FHA Loans: The Ultimate Guide to Federal Housing Administration Loans

Federal Housing Administration (FHA) loans are a type of mortgage insured by the Federal Housing Administration. The FHA is a division of the U.S. Department of Housing and Urban Development (HUD) and has insured more than 46 million mortgages since its inception in 1934. Today, the FHA has active insurance on more than 8 million single-family mortgages and almost 12,000 mortgages for multifamily properties, according to its website.

The acronym FHA is often mistakenly thought to stand for first-time homebuyers assistance. It’s important to understand that FHA loans are available to anyone, not just first-time buyers. And you’re not just limited to using FHA loans once. As long as you continue to qualify, you can use FHA loans to purchase residential properties.

Compared to traditional loans, FHA loans offer flexibility in several key areas that are attractive to buyers. These loans have no income restrictions and are typically designed for low-to-moderate-income borrowers who may have lower than average credit scores. They also require a lower down payment than the 20 percent associated with traditional mortgages—sometimes as low as 3.5 percent.

Another important characteristic of an FHA loan is that while it is funded by a lending institution, such as a mortgage company or bank, the mortgage is insured by HUD. That means if you default on your loan, the FHA will pay a claim to your lender.

Lastly, another reason people pursue FHA loans is the flexibility of their debt-to-income ratio(DTI) requirements. Your debt-to-income ratio is the percentage of your gross monthly income (not your net income) spent on monthly debt payments. If you apply for a FHA loan and are approved for the maximum DTI, your maximum can be 46.9 percent. That means that your principal interest, taxes, insurance, and any other fees—including flood insurance or homeowners association fees—cannot be more than 46.9 percent of your total income.

That 46.9 percent doesn’t capture all your monthly debts. When the above housing costs are added to your monthly debts, it should total no more than 56.9 percent of your gross income. So the 56.9 percent represents all the costs listed above plus any other financial liabilities that you have, including monthly car payments, credit card payments, and student loan payments.

Determining if FHA loans are your best option for purchasing or refinancing a home will take a bit of research. For many people, evaluating the fit of an FHA loan for their situation comes down to three main factors: property type, monetary reserves, and credit score.

The type of property you’re trying to purchase will affect your ability to secure and use an FHA loan.

Before diving into the various property types, it’s important to note that while FHA loans don’t have income restrictions, they do have loan limits, meaning you can’t take out an FHA loan for more than that predetermined amount. For example, if the house you want to purchase costs $300,000 but the FHA loan limit for that county is $275,000, using an FHA loan may no longer be beneficial for you.

As of November 2020, the loan limits for most counties in the U.S. (not including metro areas) were:

• $356,362 for a one-unit property.
• $456,275 for a two-unit property.
• $551,500 for a three-unit property.
• $685,400 for a four-unit property.

As you can see, you’re allowed to buy multi-family residences with FHA loans. Before you start making plans to buy a multi-unit property and rent out all the units, you should know that FHA loans are intended for a property that serves as the buyer’s primary residence. So if you purchase a four-unit home, you will be expected to live in one of the units.

So what types of properties qualify for FHA loans and what are the requirements for each? Let’s break down each type of property and key information you should know regarding how to purchase it with an FHA loan.

The term stick-built housing refers to traditional homes, which are typically constructed onsite and piece-by-piece from a wooden structure, hence the name stick-built. Almost all of them qualify for FHA loans and are the most common type of homes purchased through the FHA program.

It’s worth mentioning that modular homes fall into the stick-built category. A modular home is a prefabricated house that is brought to a site in large pieces. There, it is assembled and hooked up to utilities.

As previously mentioned, you also can purchase a multi-unit home with FHA loans. Again, the home has to serve as your primary residence in order to do so, and you can only purchase a house with a maximum of four units. For people thinking about getting into investment properties, FHA loans can be a great option thanks to lowering down payment requirements.

Now, when it comes to purchasing any of these types of homes with an FHA-insured loan, there are rules that all involved with the sale need to follow. One that can cause a purchase to hit a snag is the home’s condition. The following are the minimum property standards for a home purchased with an FHA loan:
Safety: the home should protect the health and safety of the occupants.
Security: the home should protect the security of the property.
Soundness: the property should not have physical deficiencies or conditions affecting its structural integrity.

Download here: FHA Minimum Standards Flyer

Per FHA rules, there cannot be any safety issues with the home in order for the sale to go through. For example, if a house you’re looking at is lacking safety rails for its stairs, those railings would need to be installed prior to the sale closing.

Here are some examples of common problems that can affect the sale of an FHA-loan purchased home:

• Cracked or damaged exit doors that otherwise work
• Cracked window glass
• Minor plumbing leaks
• Defective floor finishes or coverings
• Rotten or worn-out countertops
• Chipped and peeling paint
• OTHERS?

When it comes to cosmetic or minor defects, deferred maintenance, and normal wear and tear, the FHA does not require these types of issues to be addressed if they do not affect the safety, security, or soundness of the home.

So who determines if the house meets the minimum standards? An appraiser will visit the property and record its condition during a property appraisal. These results are reported to the FHA on an appraisal form. A property appraisal is a requirement of FHA loans and most home sales.

The second type of property you can purchase with an FHA loan is a manufactured home. A manufactured home (also known as a mobile home), as defined by HUD, is built to the standards of a special HUD building code and displays a red certification label on the exterior of each transportable section. Those labels will become important in a minute. The defining characteristic of manufactured homes is that they are built in the controlled environment of a manufacturing plant and are transported in one or more sections on a permanent chassis (the base frame of a wheeled object).

There are a few key things to know about purchasing a manufactured home using an FHA loan. Remember those HUD labels? Well, as it turns out, the absence of those labels can grind a manufactured home sale to a screeching halt. If the house does not bear those labels at the time of sale, you’ll need to request a special report from the home’s manufacturer. Obtaining that report can take up to six weeks, stopping a sale in its tracks until the report is received.

Another aspect of purchasing a manufactured home with an FHA loan is ordering a structural engineering report. This report is an evaluation of a home to confirm it is foundationally sound. One important item of difference between manufacturing and stick-built homes is that manufactured homes don’t tend to grow in value as time passes. Instead, their value depreciates, similar to a boat or a car.

Tying into that point is the third thing to know, and that’s the significance of a retired title. Essentially, a manufactured home is treated similarly to a boat or car in that it has a title, which is a document establishing ownership of the property in question. If a person owns a manufactured home and the property on which it sits, they have the option of retiring the title and converting it to a warranty deed. The deed establishes clear ownership of the property/home and that said owner has the right to sell the property.

Download here: Manufactured Home Requirements Flyer

Where people can run into trouble with this type of property purchase is discovering too late in the buying process that the home’s title wasn’t properly retired. It can then take months to get the title legally retired and that can temporarily or even permanently halt a sale.

Condominiums are the final property type discussed here. You can qualify to purchase one through the FHA, but it’s not as easy as finding a unit for sale and deciding to purchase it.

As you’re probably aware, many condos are governed by homeowners associations (HOAs). HOAs often collect fees to provide community amenities and establish standards for the appearance and condition of homes. In order to use an FHA loan on a condo, the HOA needs to have been approved by the FHA, which can take weeks. Similar to stick-built homes, purchasing a condo with an FHA loan means making sure everything meets FHA standards of safety, security, and soundness. It’s up to the HOA to agree to fix any issues in the condo that do not meet FHA requirements. If the HOA refuses to do so, it’s unlikely you’ll be able to purchase the condo with FHA financing.

Now that you’re versed on the types of property you can purchase with an FHA loan, it’s time to dive into your finances. An area that the FHA has fewer rules around than conventional home loans is reserves. Reserves are the amount of money that will be left in your financial accounts after buying the home. Lenders want to see money leftover because that says to them you’ll be able to start making payments on the home and that all your cash wasn’t used up buying the property.

Let’s say a loan program requires you to have two months of reserves in your account after purchase. If your mortgage payment comes out to $1,000, then you’ll need $2,000 on hand to make the payments and another $2,000 on hand in case something goes wrong and you need to cover an unexpected expense.

On the flip side, FHA guidelines do not require buyers to maintain reserves in order to qualify for an FHA loan. That said, if you do have a low credit score or a high debt-to-income ratio, FHA lenders may ask for up to two months of reserves. If you’re purchasing a multi-unit home with more than two units, you may be asked to have three months of reserves on hand.

Another area FHA loans differ from conventional loan programs is allowing you to use monetary gifts to cover part or all of your down payment. In contrast, some programs want the money used for the payment to be funds that you have saved, pulled from a retirement account, or have in equity.

The FHA allows you to receive gift funds as long as they are from a family member or someone with a vested interest, such as a live-in significant other. In the latter case, you’d have to prove that you and your significant other are living together because the FHA won’t just allow anyone to give you money.

As mentioned, there technically is no minimum credit score for FHA loans, but there is an evaluation program through Fannie and Freddie that loan officers will plug your information into to see if you automatically qualify or if a bit of legwork needs to be done to get you a loan. It’s best to have a credit score of 580 or above for this type of loan but many lenders have overlays that they set and require a minimum score of 620. Every lender is different so checking multiple banks and with a broker is always recommended.

The FHA is one of the most lenient loan options if your credit score is below 700. So if you have a 699 score below, you want to look at an FHA loan and compare it to a conventional loan. One of the key reasons is that the FHA does not change the mortgage insurance based on your credit score, like a conventional loan program would. Mortgage insurance is an insurance policy that compensates lenders for losses if a homebuyer defaults on a mortgage loan. This type of insurance is typically required on conventional home loans if a buyer is not able to meet the threshold of a 20 percent down payment. The insurance rate can increase for buyers with low credit scores.

On an FHA loan, the monthly mortgage insurance is the same for everyone, no matter if you have a 600 credit score or a 750 credit score. If you have a credit score below 700, you’ll want to consider FHA financing. If you have a credit score that is above 700, you might be able to get a lower payment with a conventional loan, which means an FHA loan may cost more in the long run and not make it the best option for you.

Your credit score is a reflection of your credit report, and the FHA is more lenient about items on your credit report than other lenders. The FHA does ignore items such as medical bills that have been sent into collections but will count collections on items such as utility bills as a debt against you.

Impact on monthly payment examples

Applying for and being approved for an FHA-insured loan can be a confusing, complex, and challenging process, but there are steps you can take to help keep the process as smooth as possible for yourself and any professionals involved. Here are some tips from the pros at Co/LAB Lending:

In a nutshell, HUD defines the term identity of interest as any relationship (generally based on family ties or financial interests) between the seller and purchaser (prospective owner). Examples of identity-of-interest situations include:

• If your parents are selling their home to you, you have an identity-of-interest sale because you have family ties to your parents. If you’re trying to purchase their home using an FHA loan, there are checks and balances in place to ensure you are not getting a benefit based on your relationship with your parents that other potential buyers would not.
• If you are a renter and you’re interested in purchasing the home you rent, you and the owner would not be able to come to a sale agreement until you’ve lived in the home for a minimum of six months. Again, this is about checks and balances. You have a business relationship with your landlord, and the FHA wants to make sure there is no benefit to sell to you over someone else.

In cases of identity-of-interest sales, the FHA can say you have to put 15 percent down (instead of a down payment as low as 3.5 percent) toward the cost of the home. In terms of the family example, this will take place unless you can prove the home has served as your parents’ primary residence for the 12 months preceding the sale.

Flipping houses means that you purchase a home with the intention of renovating it and then selling it for a profit. Many flippers try to complete this process as quickly as possible to get the home back on the market and make back their money.

When you purchase a home, part of the process involves a title search, which will pull up all owners of that property for the last 80 years. This is key when dealing with flipped homes because it establishes a timeline of owners.

If someone else has purchased the house and had the deed transferred to themselves in the past six months, that will create extra steps for you as a buyer. For example, a second appraisal will be required for a home sold within the last six months. And you as the buyer, you can’t pay for that. It’s the responsibility of the seller, real estate agent, or another party.

If a house you’re considering purchasing was sold in the last 90 days or less, you can’t buy the house. The FHA has a restriction for buyers that the owner of the home must have owned it for a minimum of 90 days. It might sound odd, but remember flippers want to renovate and get homes back on the market as soon as feasible.

Appraisals are a routine part of the home buying process, but the role they play in FHA loans is a bit different than conventional loans. As previously mentioned, appraisals are used to assess the property’s condition in terms of safety, security, and soundness as well as its value.

Appraisals for FHA loans also set the appraised value of the home for any and all potential FHA buyers for an extended period of time. For example, a seller could be asking $100,000 for a home and the appraisal could come back for only $90,000. The owner doesn’t have to drop the price but that appraisal of their home will stand for 120 days and will apply to any other potential buyers using the FHA program.

The FHA is open to potential buyers bringing on cosigners to qualify for loans. Some types of conventional loans allow you to have a cosigner but other types of government loan programs—USDA, Veterans Affairs, etc.—do not allow cosigners. Like the buyer, the cosigner will undergo a similar underwriting process that will check their employment history, income, assets, and other relevant information. Non-permanent aliens are permitted to be cosigners for FHA loans as long as the buyer is a U.S. citizen and the primary resident.

There are exceptions to the use of cosigners. For instance, you can’t have a cosigner on a loan for a multi-unit property, only on loans for single-family homes. Cosigners also cannot have more than five mortgages in their name and then sign for your loan on top of it.

If you currently own a home that was purchased with a conventional loan, you can still pursue an FHA loan for another property—though there will be some hoops to jump through.

Let’s say the house that you currently live in was purchased with a conventional loan, and you want to buy a new home in the same city but this time with an FHA loan. In this case, the only way you’ll qualify for an FHA loan is if you can get a tenant that will move into your current house. Typically, you can use the value of the lease (the rent payments you receive) against the mortgage payment. The FHA doesn’t make it that simple.

The FHA says, if you’re going to rent out your house and use that lease you just got, but you’re not moving that unreasonable commuting distance of 100 miles away, then you’ll need to get an appraisal on the house you currently live in and prove that you have 25 percent equity in the home. Equity refers to the portion of a home’s current value that you actually possess—essentially what you’ve paid into your home.

The only time the FHA allows you to use the lease is in a situation where you can enter into a brand new lease with a tenant because you plan to move more than 100 miles away from that current residence.

While the condition of a home plays a large role in an FHA appraisal, what’s under your feet also is held to those minimum property standards.

Utility hookups must meet these standards as well. For example, if you’re buying a home with an FHA loan that has access to public utility lines, such as water and sewage, but is not currently hooked up to those, that connection needs to be completed before the sale can go through. That type of work can be expensive—in the neighborhood of $5,000–$10,000.

The FHA won’t let you purchase the home without the connection established because it’s likely the city or township managing the utilities would put a lien on the home until the cost of connecting it to the water/sewage line is paid. A lien is a right to keep possession of property belonging to another person until a debt is paid. Banks fear this type of situation because they want the only parties with control of the property to be themselves until the mortgage is repaid.

Learning about and navigating the FHA loan process can be daunting but with the information above and trusted homebuying professionals on your side, an FHA loan could be what gets you into a new home.

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