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FHA Loan Guide: Limits and Requirements

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Young family stands in front of a yellow house.

Buying a home is the biggest investment most people make in their lives. But few can afford to do so with cash, which is why buyers need a mortgage to cover the cost.

At the same time, getting a mortgage isn’t cheap. Many expect they’ll need to pay 20% of the purchase price as a down payment — a dauntingly large obstacle for most people. Fortunately, there are options.

With Federal Housing Administration loans, borrowers might qualify for mortgages with a down payment as low as 3.5%. FHA loans also are easier to get for borrowers with less-than-perfect credit. But they come with limits, so here’s what you need to know about FHA loans:

What Is an FHA Loan?

An FHA loan is a mortgage insured by the Federal Housing Administration. The FHA does not lend money directly but works with private lenders that issue the loans according to government guidelines. Because federal backing reduces the risks for lenders who offer FHA loans, borrowers may qualify with lower credit scores and smaller down payments than are needed to get other types of loans.

This makes FHA loans a good choice for many borrowers, says Jeff Shipwash, founder of Shipwash Properties in Knoxville, Tennesee.

“The credit score requirements are typically lower for FHA borrowers,” he says. “If a homebuyer has less-than-stellar credit and little money to use towards closing, FHA loans are a great option.”

However, FHA loans are not the right choice for everyone, according to Shipwash.

“FHA loans should be avoided by someone who has great credit, and also someone who has funds to contribute towards buying a home,” he says. “FHA loans require mortgage insurance at closing and during the entire life of the loan. If you have an FHA mortgage, you would need to completely refinance it in order to eliminate the mortgage insurance.”

There also are market considerations when taking out an FHA loan.

“If you are placing an offer on a home that has a lot of interest, you will not be competitive if you are using an FHA loan to purchase,” Shipwash says. “FHA has very strict requirements on the properties they finance, and could be a hassle for the seller.”

Learn More: What Is Mortgage Refinancing?

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Types of FHA Loans

There are several types of FHA loans, each tailored to specific needs and situations. The loans you are eligible for — and the loans that make the most sense for you — will depend on your homebuying goals, as well as the type of home that you want to buy.

Fixed-rate mortgage

The fixed-rate mortgage is a basic type of FHA loan. You apply for the mortgage, receive a quote for the interest rate and monthly payment, and can use the funds from the loan to buy a home once you’re approved.

With a fixed-rate mortgage:

  • The interest rate on the loan does not change.
  • The monthly payment for principal and interest does not change. Other costs, like property tax or insurance, may change over time.
  • You can choose the repayment term, which is usually 15 or 30 years.

Fixed-rate mortgages provide certainty, but you won’t have the opportunity to save money if interest rates drop. The only way to reduce the loan’s rate is to refinance your mortgage.

Adjustable-rate mortgage

Adjustable-rate mortgages are another type of FHA loan. One of the main differences between a fixed-rate versus an adjustable-rate mortgage is that the interest rate on an ARM is typically lower than on a fixed-rate mortgage, at least at first. After a set period, the interest rate on an ARM adjusts based on a benchmark interest rate. It could increase or decrease, which in turn changes your monthly payment.

Most ARMs come with minimum and maximum interest rates, so you can estimate best- and worst-case scenarios after the introductory rate expires.

Find Out: Why Are Mortgage Interest Rates Important?

As you shop around for ARMs, you’ll see them described as 5/1, 7/1, etc. These numbers refer to the initial rate-lock period and the frequency of rate adjustments. For example, a 5/1 ARM has an initial rate lock of five years, after which the rate changes once per year.

Reverse mortgage

The FHA also insures reverse mortgages, also known as home equity conversion mortgages. They allow qualified homeowners age 62 and older to borrow against the equity in their homes as a source of income. There are no income or credit requirements, but you must own and live in the property as your primary residence.

You’ll receive payments from the lender based on:

  • The amount of equity you’ve built in your home.
  • The age of the youngest person on the loan.
  • Current interest rates.

The loan must be repaid when you no longer live in the home. Typically, the proceeds from the sale of the home cover this cost, with FHA insurance kicking in if the sale doesn’t repay the loan in full.

Graduated payment mortgage

Graduated payment mortgages are designed for low-income borrowers who expect their incomes to increase substantially in the next five to 10 years. These FHA-insured loans have low closing costs and initially low payments. The monthly payments increase at a rate of either 2.5%, 5%, or 7.5% over the first five years of the loan, or at a rate of 2% or 3% over the first 10 years of the loan.

Graduated payment mortgages can result in negative amortization. That means your payments at the start of your loan term might not cover the interest that accrues, increasing your overall debt.

Growing equity mortgage

Growing equity mortgages are similar to graduated payment mortgages in that they’re designed for people who expect their incomes to increase in the future. The difference is that growing equity mortgages don’t allow negative amortization, so your loan balance will never grow — as long as you make your monthly payments.

Energy-efficient mortgage program

FHA energy-efficient mortgages are for both current homeowners and people who want to buy a home. These loans help cover the costs of energy-efficiency improvements to a property.

To qualify for an energy-efficient mortgage, you’ll need to get a home energy assessment to determine the cost and potential savings of any improvements you could make. Improvements must be cost-effective ⁠— meaning they cost less than the energy they’ll save ⁠— to be eligible.

With an energy-efficient mortgage, you can borrow the lesser of:

  • The cost of the improvements.
  • Or the lesser of 5% of:
    • The property’s value.
    • 115% of the median area price of a single-family home.
    • 150% of the national conforming loan limit, which is set by the Federal Housing Finance Agency.

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Additional Types of FHA Loans

The FHA also offers loans for nontraditional homes.

Manufactured home FHA loans

The FHA offers fixed-rate loans for the purchase of manufactured homes. They typically have a term of 20 years, but there’s a 15-year term limit for only purchasing a lot, and a 25-year term option for the purchase of a multisection manufactured home and a lot.

Borrowers can be lent up to $92,904 to finance a manufactured home and a lot. You don’t need to own a lot for your manufactured home, but you must be able to show that you’ve secured a location to place it after the purchase.

Condominium FHA loans

You can apply for an FHA loan to help with the purchase of a condominium. These loans come with terms of up to 30 years and require a down payment of just 3.5%. Eligible condominium projects must consist only of single-family units and be primarily residential in nature, in full compliance with local and federal housing laws, ready for occupancy, and approved by a local jurisdiction.

Home improvement and refurbishment FHA loans

FHA 203(k) loans are designed to help qualified homeowners and homebuyers rehabilitate a property. Homeowners can get these as stand-alone loans, and homebuyers can add them to their mortgage.

With a 203(k) loan, homeowners can borrow a minimum of $5,000, and up to the lesser of:

  • The value of the property plus the cost of the improvements.
  • 110% of the value of the property after the improvements are completed.

Eligible improvements include:

  • Structural alterations and reconstruction.
  • Modernization.
  • Elimination of hazards.
  • Appearance changes.
  • Plumbing and septic systems.
  • Roofing and gutters.
  • Flooring.
  • Landscaping.
  • Accessibility for people with disabilities.
  • Energy efficiency.

Keep Reading:The Ultimate Guide to Different Types of Mortgages

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What Are the Limits of an FHA Loan?

The Federal Housing Administration sets limits on how much can be borrowed with an FHA loan. These limits are based on the location of the property, as well as the number of units that it contains.

The FHA sets both a floor and a ceiling for loan amounts. The floor is the limit that applies in low-cost areas, and it equals 65% of the national conforming limit. The ceiling applies in high-cost areas and is 150% of the national conforming limit. There are exceptions to these limits for loans outside of the continental U.S.

For 2021, the national conforming limit is $548,250, which makes the low-cost limit $356,362 and the high-cost limit $822,375 for a single-family home.

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Is an FHA Loan Right for You?

FHA loans are a suitable choice for many homebuyers, but it’s important to understand the pros and cons before moving forward.

Advantages of FHA loans

  • Low down payment requirement.
  • Many loan options are available.
  • Loans available for nontraditional properties.

Disadvantages of FHA loans

  • Requires mortgage insurance.
  • Lower down payments result in higher monthly payments.
  • FHA loan limits might not be high enough to buy a home in expensive areas.

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How Do You Qualify For an FHA Loan?

There are specific FHA loan requirements that potential borrowers must meet to qualify for a loan.

Credit score requirements

To qualify for an FHA loan, borrowers must have a FICO credit score of at least 500, though those with a score of 580 or higher may get better terms.

Related: How To Buy a House With No Credit

Down payment minimums

The minimum down payment for an FHA loan is based on the borrower’s credit score. Borrowers with credit scores between 500 and 579 must make a down payment equal to 10% of the home’s value. Those with scores of 580 or higher can qualify for a loan with a down payment of 3.5%.

Debt-to-income ratio

After accounting for the impact that the mortgage will have on the borrower’s debt-to-income ratio, they must have a DTI under 50%.

Property approval

The FHA only offers loans for certain types of homes. To qualify, you must be an owner-occupant of the home you’re purchasing. The property must also have no more than four units.

Mortgage insurance premium

All FHA loans include mortgage insurance, paid by the borrower. These payments include an upfront premium of 1.75% of the loan amount, and an annual premium that ranges from 0.45% to 1.05%of the loan amount, depending on how much you borrow, your loan term, and the down payment.

Unlike private mortgage insurance, FHA mortgage insurance cannot be removed from the loan by building equity. Instead, how long you’ll pay insurance varies from 11 years to the full term of the mortgage, depending on the loan amount, loan term, and down payment.

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How To Apply For an FHA Loan

If you want to apply for an FHA mortgage, follow these steps.

1. Find FHA-approved lenders

The FHA only works with approved lenders, which must meet strict requirements to offer FHA loans.

The Department of Housing and Urban Development maintains a searchable list of mortgage lenders, which you can use to narrow down your options. You also can try a mortgage calculator to estimate the cost of a loan before you apply.

2. Submit applications and documents

When you apply for a mortgage, you must fill out a detailed application. Lenders also will ask for documentation to support the information you provide on the application form.

Some of the documents that mortgage applicants can expect to provide include:

  • Address or addresses for the past two years.
  • Social Security numbers.
  • Employment history for the past two years.
  • Gross monthly income.
  • Information on financial accounts.
  • Total approximate value of all property.
  • If an applicant is self-employed: two years of tax returns, income statements, and balance sheets for their business.

3. Compare loan estimates

Each lender will give you estimates for the loan you’re trying to get, including the interest rate, closing costs, and monthly payment. Make sure to apply for loans from multiple lenders, so you can compare options and get the best deal for your situation.

4. Schedule a home inspection and an appraisal

Once you’ve made an offer on a home and it’s accepted, you’ll need to schedule an inspection and appraisal to make sure the home is in good condition, and that it’s worth enough to secure your loan. If the home appraises for too little, you may have to make a larger-than-expected down payment, or pass on purchasing it altogether.

Don’t Miss:The Ultimate Home Inspection Checklist for Buyers

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The Bottom Line on FHA Loans

Buying a home is a big undertaking, as well as a major, long-term financial commitment. For many people, the obstacles to affording a home would be nearly impossible to surmount if FHA loans didn’t exist. Low down payments and generous requirements make FHA loans a great option for those who need a little extra help to make their homeownership dreams a reality.

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