The FHA loan program has been helping home buyers since the 1930s. Through this program, borrowers are able to purchase a home with a government-insured mortgage loan. This insurance protects the lender from losses stemming from borrower default.
The FHA program is especially popular among first-time home buyers. A 2012 survey by Campbell Communications and Inside Mortgage Finance found that 53% of first-time buyers used FHA loans when buying a home. This is not surprising, as the program offers several key benefits to this particular group.
We will talk about those benefits in a moment. But first, some definitions are in order:
An FHA loan is a mortgage that is insured by the government, through the Federal Housing Administration (part of HUD). Financing is provided by a lender in the private sector — not by the government. The federal government insures the lender against losses, in the event that the borrower fails to make payments.
As a result of this government backing, mortgage lenders are willing to relax certain guidelines during the approval process. The FHA program is often the last resort for borrowers with limited capital, low credit scores, or other qualification problems.
Check out our 2013 FHA outlook.
The Benefits of Using an FHA Loan
What makes this program so popular among first-time home buyers? It’s a combination of factors, really. Here are the top benefits for borrowers:
1. Low down payments. FHA allows borrowers to make down payments as low as 3.5% of the amount borrowed. Conventional loans, on the other hand, require down payments of 5% or higher. Some lenders require a minimum of 10% on conventional loans, especially when the borrower has shaky qualifications (bad credit, high debt ratios, etc.).
2. Lower credit-score cutoff. The Department of Housing and Urban Development (HUD) has imposed a minimum credit score of 500 for all FHA loans. Granted, lenders have the final say, and most of them require scores well above 500. But overall, the cutoff is typically lower for government-backed mortgages than conventional financing. Lenders allow scores down to 600, and sometimes below, for the FHA program. The minimum score for conventional financing is typically 20 – 40 points higher.
3. Flexible debt ratios. Debt can be a deal-breaker during the mortgage approval process. If a borrower carries too much debt relative to monthly income, he or she may be denied financing. In lending jargon, this is known as the debt-to-income ratio, or DTI. Government-backed mortgages typically have lower DTI restrictions, when compared to conventional loans. Most lenders today limit total monthly debt to 39% – 41% of income, for conventional loans. But there’s more leniency in the FHA program. We have seen borrowers with excellent credit get approved for FHA with debt ratios as high as 50% (whether it’s wise to do so is the subject of another article).
[Update: Borrowers with credit scores below 620 could face higher DTI standards in 2013. Learn more]
4. Streamlined refinancing. Borrowers with an FHA loan can refinance into a new government-backed mortgage with minimal hassle, and sometimes without an appraisal. This can be a huge benefit in certain scenarios. For instance, if rates drop significantly a few years after the original home purchase, eligible homeowners could use the FHA streamline refinance program to secure a lower rate. This could lead to big savings over time.
5. Down payment gifts. With an FHA loan, the entire down payment can be gifted from a family member — ‘entire’ being the key word. In contrast, most conventional loans do not allow 100% gifting for the down payment funds. This is another key benefit of the FHA program, one that appeals to first-time home buyers in particular. The borrower must obtain a letter from the family member who gifted the money. At a minimum, the gift letter must include (A) the dollar amount given; (B) the name, address and phone number of the donor; and (C) a statement that no repayment is required.
6. FHA loans are assumable. Most conventional mortgages are not. ‘Assumable’ means that if the homeowner decides to sell the home, he or she can transfer the mortgage to the new buyer. Many buyers will see this is a major benefit, especially if the homeowner’s interest rate is lower than current interest rates.
According to Jack Guttentag, the Mortgage Professor, “having the buyer assume the seller’s loan can be better for both. The buyer enjoys a [potentially] lower rate and avoids the settlement costs on a new mortgage.”