How do FHA loans work? A 2024 primer on the popular FHA program

How do FHA loans work?

Everyone has heard about such 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.

About FHA Mortgages

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 the typical existing home sold for $249,500. That means 20% up front was around $50,000 – a sum most people simply don’t have.

This is where the FHA comes in. If you buy real estate you don’t need 20% down with FHA backing. Instead, you can buy with as little as 3.5% down. That’s about $8,750 for the down payment instead of $50,000. In other words, lenders are happy to substitute FHA insurance for a big down payment.

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 2018, 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.

FHA mortgage insurance

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

In the case of our $200,000 property with 3.5% down the monthly cost for MIP is $136.

FHA loans & credit scores

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 in full and on time. This will not only raise your credit score and lower interest costs it will also help you avoid late fees and other charges.

Monthly debts

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 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.

Some FHA programs are more liberal. For instance, with an energy efficient mortgage (EEM) the ratios can be stretched to 33/45.

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.

However, in early 2019 the FHA established stricter underwriting standards as a result of several trends.

• In January 2019 with more than a quarter of all FHA mortgages had DTI ratios above 50%
• Average credit scores sank to 670 in FY 2018, the lowest since 2008. And 2008, of course, was the height of the Great Recession.
• There was “an increasing concentration of credit scores less than 640 combined with DTI ratios greater than 50%.”

Now, when a mortgage applicant has a 620 or less credit score and a DTI above 43%, lenders will be required to manually underwrite the loan (another way of saying that a human reviews the file instead of a computer algorithm).

As a practical matter, many lenders will set even tighter standards to assure that FHA financing is correctly underwritten. The result is that marginal borrowers will now face a tougher underwriting process.

An FHA loan from lender Smith is the same as an FHA loan from lender Jones. The result is that it can pay borrowers to shop around for the best rates.

Check your FHA eligibility

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.