FHA Loan

It is a government-backed mortgage insured by the Federal Housing Administration

Author: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Reviewed By: Andy Yan
Andy Yan
Andy Yan
Investment Banking | Corporate Development

Before deciding to pursue his MBA, Andy previously spent two years at Credit Suisse in Investment Banking, primarily working on M&A and IPO transactions. Prior to joining Credit Suisse, Andy was a Business Analyst Intern for Capital One and worked as an associate for Cambridge Realty Capital Companies.

Andy graduated from University of Chicago with a Bachelor of Arts in Economics and Statistics and is currently an MBA candidate at The University of Chicago Booth School of Business with a concentration in Analytical Finance.

Last Updated:October 1, 2023

What Is a Federal Housing Administration (FHA) Loan?

As stated by Bankrate, a Federal Housing Administration loan (FHA), an FHA loan is a government-backed mortgage insured by the Federal Housing Administration. 

These loans allow potential/desired homeowners to qualify for their dream home without putting the traditional 15%-30% as a downpayment.

The program is ultimately made to assist people with lower credit scores and lower sources of income. The minimum credit score required is 580 and can get as low as 560.

Moreover, and most importantly, you are allowed to put as low as a 3.5% down payment on your new dream home.  

The program has been active since 1934, a few hundred years that this program has benefited the lives of lower, middle, and even upper-class individuals.

Fun fact: FHA’S 2020 annual report states more than 83% of all Federal Housing Administration loans were borrowers purchasing their first home.

FHA Loan Pros and Cons

A few of the pros and cons are:

The pros are:

  • As mentioned earlier, you can carry a lower credit score than normal (580 or higher). 44% of Americans currently struggle with credit card debt, so as you can see, this magical program can benefit a lot of first-time home buyers.
  • In a conventional mortgage, you must have a minimum 630 credit score or higher; therefore, the loan can be extremely beneficial.
  • Down payments can be as low as 3.5%. For example, if a home costs 500K and you need to put 3.5% down, your required cash out of pocket would be $17,500.
  • You can build up a real estate portfolio by using the loan: it requires you to live in the home for at least one year. 
  • Once you have done that, you can purchase another property using the loan. Most investors typically buy multi-family homes using this loan; they live in one unit and rent the other units out to tenants.

On the other hand, the cons are:

  • To the bank, you are considered “higher of a risk .” So, although you got approved for the Federal Housing Administration loan to acquire a house, your credit score is still lower than recommended by the banks.
  • You cannot purchase a house in any given condition. New investors think they can use the loan to put down 3.5% on a fixer-up property and make a huge profit, but that is not the case. It has certain property requirements that you have to meet to qualify for the loan. 
  • If the market is considered a “seller's market,” sellers will usually turn down or view Federal Housing Administration offers as less favorable due to the volume of offers sellers typically receive.

Other types of FHA loans

Some of the types are:

1. 203(k) loan

FHA 203(k) loans assist homebuyers with purchasing a property that requires a substantial amount of work done to the home. It is important to note that the 203(k) loan is specifically appealing to newbie fixes and flippers.

3.5% as a downpayment is still sufficient, and the loan allows you to refinance your investment into a brand new loan. 

  • The home must be totaled at $35,000 worth of needed home improvements. As with all government-backed loans, there are stringent rules and regulations when securing these loans.
  • After improvements on your new home are all said and done, the property's value must meet the Federal Housing Administration mortgage limit for the specified area/neighborhood.

2. HECM

  • Home Equity Conversion Mortgage (HECM) is designated for Americans who can pull out pure equity from their homes and do as they please with the funds. 
  • The loan is geared towards older homeowners.

3. Section 245(a) Loan

  • Although this loan exists under the Federal Housing Administration programs, this is not one you will see individuals use very often.
  • This loan aims to start a person off with lower monthly payments and then increase over time.
  • This loan is for individuals who know their income will increase indefinitely, hence the lower mortgage payments in the early stages of their career. Then payments increase as the individual's income rises.
  • Federal Housing Administration 245(a) requires you to occupy a home as the primary residence. It is important to note that the home cannot be used as an investment property. 

4. Federal Housing Administration Energy Efficient Mortgage

  • Like the 203(k) loan, the energy-efficient mortgage is aimed at homeowners looking to lower their utility bills.
  • Examples of this would be a homeowner who wants solar-powered energy for their home and upgraded energy-efficient appliances.
  • The purpose of this loan is to cut total operating costs for the owner, and the government is all for it.
  • This loan is perfect for the ideal owner who does not have the upfront capital to apply these changes to their home.  

Cost of Federal Housing Administration Mortgage Insurance

When it comes to insurance, anyone with a solid head on their shoulders is aiming for the best rate possible. 

One thing about the Federal Housing Administration mortgage insurance is that they require an upfront premium fee (which can be added to your monthly mortgage payment). However, the upfront fee would not be necessary when choosing the conventional mortgage route. 

The upfront fee for the FHA route is roughly 1.5%-2% of your total loan amount, and the monthly fee depends on the home's value in your given market.

The reason is that while you have been granted approval by the banks to acquire the FHA loan, in hindsight, you are not fully trusted by the lender.

The individual would be required to pay insurance payments on their property when it is anything less than 200%-25% down on a home. 

Minimum Property Standards

Any business transaction is always a give-and-take scenario. What is meant by that is there is always a risk when it comes to investing, especially when buying a home, which is considered the American dream for most people. 

Although you are purchasing the home as your primary residence, and essentially this new home is where you will raise your family, the property serves as collateral for the loan. 

Therefore, when you take out a mortgage and purchase the home, the minute you stop making payments on that home, you are at risk of the bank foreclosing the property.

In other words, the bank will kick you to the street if you stop making payments. 

This is a necessary process when acquiring an FHA loan. Even though this sounds simple and makes sense, the FHA makes this very clear when lending funds when house seekers are looking to purchase a home. 

However, even though the lender is protected in this case, the loan protects the borrower. 

The protection, in this case, is the loan itself: homeowners will be saving themselves the cost of repair bills, maintenance, and major renovations from the start.

Conclusion

We've touched base on a lot in this article, and the most important thing to take away is that FHA loans are the easiest and most convenient way to purchase a new home, especially your first one. 

Although it is easy to put 3.5% down on your dream home, the requirements to meet tend to get frustrating, especially for first-time homeowners.

The frustrating process is indeed worth it, and 46% of Americans can agree with that because that's the statistic shows how many Americans purchased their first home through this government-backed loan.

Americans know what they are getting into when applying for and securing this loan. Even though 46% of Americans purchased their home through this loan, the statistic shows that 46% of those Americans are middle-class earners.

That said, although the process is frustrating, more than half of the nation can not afford any other way to purchase a home.  

The process is tedious, but it is much better than dropping 20%-30% on a home, especially if the potential homeowner is a middle-class earner.

If the property being viewed does not match Federal Housing Administration requirements, we move on to the next property until we do. You must remember that buying a home is a tedious and lengthy process.

However, it is the home you will be raising your family in and pulling out a 30-year mortgage from the bank.

Researched and Authored by Tarek Emam

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