The FHA loan is a popular option for borrowers because it allows them to buy a home with a relatively small down payment. It is also one of the most misunderstood loan products in the market. In this article we get to the bottom of how FHA mortgages work, and bust some of the common misconceptions about this flexible loan product.
FACT 1: The FHA is NOT a mortgage lender
The Federal Housing Administration (FHA) a government agency within the U.S. Department of Housing and Urban Development, mandated to promote home ownership. Contrary to popular belief, the FHA is not a mortgage lender. It does not make mortgage loans to home buyers. Rather, the FHA is a mortgage insurer. It reimburses banks and other mortgage lenders for their losses in the event that their FHA-insured loan goes into default. Because of the government guarantee, banks and other mortgage lenders are willing to lend money to borrowers who might not qualify for a traditional mortgage.
FACT 2: FHA loans are NOT just for first time buyers
The FHA loan is often touted as a mortgage for first-time buyers because of its low credit score and down payment requirements. In truth, anyone can apply for an FHA loan, as long as the loan is for the borrower’s primary residence.
FACT 3: FHA loans typically require just a 3.5 percent down payment
While most traditional mortgages require a 20 percent down payment, the FHA requires just 3.5 percent down. And, unlike other low or zero down payment mortgages such as those from the U.S. Department of Veterans Affairs, there are no eligibility requirements attached to the loan. This makes the FHA mortgage one of the most lenient mortgage types available in the U.S.
FACT 4: The cash down payment can come from any source
The down payment can come from any legitimate source. This means that parents, siblings, employers, charitable organizations or government homebuyer programs can finance the down payment. What’s more, the seller can pay up to 6 percent of the loan amount towards the buyer’s closing costs, compared to just 3 percent for conventional loans. These concessions allow buyers with zero cash savings to fulfill their dream of homeownership.
FACT 5: Lenders can approve FHA borrowers with poor credit scores
Not everyone will qualify for an FHA-backed loan. Borrowers have to show that they have a steady income and can reasonably afford to repay the loan. However, borrowers with a poor or nonexistent credit score stand a better chance of qualifying for an FHA loan than any other mortgage type. The reason? FHA mortgage providers are expressly instructed to analyze the borrower’s complete credit profile and not just isolated instances of default here and there. Even borrowers who have suffered a catastrophic credit event, such as a bankruptcy or foreclosure, will find it easier to get an FHA mortgage than a mortgage that does not come with the government guarantee. The wait period is typically just two or three years.
FACT 6: Some lenders set stricter standards
Because the FHA does not advance the loan, the mortgage lender can choose to apply stricter underwriting criteria than the standards set by the FHA. “Investor overlays,” as these standards are known, might include raising the minimum credit score or requiring additional time since a foreclosure, short sale or bankruptcy. A borrower who is disqualified by one FHA-approved lender might have better luck with another.
FACT 7: FHA loans may be more expensive, or less expensive, than other types of mortgage
Since 2011, FHA interest rates have been lower than comparable conventional rates via Freddie Mac and Fannie Mae. But it is not the rate that determines how expensive a mortgage is. The true cost of the product depends on the loan size, the mortgage term, the down payment and the property’s location.
The biggest cost of FHA-backed loan is mortgage insurance. Borrowers taking out an FHA mortgage are required to pay mortgage insurance premiums – this is non-negotiable, unless the borrower puts down more than 20 percent. MIPs are paid into a pot of cash that the FHA uses to compensate lenders against mortgage default without cost to the U.S. taxpayer. Ultimately, MIPs keep the FHA scheme running.
MIPs are paid in two parts. An upfront MIP of 1.75 percent of the loan size is automatically added to the loan balance at closing. In addition, borrowers pay an annual MIP in monthly installments along with the mortgage payment. For most borrowers, the annual mortgage interest payment is between 0.45 and 1.35 percent, though it can be higher, depending on the property’s location.
MIPs can add significantly to the cost of an FHA loan.As always, borrowers should compare offers from several different lenders – conventional as well as FHA loans – before committing to buy.
FACT 8: Homeowners “armed with knowledge” get a MIP reduction
Evidence suggests that homeowners who undertake counseling are 30 percent less likely to default. Thus, first-time buyers who agree to attend homeownership education classes through the FHA’s “Homeowner’s Armed With Knowledge” (HAWK) program are granted reduced upfront and annual MIP payments. Counseling lasts a minimum of six hours and is conducted before the buyer goes into contract.
FACT 9: There are limits on how much you can borrow
Limits vary by region, and the amounts are not as modest as you might think. In some counties, FHA loans are available for properties priced at over $1 million.
FACT 10: FHA loans are assumable
In general, a buyer can take over the seller’s FHA loan. In other words, the buyer will pick up the seller’s rate, repayment period, principal balance and other terms. Often, the terms of the seller’s mortgage are more favorable than the terms the buyer would be offered if he were to take out a loan at today’s rates. When interest rates are rising, the ability to assume an existing loan may make the house more attractive to buyers and easier to sell.
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The media is rife with advertisements telling you that unbelievably low mortgage interest rates are in the palm of your hands. Unfortunately, in many cases, borrowers find out that they only qualify for interest rates that are one to two percentage points higher than the average rate. So, what gives?
Basically, lenders see the mortgage interest rate as a representation of the risk involved in lending money to borrowers. A lower risk translates into favorable interest rates. You may ask then: How can I be a low-risk mortgage applicant? Lenders generally use certain criteria to determine if you qualify for an ultimately low interest rate.
Explained below are some of the major determinants that lenders typically consider when deciding whether to give you attractive mortgage rates.
A Credit Score of 760 or Higher
Lenders want to know if you’re capable of paying back the money you intend to borrow. A high credit score is a good indication that you’re a trustworthy payer. In contrast, if your credit score is low, it means you likely have a history of late and missed payments or other undesirable financial faults. A low score may indicate that you’re not quite responsible in managing your finances, making you a high-risk applicant in the eyes of lenders.
In a nutshell, the higher your credit score, the better the interest rates you’ll get. To access the most competitive rates, your credit score shouldn’t fall below 760, which is considered a good score especially if you’re planning to take out a 30-year mortgage. A credit score of 760 or higher opens the door to the most coveted mortgage rates and considerably lower down payments, as it implies that you have an excellent credit history and you have extremely low chances of becoming delinquent in your loans.
Generally, the minimum score to have your mortgage application approved is 620, although having this score means you’ll likely end up paying much more for the debt you owe. However, those with very low credit scores ranging from 500 to 579 can still qualify for a mortgage by getting Federal Housing Administration-insured loans, which require a minimum of 10 percent down payment. Those with credit scores of at least 580 can get FHA-insured loans with as low as 3.5 percent down payment.
A Debt-to-Income Ratio of 40 Percent or Lower
Debt-to-income ratio refers to the portion of your gross monthly income that goes to debt payments, and you calculate it by dividing your debt amount by your total income. For example, if your gross income is $8,000 monthly and you have a total debt of $1,500 each month, your debt-to-income ratio would be around 0.19 percent.
A low debt-to-income ratio means lower mortgage interest rates. The ideal percentage to qualify for a new loan is no higher than 40 percent. Lenders take a look at your debt-to-income ratio when considering to grant your loan application, because they want to know if the new loan is within your means and it’s not too hard for you to pay it off. They want to be assured that you’re capable of making prompt payments consistently despite pay cuts, additional debts and other financial setbacks.
What do lenders consider as debt exactly? Generally, anything that’s stated on your credit report can be seen as debt, including personal loans, credit card debts and auto loan debts. Future mortgage payments also are usually taken into account.
A Stable Job
Lenders want to check if you have a stable and consistent career, because a stable job means better capability of paying off a loan for long-term. A long-standing career indicates stability and bolsters your chances of getting the best mortgage rates. That said, don’t panic if you changed jobs before. The important factor is that your previous jobs and current work are in the same industry.
Ideally, you should have a job in the same industry for at least two years. On the other hand, being unemployed or having been fired in the recent years won’t help you get favorable rates, so remember to keep your job for as long as you can to secure excellent mortgage rates in the future.
An Equity Equal to 20 Percent or More
From a lender’s perspective, having more equity means a lower risk. In a real estate context, equity refers to your home’s market value after deducting your remaining mortgage balance. For example, if your home value is worth $600,000 and you have a remaining mortgage balance of $500,000, then you have a 17 percent home equity. Basically, this means you own 17 percent of your home property, and the lender owns 83 percent of it.
How does equity represent risk? If the value of your home decreases by up to 17 percent, you’d incur loss if you decide to sell your property, and you’ll have to come up with enough cash from other sources to repay your debts upon selling your home. And if your home’s value declines by 18 percent or more, the lender could possibly lose money considering that the lender owns the rest of your home. Thus, a lower equity means a higher risk for the lender.
Lenders don’t like losing money, and they want to provide loans if there’s a good guarantee that the loans would bring in some profit rather than losses. To get the most favorable mortgage interest rates, you should maintain a minimum of 20 percent equity in your property and strive to maximize it, whether by paying off your mortgage balance or renovating your home to raise its market value.
Sufficient Cash Reserves
When you have ample money in your savings or checking account, certificates of deposit, or money market funds, lenders will feel more confident that you have the financial backing to continue your monthly house payments even if sudden expenses affect your cash flow. Most lenders requires cash reserves that cover at least two months’ worth of house payments, although the requirement may be higher if you’re considered a high-risk applicant.
A Down Payment of At Least 20 Percent of the Purchase Price
To get the most enticing mortgage rates, you’ll have to save up for a down payment of at least 20 percent of your property’s purchase price. Also, this amount of down payment helps you make substantial savings because it eliminates the need to pay for private mortgage insurance.
Shopping for the Best Mortgage Rates
After determining where you stand in terms of qualifying for competitive mortgage rates, your next step is to shop around. Check out reputable online sources to compare the rates offered by various lenders. Many sites feature tools that let you enter details about your desired mortgage and automatically provide a list of the most attractive rates. You may also want to visit your local bank or credit union, as you may have higher chances of bagging low rates and discounts, particularly if you’ve established a good relationship with them over the years.
Best Fixed Mortgage Rates Available by Positioning Yourself as a Low-Risk Applicant
To gain the trust of mortgage lenders and enjoy a selection of low interest rates, it’s important to maintain a good credit score, avoid switching jobs frequently, obtain a higher equity, and save up as much and as often as you can. Try to monitor your credit score regularly and control your spending. It’s wise to create a fail-safe plan for sudden expenses and unforeseen situations by building an emergency fund. Mortgage lenders prefer that you keep a good amount of savings instead of using it all up on the down payment, so you won’t have to miss payments even if something unexpected comes up. Evaluate your cash flow, existing debts and monthly expenses carefully, and make sure to borrow only what you can afford to pay off. The rule of thumb is that all of your monthly debts should be no higher than 36 percent of your total income pretax.
Make sure to manage your finances wisely from the time you take out a loan until closing on it, as your lender will likely review your credit report to check if there’s any significant change in your credit score and history. Maxing out your cards and getting another loan may just derail your mortgage closing. Knowing the major criteria lenders use to determine the appropriate mortgage rates for loan applicants, it’s best that you take action immediately and address anything that hampers you from being a well-qualified, low-risk applicant, whether it’s about your credit score, amount of debts, cash reserves or total equity.
Mortgage Questions: Can Your Relationship Affect Your Mortgage?
Buying a new home is one of the biggest commitments that you can make in life. It’s probably going to be your biggest purchase and you’ll probably spend the next 15 to 30 years paying off the mortgage you took out. If you are buying a new home with your partner, then you are making an even bigger commitment. However, you might find that buying a home with your partner might be more difficult than you thought. You might think that having two incomes can only benefit you, especially in the process of applying for a mortgage, but there are a number of things that could hold you back as well. Here are a few potential concerns for couples looking to buy a home together:
You just got married
Although it varies from state to state, most of the time you’ll find that real estate is considered to be marital property. This means that the name that appears on the deed and the mortgage is very important. Joint ownership is a good idea, as it helps to provide extra stability if a tragedy occurs to either you or your spouse. However, things can get tricky if you’re the one that paid for the real estate and both of your names appear on the deed, if you happen to go through a divorce in the future. While this is not a pleasant thing to think about, it’s something you should consider when determining whether both names should appear on the deed and mortgage.
You or your partner has bad credit
It doesn’t matter if one of you has absolutely incredible credit; if the other has poor credit, then it could hurt your chances of qualifying for a mortgage or getting the mortgage terms that you want. This is because the mortgage lender will use the lower of the two credit scores. The lender may still offer you a loan if one of your credit scores is bad, but it will most likely be a smaller loan with higher interest rates. You should sit down with your partner to look over both of your credit reports before applying for a mortgage.
If one of you has poor credit, then you have three options:
- Hope that you qualify for a smaller loan with high interest rates
- Work on improving your credit scores before applying for a mortgage
- Leave the person with the bad credit off the mortgage application
Leaving the person with the bad credit off the mortgage application is a risky move, especially if you’re not married. If you leave each other or get a divorce, then the person not on the mortgage isn’t legally obligated to help with payments.
You or your partner doesn’t meet the income requirements
Mortgage lenders will review the applicant’s last two years of W-2s and tax returns. If either of you is working as an independent consultant or has just started a business, you’ll need to be able to prove that you have had steady income throughout those last two years to qualify for the loan. If one of you can’t prove that you have had steady income over the past two years, then your income probably won’t qualify for the mortgage.
You or your partner’s expenses and debt are too high
In order to qualify for a mortgage, you’ll need to be able to prove that you can afford the monthly payments. Lenders will take a close look at your debt-to-income ratio, which they will determine by checking your income as well as the items on your credit report. You’ll typically need to have a qualifying ratio that’s less than or equal to 43 percent. If either debt-to-income ratio is higher than that, you may not qualify. You should sit down with your partner when you first figure out your budget to determine what your debt-to-income ratio is. If either of your expenses or debts are too high, you may want to hold off on applying for a mortgage until you can pay down your debts a little more.
If you are planning on buying a home with your partner, then you need to be aware that both you and your partner’s financial situations will be taken into account by lenders, and that the risk is usually determined by the person with the worse financial background. Because of this, getting your finances straightened out before you apply for a mortgage is a smart idea.