FHA loan is a fantastic option not just first time home buyers, but anybody who's looking to buy a home and wants a low down payment option with a lot of flexible credit options. So if you have credit, that's even all the way down to a 500 credit score, you could go FHA. There are many facets of FHA and choosing the right loan is going to help you save the most amount and help you Win the House you Love!
So let's talk about FHA loan. FHA loans are insured and backed by HUD (Department of Housing and Urban Development). Now, what do we mean by insured? This means that the property under FHA is insured for lenders. So basically what it's saying is HUD is going to come in and they're going to insure the loan that way.
If somebody defaults on a loan or goes into foreclosure, they're going to give the lender the property back. It may not do anything to protect you, but since lenders have less risk and they can pass on some cost savings to you, the loans can be a little bit more risky. What that means is they'll lend on a lot more difficult loans that may be a conventional loan wouldn't allow. Lenders can be a lot more flexible than that other types of loan programs because they are insured.
FHA started to help people who couldn't qualify for conventional. Conventional started out at least around 43% Debt-to-Income ratio and needing 20% down. Most people couldn't fit in that box and that's the reason why FHA was created.
No, this is not just for first time buyers. This is really for anyone who wants an FHA loan. There are construction loans available but we're not going to cover that in here because the qualifications to get a construction loan, to purchase land, and build a home as with purchasing existing home is standard.
Now, FHA tends to be for the lower to mid-credit scores. Low would be on the 500 range and mid would be on the 600 range.
However, FHA is not long-term because it has really costly mortgage insurance. It can be a good option short term, but the long-term probably isn't your best option with financing. And also, FHA loans tend to be overlay stacked. So basically the way overlays work is FHA sets out their guidelines and that's their base rules. Then, lenders are allowed to tighten those up if they want to. They can add rules on top of the rules that FHA already has and this is what's called an "overlay". FHA loans tend to have a lot of overlays with them because they have pretty lenient standards in which the lenders want to take on less risk. A good example with COVID is that the minimum being 500 and a lot of lenders saying that the minimum is now 640.
So let's talk about some COVID changes that have happened here with FHA. One of the biggest changes that I've seen with this pandemic is that lenders have an overlay. Not all lenders, but most lenders are put on a relay that says the minimum credit score is 640. And I even see people making videos saying, the new minimum credit score for FHA is 640. That is not true at all. It still goes down to a 500 credit score. It's just that some lenders are choosing not to do that with COVID. Actually, most lenders are choosing not to do 640. Also if you're self-employed, FHA wants evidence of ongoing work or current work in your organization. So they want some sort of proof that you're going to continue seeing income coming in with COVID.
And also this is an overlay here, but future income used to be allowed with FHA. Meaning that you could purchase a home with a job offer and not be working there yet. However, with COVID most lenders are not allowing that they want to see you at work. Normally enough to collect anywhere between two to four weeks worth of pay stubs, to be able to qualify for a loan.
About down payment and closing costs, the minimum down payment is 3.5% and the down payment is actually tied to the credit score.
You're allowed to use collateralized loans like a 401k loan or a home equity loan to be able to qualify for the down payment and closing costs. However, you can't use unsecured loans. We can't use a credit card, that's not allowed. We also can't use a personal loan for down payment or closing costs. However, we can use a family member loan that can be either secured or unsecured, meaning they can either have a claim to the property or no claims to the property with that type of loan from a family member. Also, we could get a gift from a family member to go towards our closing costs or down payment. If we need some help.
There are also local down payment assistance programs and national down payment assistance programs where you're going to get help to pay for your down payment or some of your closing costs. The issue here is that they can be costly and I rarely seen a down payment assistance program that is more beneficial for a buyer than if the fund the loan themselves, paying their own down payment, their own closing costs on their own which is something to be mindful of here. Meaning, So credit requirements in down payment, go hand in hand with FHA.
So it goes all the way down to a 500 credit score, which is crazy because you know, it's hard to find loans or lenders who will go down to a 500, but FHA does. And if you're struggling to find a lender, who's not going down to 500 with FHA, you may want to shop around to find a lender that will help you out there. So if you have a 500 score up to a 579, you're going to need to put 10%. And if you have a 580 plus, then you can do 3 1/2 % down.
Now FHA is one of the most lenient types of major loans. If we're talking about Conventional, FHA, USDA, VA, it's one of the most lenient types of those loans and it tends to be best for scores below 680. So technically you could qualify for a conventional loan if you have a 620 score. However, what I've found is even if you can qualify conventional, if you have below as 680 FHA is probably going to be a better route for you short term, then you can build your credit score and refinance into a conventional loan.
Normally, that's going to give you the best mix, the best loan strategy moving forward instead of just holding onto an FHA for a long period of time or getting a conventional loan with a middle credit score. That's going to cost you a lot of money because you're going to penalize with the interest rate.
So FHA loans are more forgiving on revolving and installment lates. They normally let you have around two late payments within the past 12 months on revolving accounts and normally one installment late within the past 12 months. Ideally you would have none, but FHA can be a little bit more lenient.
Also as far as like non-medical collections greater than $2,000 total, again, this is nonmedical. You either need to have one of these three remedies, either a payment plan. It needs to be paid off, or 5% of the balance is going to be calculated in your debt-to-income ratio. And this is going to shrink how much you can qualify for with a new home.
So here's some waiting periods that you might need to wait for. So if you've had a deed in lieu of foreclosure, a short sale, you need to wait three years from the deed transfer of those events. If you had a chapter seven bankruptcy, you'll need to wait two years from the discharge, and if you've had a chapter 13 bankruptcy, you need 12 months of on-time payments and court approval to be able to get into an FHA loan.
Now rates with FHA actually are really low. This can trip people up because they think why in the world is FHA having such a lower rate. And that tends to actually have lower rates than conventional. The reason why there's lower rates is because it's backed by the government.
Now what offsets these low rates is high mortgage insurance cost. So rates are similar to USDA and FHA. Brokers are going to tend to have better rates on FHA loans. And the reason why is because legally they can't take a difference in the risk-based pricing and pocket themselves like someone like a direct lender or bank could.
It doesn't mean all of them, all banks or direct lenders do that. But for the most part, if you're using an FHA loan or any government loan for that matter, brokers tend to have lower rates. And it's going to be easier than conventional to get lender credits if you need to.
A lender credit is where you would increase the rate slightly to receive a credit towards your closing costs. Again, because FHA loans are insured and backed by the government lenders take on less risk, meaning you can get a lower rate, meaning that there's more flexibility for the lenders to give you money towards your closing costs, if you need it. So they would increase your rates slightly to give you a credit towards your closing costs. Again, that's only if you want it only if you need it.
Mortgage Insurance is one of the most costly things about FHA. It is one of the biggest downsides of FHA. FHA gives us so much leniency and flexibility with how we set up this loan and who can qualify for it. But the big downside though, is through mortgage insurance. Mortgage insurance is what funds FHA's ability to insure a loan for the lender.
So FHA has two types of mortgages. Number one, there's upfront mortgage insurance. This is 1.75% of the loan amount, it's not paid upfront, but it's going to be wrapped back into your loan. So if we were purchasing a $300,000 loan, the mortgage insurance costs upfront would be $5,250. So instead of taking out a $300,000 loan, we're actually taking out a $305,250 loan. Then, also we have a mortgage insurance premium. This is similar to Conventional's PMI (Private Mortgage Insurance) on Conventional. It's basically the same thing on FHA, except they call it a mortgage insurance premium it's 0.85%.
So that would actually be $216 per month on a $300,000 loan. So FHA can have pretty intense mortgage insurance. Also, mortgage insurance that doesn't change based on the buyer. On a conventional loan, the higher your credit score, the less risky your loan is the lower your mortgage insurance. On FHA, it does not matter if you have a 500 credit score or an 800 credit score, your mortgage insurance is always going to be the exact same cost with both of these types of mortgage insurance.
Your mortgage insurance will not fall off at 20% equity. No matter how much you put down, they do not go off of equity with if your mortgage insurance falls up. In fact, it's going to stay on for the entire life of the loan, unless you put 10% down, then it's going to fall off after year 11.
This is why FHA is not a good long-term loan option, but it can be a really great short-term option. And FHA actually works really well for people with low to mid-credit scores to purchase a home work on their credit, and then refinance into Conventional.
For property requirements, this has to be a primary residence for a minimum of one year. You need to live in the home for a year and then you can decide if you want to rent it out. Now, obviously, you can sell any time you want. You can go purchase the home and sell it two weeks later. That's no problem at all, but you need to live there for a year if you're going to choose to rent it out and not.
House hacking is allowed. This is really common with FHA loans. House hacking is basically a way of using primary residence loans to try to generate some sort of rental income from them. So a good example with house hacking would be , you can purchase up to two to four units and live in one unit and rent out the other units. That's still primary residence cause you live in it, but you're getting rental income from the other units. Another example is I purchased the home 3.5% down, I live in there for a year and then I rent out the property and I go purchase another home.
All right. So I still have the FHA loan that still stays on there. Where I have the lower interest rate, I didn't have to put a huge down payment for an investment property, but I now have rental income after a year of living in the house. So 75% of rental income is considered to go to offset your mortgage payment.
That's, if you have other homes or if you're renting out other units. Something that can be really tricky with FHA loans is if you're looking at a condo, it has to be on a FHA condo approved list. This is where each condo individually is vetted for their financial viability, which most condos can be pretty mismanaged financially.
And if you're you're looking at is not on that list, you can have an individual approval, but it takes a long amount of time. And good chances are, if it's not already on the FHA approved list, it probably won't qualify to be an FHA approved condo. It's not always true, but FHA only wants to fund loans for condos that have good financial management. They don't want the condo association to go under that way. They then have to go pay for that loan if it results in a foreclosure.
There's also a Property Flip Role with FHA. If you're looking at single family home, you're buying it as a primary residence. You're not going to run into any of these weird situations, but FHA is so flexible that people like to do a lot of things with it. So it's going to clear up what it can and can't do. So with the property flip rule it's basically saying there's a 90-day period when you purchase a home.
So they're the seller and they'll say they purchase it today, and then they flipped it. Two weeks later, we want to go buy it with an FHA loan, that is not allowed. We have to wait 90 days from a sale to a new transfer of the deed to us. FHA doesn't let these flips happen that quickly. The only exception is if it's being sold by HUD itself, or there's a couple of other situations where you'll barely ever run into these situations where you can get around this rule, but for the most part, if the home was already transferred, title less than 90 days ago, you're going to have to wait out that 90 day period to be able to purchase it with an FHA loan.
So let's talk about some example homes. First, have a home in Columbus, super nice home. Just remodeled fits under our loan limit, which we'll talk about here in just a little bit, but $315,000, four beds, three baths, almost 2000 square feet. If we purchase this with an FHA loan, we'd be looking somewhere around $2,200 per month as a payment, including taxes and insurance and all of that stuff with 3.5% down.
We also have another example. This one is in San Diego, California. Again, this is under the loans limit and it's $725,000 is four bed, three bath, 2000 square feet. And we'd be looking closer to $4,260 per month payment on FHA if we did 3 1/2% down. FHA has loan limits, meaning you can't purchase a home with FHA above that limit. Now there is a link to the lookup in the description you'll put in the county that you're looking to buy in, and it's going to show you what that loan limit is for that county.
So the new base limit is $356,362 and an increase of over 24,000 from last year. And the way that you calculate what your max purchase price is you take the loan limit, divided by 0.965, and that's going to show you how much your purchase price can be. So keep in mind when you see that number, like 356,000, that's not your max purchase price, that's your max loan.
So we have to do a little bit of math to reverse it and figure out what our max purchase price is then with 3.5% down, that's our max loan. So just take the loan limit, divided by 0.965, and that's going to give you the max purchase price.
So we can see here with our low cost areas and high cost areas what FHA has decided is their new loan limits for 2021. And again, you don't have to really worry about this too much. Just look on that link in the description, put in the county that you're looking in and that's going to give you really detailed information about that specific county.
So appraisal requirements, this is one of the really difficult parts about FHA is they can be pretty tight about what they want as far as the appraisal. So an FHA appraiser is going to come out and they're basically going to see if it meets the standards of an FHA loan. And there are a lot tighter than conventional. So FHA is mainly about what they call health and safety and they can take this to a bit of an extreme, but they want to see structural soundness think of a home that's going to be move in ready.
If it has work that needs done most likely, you're going to need some sort of like a FHA rehab loan to make that work. It's most likely not going to qualify FHA if it needs some work done. And it is stricter than conventional because it's government insured. Again, they don't want to have to pay out to a lender if there's big issues. So that's why they have all these tight restrictions upfront.
So here's some common issues that you may run into. That's going to be called out by FHA: broken glass, chipping paint. These are two huge ones. I see these all the time on FHA appraisals, when the appraisers goes in and says, "Here's chipping paint".
We have to get this fixed before it can be funded with FHA. Plumbing issues, exposed wiring, broken HVAC, rotting, wood, and wet basement or crawlspace. These are some of the big things that it keeps seeing come up on FHA appraisals that need to be fixed. If you have a good real estate agent, they should be able to spot these things before an appraisal happens.
The last thing you want is an appraisal to happen, and then you have to get something fixed and then repay for re-inspection fee, which is going to be around 200 bucks to have an appraiser go out again and make sure that those repairs are fixed.
For employment, FHA wants two year history of stable employment. Now, they even specify there is no set length of time at a specific job. So it doesn't mean two years at one job. It means two years history is what they want to see. They want to see that over the past two years that you can be employed, that you can make a consistent amount of income and your income isn't this big, rollercoaster going up and down. They want to see some sort of consistency with your employment. And even if you change jobs frequently, as long as it's within the same field, that's perfectly fine. You can change your job six times within the past two years, as long as it's within the same field.
So let's say you worked as a teacher for six different schools. Maybe you had a move in between there that's perfectly fine, or you work for six different plumbing. Perfectly fine. Those are in the same line of work there. We don't have to be at a specific job for a set period of time. However, the longer we're there, the easier it is for an underwriter to use the income in a more consistent basis. It is ideal to be in a similar field, if you're changing jobs.
Now Debt to income ratio, this is going to change how much we can afford for a home. Again, this is keep in mind. This is all about what a lender would qualify you for and not what you should take out. There's a huge difference between what you could get approved for and what you should take out for a loan, just because a lender is going to give you money doesn't mean you should take it. A lender is not a financial advisor, you are your own financial advisor, and you have to be in control of your budget.
Just because someone says here's a loan for $400,000. It doesn't mean it's a smart choice for you. The bank is going to willing to give you a lot more money than you probably should take out. You just have to keep that in mind.
So there are two different types of debt-to-income ratios and debt-income-ratios are just showing us how much in debt do we have compared to our income. So a front-end ratio is where we take the future housing payment, how much we might spend monthly on a home divided by our income.
So if we had a hundred thousand dollars per year income in this could be as a household, or this could be individually. FHA will allow us to do 36.99% front end ratio. That's the maximum that they'll allow. That's a $3,000 monthly mortgage payment that they would allow on a hundred thousand dollar income. That's pretty significant on a hundred thousand dollars income.
Our back end ratio goes up to 56.99% on FHA, meaning that you can qualify for up to $4,750 per month in total debt. A hundred thousand dollars per year income that's $8,300 per month. FHA says that even based on $8,300 per month, gross, they'll allow you to have almost up to $5,000 per month in monthly debt payments.
FHA has so much leniency there. Again, just because someone will give that to you doesn't mean that you should take it on. So if we wanted to max out on an FHA loan, we could purchase a home that's $3,000 per month and have an additional $1,700 per month in monthly debt payments like payments to credit cards, student loans, auto loans, all of that stuff here.
Student loans, FHA can be a little bit tricky. Mainly because of, they do not allow IBR. So IBR is just Income-Based Repayment basically where your monthly payment is going to be based off of your income and not necessarily the loan balance itself. So conventional loans allow you to use income-based repayment.
If your income-based repayment is $0 per month, right now, meaning you pay $0 per month on your student loans, on FHA, they're actually gonna make you use 1% of your balance in your debt to income ratio. So if we go back to looking at these front end and back end ratios, having student loans is going to probably significantly reduce how much we can afford.
Cause if we took an example of, let's say we had $40,000 in student loans, that's a $400 per month debt payment that we have to include in our debt income ratio. And your lender is going to do this for you. But it's just helpful to know that if you are on income-based repayment, conventional might be a better option for you if you're tight on your debt-to-income ratio.
Now, FHA is interesting because it allows what's called manual underwriting. Most of what we talked about so far is all through what's called an automated underwriting system. And this is basically where it's a computer software that all lenders have access to and they're taking all the information about you and your loan and running it through a software that says you're good to go, or you're not good to go. If the software comes back and says, Hey, this has too much risk for the software to actually give an answer on. You can do a manual underwriting.
A manual underwriting requires a lot more documentation, a lot more work, normally a higher interest rate and a couple other things that can be a little bit more difficult and it will also change our ratio. Here for how much we can qualify for with what's called compensating factors. So I know that sounds a little bit tricky here, but your lender is going to take care of all this for you. But it's just helpful to know that this is an option for you.
So a good example would be, let's say we went to go apply for an FHA loan and the underwriting software kicks back and says: "We can't give this approved." So we can talk with the lender that does manual underwriting.
And let's say our credit score was 580 and above. Our debt-to-income ratio is going to be capped at 40 and 50% front-end and back-end ratio. And we also need two of the following. We either need cash reserves, meaning extra money in the bank after we close we need a minimal increase in housing payment, we need additional income not reflected in our application, or residual income meaning a lot more income left over compared to our debts. So basically, we don't get overwhelmed by all the details here. This is your lender's job, but it's helpful to know that there are extra ways.
What to do if a lender says that you don't qualify
If a lender comes back immediately and says, you're not qualified ask them about manual underwriting. Ask if that is something that you could qualify for? And if they say no, it's something we can't do, then maybe you look at another lender who does do manual underwriting. That way, you can get an additional opinion, an additional view with FHA, and if you can qualify.
Now, seller credits are when you ask the seller to pay a portion of the purchase price towards your closing costs. This is negotiated when you get under contract. FHA will allow you to ask for up to 6% of the purchase price. So on a hundred thousand dollars purchase price, you could ask for up to $6,000 towards your closing costs on a $200,000 home, we could ask for up to $12,000 towards our closing costs and your closing costs are probably never going to be that high, but it is what FHA does allow here for what you can ask as a maximum. So some social requirements and features. We did talk about house hacking. This is super common on FHA loans kind of in the investing world a little bit.
Also, there is a hundred dollars down HUD REO program. Meaning, if you're purchasing a home from HUD and you can go, you can just Google the HUD home store, find homes there. You can actually do a $100 minimum down payment instead of 3.5. HUD basically says, Hey, if you buy this home from us, meaning it was a foreclosure, it wasn't FHA foreclosure. Instead of doing a three and a half percent down, you can just do a hundred dollars down.
There also is a 203K Rehab loan meaning if there is a home that needs work and it's not going to qualify through an FHA appraisal, you can actually finance the rehab costs inside of the FHA loan. You're going to run into higher rates. It's going to take a longer time to close. It can be a more complicated process, but it is an option that you have available to you. Also FHA is really common as in my mind, a bridge strategy. Now no one else calls it that I call it that personally when I'm talking to clients, but anytime I run into somebody who has a lower to mid credit score and say, we're probably going to need an FHA loan to get you qualified for this house.
What I recommend is that they qualify with FHA to get the home. Then they work on their credit score. Ideally within two to three years, I'd like them to refinance into a conventional loan with a higher credit score. And I call this a bridge because in my mind, FHA really is only good as a short-term loan.
I shouldn't be holding an FHA loan for longer than, personally. Five years is even getting to the point where it's like a, we're holding onto this for a little bit too long. So, FHA is going to be given in 30 year terms, 20 year terms, 15 year terms, but you shouldn't be holding it on to it longer than five years. I think.
What would be best is if you need to qualify with FHA, maybe because your credit is a little bit lower or you have a high debt-to-income ratio then get that loan. That's perfectly fine, but now we need to work on a game plan to refinance into a cheaper loan in the future.
There's also a down payment assistance programs that you can find. Again, they're going to be a little bit more costly. It's going to be a longer process to go through than just going, funding the down payment yourself. But it is an option that you have available to you.
Now, refinancing after you get this FHA loan you can refinance through a process called streamlines, called an FHA streamline refinance. And this is actually really nice if you want to take advantage of a rate. A good example would be if you purchase a home with FHA last year, maybe your rate was closer to 4% well interest rates have dropped significantly. And now it's closer to high 2%.
So instead of doing a refinance where you need to recheck credit, recheck income, recheck the appraisal and get the whole process done again, FHA allows what's called a streamlined refinance. This is where they don't have to check credit. they don't have to check income and they don't have to check the appraisal. You go through a refinance that's cheaper and a lot easier of a process. You can probably get this done within two weeks. And it's just going to take you to a lower interest rate.
Now, you can also refinance from FHA to a Conventional loan. Now they're going to have to recheck income, recheck credit, and recheck your appraisal but the ideal goal is that you had a higher credit score. So now you can move into a conventional loan that is going to be cheaper for you long-term and or you can remove that mortgage insurance premium when you hit 20% equity and loan. Because again, keep in mind for most people, mortgage insurance is not going to fall off on an FHA loan and eventually we'll want to get right.
So now let's walk through a cost comparison. A lot of people just don't talk about the comparison of costs with FHA. So we're going to compare this with a 640 credit score.
Now, 640 is interesting. Technically the minimum for a conventional loan is 620. So with 640 score, there's a good chance that we could qualify in Conventional. However, conventional tends to be better for people with a 680 score and above. And in fact, conventional loans tend to penalize people who have below a 680 score with a higher interest rate and higher mortgage insurance.
And so what I recommend for people is even if they can qualify for conventional loan, if they have a mid 600 score FHA short-term. It's probably going to be a better option. So let's run through an example here. So we can see conventional we're we're comparing is a $300,000 property. We can see the down payment on each, so conventional is 5%. FHA is 3 1/2%. We can also see the interest rate, how significantly lower the interest rate is on FHA. Again, because conventional tends to penalize those middle to lower credit scores. Even though they technically can qualify. Also our mortgage insurance cost is significantly cheaper by about a hundred dollars.
We can see this monthly breakdown in an estimate of taxes and insurance. But looking at this chart tells us a lot about these as well. We can see if we took a 640 score and we went conventional over a period of 20 years we would be saving $73,000 by going with FHA.
Now what this doesn't account for is you increasing your credit score and then getting a conventional loan. But what ends up happening is we can see FHA is actually a cheaper option, even though it has mortgage insurance, because we get such a lower rate on FHA. It's a cheaper option. If we have low to middle credit.
Now, ideally the best thing to do would be to get the FHA loan, take advantage of the cost savings within this period, take advantage of the cost savings here. And then when your credit has increased, that's where we want to refinance to conventional.
And when we refi to conventional this, we're not going to get this conventional loan. We're going to get a conventional loan that's probably going to be charting closer like that. Well, we're going to get a lot more cost savings compared to FHA because we have a higher credit score, which is what conventional loans tend to want.
Now let's also talk about the seller perception because when we're using loans, it's really important to keep in mind. How is the seller perceiving our offer? Because it's, we're not gonna have a good chance of actually getting home. If we come in with bad financing. So sellers see FHA loans is less attractive than conventional, however, more common than other types of loans like VA and USDA. If you are coming in with a FHA loan, it is good to maybe ask for less seller credits, maybe to ask for a shorter closing time do things that would make your offer a little bit more attractive, knowing that you're competing against cash and conventional offers.
Even things like writing an offer letter can be really helpful if you're coming in with an FHA loan. That way, we can give the seller confidence that we can still close on this loan even if we have to use an FHA loan here.
And then also, how do we apply? We don't apply with FHA. You can't actually apply with FHA, but you can apply with pretty much any lender. Almost all lenders are going to allow you to use FHA no matter who it is, it's a broker or a credit union, a bank, a direct lender. They're all going to be able to give you an FHA loan. So in my recommendation is s shop of three different types, shop with a local credit union, shop with a local broker, and then shop with a direct lender or a big bank.
That's going to give you a really nice spread, see the different options that you have available to you based on different types of lending organizations. That way you can see same, they're all FHA loans, but they're all gonna look slightly different depending on the rate and their costs based on the company itself.
So if you want to learn more about the four main types of loans, this playlist over here is going to give you some insights so you can choose the best loan to save the most amount of money moving forward.