthly payment will look like…
#3)- I am here for you…Reach out to me with ANY questions and /or for personalized help.
On Your Team,
Kurt Nilsen-Mortgage Advisor
Serving Oregonians Since 2002
Sunrise Mortgage Group-Oregon City, OR.
NMLS # 251455