Federal Housing Administration (FHA) loans have become increasingly popular with buyers who are ready to purchase a new home, but may not have the cash up front to do so. If you haven’t already, you may be seeing more real estate clients interested in pursuing an FHA loan. In a nutshell, FHA loans, which can be either adjustable-rate or fixed-rate mortgages, are backed by the government, protecting lenders against defaults. Without fear of financial losses, lenders are more likely to take on riskier loans that they may otherwise avoid. While FHA loans are rather commonplace, they do differ from conventional loans in several ways. Be in the know and keep reading to learn the basics of this type of home loan.
Borrowers with FHA loans must pay a monthly mortgage insurance
This insurance increases the amount buyers will be required to pay—sometimes a good bit. So buyers have to account for that when they set their budgets. Additionally, most FHA loans require mortgage insurance to be paid for the entire life of the loan, whereas conventional loans typically allow buyers to stop paying mortgage insurance once they reach 20% equity. That could get costly over time.
Net—not gross—monthly income is the deciding factor
Too many buyers make the mistake of calculating their housing budget using their gross income—meaning the money they make before taxes, medical, and so on are taken out. However, borrowers’ monthly housing cost should not exceed 31% of their net, or take home, monthly income. That is a huge distinction buyers need to be aware of.
Borrowers don’t need much cash to close
For cashed-strapped individuals, FHA loans are the way to go because they don’t have to bring loads of cash to closing. The down payment can be as low as 3.5% of the total purchase price of the house—if the borrower has a least a 580 credit score. Additionally, if the borrower chooses to do so, all closing costs can be rolled into the loan. And gift funds can be used to cover the full cost of the down payment and any closing costs.
Loan amounts vary depending on location
Max loan amounts range from state to state and even city to city, so it is imperative that buyers check the max loan amounts in their area. For example, in some Hawaiian counties the max loan amount goes up to $721,050, while in Phoenix, AZ, it tops out at $271,050.
Secondary loans for renovations may be hard to come by
Traditionally, FHA loans have high Loan-to-Value (LTV) ratios—the ratio of the first mortgage lien as a percentage of the total appraised value of real property. So buyers will need equity in their properties before they can take out a second mortgage, such as a HELOC. Properties priced well below their market value are hard to come by, so it’s unlikely that buyers will have equity right away, especially if they put only 3.5% down.
Buyers are only permitted to have one FHA loan at a time—in most cases
Real estate clients looking to invest in rental properties or flips aren’t permitted to have multiple FHA loans. However, some borrowers who have an FHA loan on one property may be able to get an FHA loan on a second property if, for example, they are going through a divorce or if they are relocating for work and decide to keep both properties. Additionally, borrowers who are looking to upgrade may get an FHA loan on the new property if they maintain the initial FHA loan on the first home and convert it to an investment property. In any case, a good bit of proof and documentation is required before the loan will be approved.
Banks are still pretty much in control
The bank a buyer chooses will set its own FHA underwriting guidelines, also called lender overlays, in addition to any FHA guidelines. While the FHA insures the loans, it doesn’t lend money to borrowers or set interest rates for the loans. Buyers are still very much beholden to the lender.
Sellers may be leery of FHA loans
Unfortunately, because of a lack of knowledge, some sellers see FHA loans as risky, believing that the buyer can’t truly afford the property or that credit issues will turn up and prevent closing. Others worry that the buyers won’t have enough money for repairs or renovations, so anything that turns up during inspection may kill the deal. Those issues occur with traditional loans all the time, too, so it would be wise for you and your sellers to not immediately discount an FHA loan.
Additionally, you can help your FHA borrowers by making their offers more attractive to sellers, for example, by accepting properties as-is or by offering the full asking price—if both are financially doable for the buyer.
For more information on FHA mortgage lending policies, register for McKissock’s online real estate course, The New FHA Handbook for Real Estate Professionals.