All About FHA Loans

MARCH / APRIL 2002

Buyers have a wide array of financing options when looking to purchase a home. There are more opportunities than ever before to find a suitable financing option to get into a new home. One option that has been around for a long time is an FHA loan. FHA is short for Federal Housing Administration, which is a branch of the Department of Housing and Urban Development (HUD). The loan may be referred to as either an FHA loan or a HUD loan, and is a good option for a buyer who is short on cash.

The first thing one should know about an FHA loan is that the money does not come from FHA or HUD. The loans still come from many of the same lenders that do Conventional loans. FHA loans are instead INSURED by FHA or HUD. This insurance makes the loan very safe for lenders, so it enables the lenders to provide the loans at lower cost to the borrower.

There are misconceptions about FHA loans. One misconception is that it can only be used by first-time homebuyers. While closing costs are slightly cheaper for first-time buyers, an FHA loan is available to everyone that meets the other FHA guidelines. Guidelines for the buyer/borrower include having an acceptable ratio between their debts and their income. The normal debt ratio for an FHA loan is 29/41. This means that 29% of their gross monthly income (before taxes) can go to their house payment, and 41% of their gross monthly income can go to ALL of their debts, INCLUDING the house payment. FHA and lenders figure that the other 59% will be needed to cover income taxes, food, utilities and other living expenses. If someone has excellent credit, the debt ratio can sometimes be bent slightly.

The amount of money someone can borrow is also limited by a loan ceiling. The ceilings on FHA loans vary from county to county, based on the cost of purchasing home in that particular area. It is important to note that the ceiling is on the amount of the loan, NOT the purchase price. If a buyer was in a county with a $250,000 loan ceiling and wanted to buy a $650,000 house with an FHA loan, it would be POSSIBLE to do that, as long as the buyer was able to produce the other $400,000 in cash. This is not practical, however. If a buyer has that much cash available, they are probably better off using a conventional loan.

FHA loans are ideal for someone who does not have a lot of cash on hand. The downpayment can be as low as 2 ¼%, and the buyer may be able to finance some of the closing costs into the FHA loan. There is a Mortgage Insurance Premium (MIP) that must be paid, both at settlement and as part of the monthly payment. This can be stopped when the borrower has 20% equity in the house, and will be stopped automatically when the buyer has 22% equity, assuming the borrower is current on their payments.

Another misconception that has floated around quite a bit is that a buyer using an FHA loan does not need a home inspection. This is bad advice that has unfortunately been passed on quite a bit, sometimes by real estate agents. There is a conditional appraisal, meaning the appraiser has specific items in the house that they have to look at to determine if the house meets certain standards. This would include peeling paint (there can’t be any peeling paint in the house), loose and missing railings and electrical systems. The conditional appraisal is no substitute for a home inspection, and NEVER has been. The appraiser skips over many potential defects that a home inspector would probably find. Because it was becoming such a problem, several years ago FHA required an addendum be added to FHA contracts on the importance of getting a home inspection.

There are various types of FHA/HUD loans. The most common type is called the 203B, which can be used for a 1 to 4 family residence. Another is the 203VET, which is for U.S. military veterans only. VA loans have strict credit standards that some veterans might not qualify for, but they may still get some benefit of being a veteran through this type of loan. One more type is the 203K, which allows the borrower to finance repairs to the property along with the purchase price. This is more complicated, but it’s a great loan for fixer-uppers.

One last requirement from FHA is that the borrower must live in the house. This loan program is not set up to help investors. It is there to help give people a home to live in. If the building is a 2, 3 or 4 family residence, the borrower would have to live in one of the units.