FHA loans: condo approval and 5 step guide

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If you're a potential home buyer looking at your mortgage options, it's important to be familiar with FHA loans. While these loans are widespread in certain markets and form an important part of the mortgage landscape in the United States, FHA loans are often misunderstood by new home buyers. An FHA loan is defined as any mortgage that’s insured by the Federal Housing Administration (FHA), with the FHA providing insurance to a number of approved lenders on single family and multi-family homes across the country.

FHA loans offer a number of advantages over other types of mortgages, with the combination of low down payment and credit score thresholds making them popular with many first-home buyers. There are also disadvantages associated with these government-insured loans, however, which often come with higher insurance rates and more stringent lending conditions than other home loans. Let's take a detailed look at FHA loans, including a useful 5-step guide on how to qualify and apply for a loan if you decide to go down this route.

Conventional vs non-conventional loans

FHA home loans are considered to be non-conventional, with all conventional mortgage products defined by the lack of any government insurance or guarantee. Conventional mortgages originate in the private sector, with all conventional loans described as either conforming or jumbo loans based on the size of the loan.

While the difference between conventional and conforming loans can seem confusing, the distinction between conforming and non-conforming loans is defined by size limits alone. In contrast, the distinction between conventional and non-conventional loans is defined by the absence or presence of government involvement in the home loan process. Along with FHA loans, other non-conventional mortgage products are offered by the Department of Veterans Affairs and the Department of Agriculture.

What is the FHA?

The FHA is a US agency involved with stimulating the domestic housing industry by helping more people to obtain finance for a home loan. The FHA has helped millions of homeowners to purchase property, people who otherwise would be unable to do so. Unlike the home loan products available from the Department of Veterans Affairs and Department of Agriculture, the Federal Housing Administration has no role apart from its involvement as a mortgage insurance provider.

The FHA was created alongside the Federal Savings and Loan Insurance Corporation (FSLIC) in 1934 as a result of the National Housing Act. With home ownership rates having decreased significantly during the Great Depression due to multiple bank failures, new legislation was needed to improve the housing market.

The FHA and FSLIC were created to improve housing standards and conditions, provide a method of mutual mortgage insurance, and reduce foreclosures on family home mortgages. It's important to note that the FHA is not a lender itself, but a specialist insurance provider for other mortgage lenders.

What is an FHA loan?

An FHA loan is a mortgage that has been insured by the FHA. While conventional home loans typically require a down payment of around 20 percent, FHA loans have a much smaller down payment threshold of 3.5 percent if certain conditions are met. For example, it you have a credit score of 580 or higher, you're likely to qualify for a home loan with a 3.5 percent deposit. If your credit score is a little more compromised, let's say between 500-579, a 10 percent down payment will be needed.

FHA loans are based on insurance, in fact, the existence of the FHA itself can be understood as a form of insurance set up by the federal government in order to reduce the widespread risk of loss in adverse economic conditions. While FHA loans are designed to make it easier for first time buyers, a number of requirements need to be met to satisfy the conditions of these loan.

Types of FHA loans

The FHA offers a range of home loan options, from their popular owner-occupier home loan through to specialized loans for existing homeowners.

  • Traditional owner-occupier or first time buyer mortgage

  • Home Equity Conversion Mortgage (HECM) program, which is a reverse mortgage program for seniors

  • FHA 203k improvement loan, for repairs and renovations

  • FHA’s Energy Efficient Mortgage program, for upgrades capable of lowering energy bills

  • Section 245 (a) loan, a program for borrowers who expect their incomes to increase



FHA loan eligibility

As already mentioned, FHA loans are often taken out by people who are unable or unwilling to save a large 20 deposit for a conventional home loan. Credit scores also come into play, with conventional loans often unavailable to people with a compromised credit history. Credit score and down payment amounts are just two of many FHA loan requirements, however, with a number of additional requirements also needing to be met before you can qualify.

The individual borrower

In order to qualify for an FHA loan, the individual needs to meet certain criteria. It's important to identify these eligibility issues from the outset and do everything you can to correct them before making a loan application.

  • A steady employment history, ideally a period of at least two years with the same employer

  • A valid social security number

  • Lawful residence in the United States

  • To be of legal age to obtain a mortgage in your state

  • Borrowers must be at least two years out of bankruptcy if relevant

  • Borrowers must be at least three years out of foreclosure if relevant

The property

Among other things, FHA loans have been designed to help first time property buyers and owner-occupiers rather than property investors. For this reason, FHA loans are unavailable if the property is to be rented out. While FHA loans can be used by investment property buyers, the property must become the investor’s primary residence.

  • The property in question needs to be used as the primary residence occupancy

  • Home loan appraisal from an FHA approved appraiser

  • The property must meet minimum construction and repair standards

Home loan ratios

Lenders typically use a number of ratios when defining their loan limits, with FHA lenders setting front-end and back-end ratios to help qualify home loans. The front-end ratio is your property-related expenses in relation to your gross income. These expenses include your mortgage payments, Homeowners Association (HOA) fees, property taxes, homeowners insurance, and mortgage insurance.

The back-end ratio is all of your living expenses in relation to your gross income. While your property-related expenses will make up a significant proportion of this figure, you also need to account for things like credit card payments, car loan payments, personal loans, and student loans.

  • The front-end ratio should ideally be 30 percent or less, with up to 40 percent possible with compensating factors

  • The back-end ratio should be less than 43 percent, with up to 50 percent possible with compensating factors

Down payment thresholds

FHA loans are intended for low-to-middle income earners, people who are unable to raise a 20 percent deposit, and people with a low credit score or compromised credit history. Other than the low down payment threshold, the ability to get a loan with a relatively low credit score is one of the main attractions of these loans.

Your FICO score is used to make these decisions, with this score ranging from 300 to 850 in the United States. While a credit score lower than 620 is considered to be "bad" in the context of a conventional loan, and at least 700 is needed for a "good" score, this figure is dramatically reduced for FHA loans.

  • A minimum down payment of 3.5 percent with a credit score of 580 or more

  • A minimum down payment of 10 percent with a credit score of 500 or more

Condos

Condominiums have unique requirements when it comes to FHA loans, with both the unit owner and the building needing to be approved separately. The condo community needs to be on the list of FHA approved projects, with only a small number of buildings included due to the expensive and time-consuming nature of the approval process. While this can limit your options, there are still lots of condos out there which have met the strict requirements set by the FHA.

  • Must have adequate insurance coverage

  • Commercial use limited to 25 percent of floor space

  • Individual investors limited to 10 percent of all units

  • Project must be complete

  • Owner-occupiers must make up at least 50 percent of units

  • Location must be accessible

  • Condo fees and capital reserves must be healthy

FHA loan limits

FHA loans also have limits based on the number of units per sale. The maximum loan amount in high-cost markets is currently $725,525 in 2019, with different values used for low-cost markets and special exceptions available for unique markets such as Alaska and Hawaii. While the following numbers represent FHA limits, additional limits are also set per county at 115 percent of the median home price. Based on the Home Price Index (HPI) each year, the FHA also sets a limit "floor" at 65 percent of the national conforming average.

The FHA’s high-cost value is set each year at 150 percent of the national conforming cap of $453,100. Low-cost area mortgage limits are set nationally based on 65 percent of the national conforming limit of $484,350. Special exception areas include Alaska, Hawaii, Guam, and the Virgin Islands. It's important to note that these numbers refer to the number of individual residences and not the number of bedrooms.

High-cost markets

  • one-unit: $726,525

  • two-unit: $930,000

  • three-unit: $1,124,475

  • four-unit: $1,397,400

Low-cost markets

  • one-unit: $314,827

  • two-unit: $403,125

  • three-unit: $487,250

  • four-unit: $605,525

Special exception markets

  • one-unit: $1,089,787

  • two-unit: $1,395,450

  • three-unit: $1,686,700

  • four-unit: $2,096,100

5 step guide when applying for an FHA loan

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1. Pre-qualification or pre-approval

Pre-qualification is the first step in the mortgage process, with this term often used interchangeably with the term pre-approval. They are not exactly the same thing in all situations, however, with pre-qualification a less formal process that's designed to come first. In both cases, you need to supply an overview of your financial situation to the lender, including your income, expenses, and credit score. When they have reviewed your information, they will supply you with a letter stipulating how much money they are likely to lend. With pre-approval, financial verification and a credit check will be required.

2. Identify eligibility issues

Once you've received pre-qualification or pre-approval from one or more lenders, it's important to research the FHA loan process and eligibility standards. Most of the issues that you need to address are summarized above, with lenders likely to look at each and every factor before they offer you finance. While getting accepted for an FHA loan can be difficult, the actual process is quite simple once you know what they’re looking for.

3. Correct eligibility issues

Once you've identified any eligibility issues, it's time to put in the hard work and fix them. While some people will be unable to qualify for an FHA loan, others simply need to wait or make some changes. For example, you may need to wait a little longer to extend your employment history, look at cheaper properties to fit in with existing limits, and save longer for a 10 percent deposit if your credit score is below 580. While it's important to check your credit score during this process, you should try to limit hard inquiries and anything else that may compromise your credit history.

4. Submission and appraisal

The FHA requires that you fill out the Uniform Residential Loan Application, which is also known as Fannie Mae form 1003. The application will ask for the type of loan, the property address, and lots of personal information about the borrower. Among other things, you will need to provide details about your income, employment, debts, and expenses. The current market value of the property in question is also extremely important to the FHA, with a home appraisal needed to make sure the property fits within FHA limits.

5. Get approval for the loan

The final stage of the FHA home loan process depends on the underwriting process carried out by the lender. They will review your financial information with a fine toothed comb, analyze your credit scores and history, and double check the value of the property. If everything is in order, they will offer you loan approval or send you a letter which explains the reasons for their refusal. When approval has been granted, you can move on to the home closing process, which is where closing costs are addressed and legal ownership is transferred from the seller to the buyer.

Pros of FHA loans

FHA mortgages offer a number of benefits over conventional home loans, including low down payments and less strict credit score requirements. These loans are also much easier to access for people with a history of money and debt problems, including a lack of credit history, bankruptcy, late payments, and foreclosure. While a good track record of on-time payments is needed, the eligibility criteria for an FHA loan is generally much more flexible than it is for a conventional home loan.

Low down payments

The biggest advantage of an FHA loan is the much smaller down payment threshold. While conventional home loans require a large 20 deposit, loans insured by the government may be available with a down payment as low as 3.5 percent. As you can imagine, this makes it much easier for first-home buyers and low income earners to enter the property market. This is a huge incentive for many people and the primary reason why FHA loans remain popular across the United States.

Easier access

FHA loans were originally designed to stimulate the housing market by making it easier for people to access home loans. Whether it's a low credit score, a history of bankruptcy, or a past foreclosure, there are many reasons why a conventional home loan can be denied. FHA loans remove many of the roadblocks associated with getting a mortgage, which opens the property market up to a much wider and diverse group of people. As mentioned above, a FICO credit score of 500 or more will give you access to a 10 percent down payment loan, with 580 or more giving you access to a 3.5 percent down payment loan.

While there are still a number of requirements that need to be met regarding on-time payments and financial responsibility, the FHA loan approval process is often flexible enough to accommodate different people and circumstances. For example, a lack of credit history can be overcome with a non-traditional merged credit report, bankruptcy is not a hurdle if it happened at least two years ago, and past collections and judgments are unlikely to cause concern if they've been resolved or paid prior to closing.

  • lower down payments required

  • lower credit scores allowed

  • fewer reserve funds needed

  • larger income to debt ratios allowed

  • loan relief program for legitimate financial hardship

  • FHA loans are assumable, which can be a good selling point

Lower closing costs

When you purchase a property, you have an obligation to pay all of the closing costs associated with the sale. While these costs vary considerably depending on the jurisdiction, type of property, and type of loan, a number of common fees need to be taken care of before the sale can progress. Typical closing costs include appraisal, application fee, legal fees, credit report fees, property insurance, mortgage insurance, homeowner's insurance, HOA fees, home inspection fees, property tax, title search fees and many others.

While some FHA loans do not actually have lower closing costs, under FHA policy, borrowers can get a lot of help paying these fees. In a typical case scenario, home sellers, lenders, and even builders pay some of these closing costs in order to close the deal and keep the FHA administration happy. This can be a double edged sword, however, with lenders covering costs initially but often charging more interest on the loan. Keep your eye on the total closing costs billed, with 5 percent or more of the home's value likely for some FHA loans.

Lower home repair bills

Just like closing costs, some FHA lenders are able to cover home repair bills under the terms of 203(k) loans. These loans differ from standard home repair loans, however, so it's important to read the fine print before you agree to conditions. While a standard repair loan uses the current appraised value of the residence, FHA home repair loans use the forecast value of the home after the repairs have been completed.

While this loan makes it easier for low-income earners and first time buyers to carry out necessary repairs, the higher appraised value can lead to complications if something goes wrong before repairs are completed. Just like a regular home repair loan, a detailed proposal complete with cost estimates will be required.

Cons of FHA loans

While FHA loans make it much easier for people to enter the property market, there are also a number of disadvantages compared to a conventional mortgage agreement. Generally speaking, an FHA loan is more expensive over-time than a conventional mortgage, with higher insurance costs a given and higher interest rates sometimes used depending on the loan. Borrowers also have to live with a more restrictive lending environment, including strict loan limits, minimum property standards, and tight mortgage terms.

Mortgage insurance

FHA loans are based around mortgage insurance, after all, the inclusion of tight insurance conditions is the only reason why these loans exist in the first place. These loans are riskier than conventional mortgages, with insurers demanding both an upfront payment and a monthly premium for the lifetime of the loan. At the standard rate of 1.75 percent of the total home cost, the upfront mortgage insurance premium (UFMIP) for an FHA loan can be expensive.

As if this wasn't enough, borrowers also have to pay a monthly mortgage insurance premium (MIP), which is the equivalent of private mortgage insurance (PMI) for a conventional mortgage. While mortgage insurance is only relevant for the part of your mortgage that exceeds 80 percent of the home's value, when you're dealing with a 3.5 percent deposit for an FHA loan, this can be a huge figure over time.

Interest rates

Anyone with a mortgage knows how much interest rates contribute to your monthly payments, along with the life of the loan. Generally speaking, FHA loans come with lower interest rates than comparable conventional home loans, although this can differ considerably between lenders. Even when interest rates are lower, the overall cost of your monthly repayments is likely to be higher due to mortgage insurance being used as a form of protection.

Loan limit restrictions

Conventional home loans have no mortgage limits, with borrowers able to take out Jumbo loans when the price of their property exceeds the conforming limits. This same freedom is not available to FHA borrowers, with price "floors" and "ceilings" determined by the U.S. Dept. of Housing and Urban Development based on current market value. While these limits are set carefully for high and low-cost areas around the country, it's important to understand these limits so that they don't restrict you during the house hunting process.

Minimum property standards

Along with a minimum and maximum loan size, the property itself also needs to meet certain construction and quality standards. Before you can get an FHA loan, you will need a property appraisal from an FHA-approved appraiser. While their final decisions is based on set guidelines, there is some discretion as to whether or not something is deemed to be a problem. If the home doesn’t meet the standards set, and the seller won’t agree to the required repairs, you will be responsible for paying the repair bill when it comes to closing.

FHA loans form an important part of the mortgage landscape in the United States. While they are not ideal for everyone, these loans can make it much easier for people to access finance and get a foot onto the property ladder. If you want to purchase a detached house or condo with a compromised credit score or down payment less than 20 percent, an FHA loan may be the answer you've been looking for. While mortgage insurance can be expensive, and certain requirements still need to be met, FHA loans are a great fit for first time buyers and a valuable mortgage alternative.