One of the most common questions I get asked on a daily basis other than “What is the rate?” is “What is the best loan for me?” To answer this question requires a thorough understanding of the client and what they are looking to achieve both in the short term and in the future. In today’s tough lending environment, there are essential two types of loan available: Government which includes FHA, VA and USDA and Conventional loans. Government loans are insured by the Federal Government, while conventional loans are underwritten to Fannie Mae or Freddie Mac guidelines and are not insured by the government. Although, today the government does control both Fannie and Freddie, but that is a topic all to itself.
For the purpose of this article, we will be spending our time dissection the FHA loan. First of all, what is FHA and what is its purpose. FHA stands for the Federal Housing Administration and it was created by the National Housing Act of 1934 to increase home construction, reduce unemployment and operate various loan insurance programs. There are several advantages for using FHA financing. The first is the low down payment requirement. Today, FHA only requires 3.5% of the purchase price for a down payment. If someone is buying a house for $100,000, they would be required to bring a minimum of $3,500 to the closing table. They would also be required to pay closing costs but this can be negotiated with the seller to have him pay it. The second advantage of FHA is that is allows the seller to pay up to 6% of the closing costs, which should cover all closing costs. Make sure you speak with a loan originator so you will have a good idea how much closing costs will be for your transaction. Another nice feature is that a FHA loan allows for a family member to gift the funds needed to close on the loan. The person giving the needs to be an immediate family member such as parent, grandparent, sibling or spouse and can gift the entire amount needed to close the loan.
When it comes to determining how much you can qualify for in terms of maximum loan amount, we use the debt-to-income ratio. This ratio is calculated by taking your gross monthly income and dividing it by your total monthly expense plus your new housing payment. So if you make $5,000 per month and your minimum monthly expenses that show up on your credit report equals $850 and your new monthly mortgage payment will be $1,000 your DTI will be (850+1000)/5000 = 37%. FHA will typically go up to 50% or more with compensating factors. FHA allows for a family member to act as a non-occupant co-borrower and help the borrower to qualify. This is a fantastic feature of FHA.
Possibly the main reasons why someone chooses to go with FHA is the credit profile requirements. FHA is more lenient than other types of financing. FHA does not typically require someone to pay off open collections or have a specific number of open trade lines (credit accounts are also called trade lines), although this falls under the underwriter’s discretion. Another credit advantage is for someone who has had a bankruptcy or foreclosure in the past. For Bankruptcies, FHA requires 2 years after a Chapter 7 has been discharged and you can still be in a Chapter 13 as long as you can show 12 months of payment history. As for a foreclosure, you will need to wait 3 years from the time the foreclosure settlement date. Lastly, one can typically get approved with a middle score as low as 620 and still get a great interest rate.
To summarize, FHA is a fantastic loan for a first time home buyer, someone with lower credit or newly established credit, someone who needs assistance from family in terms of cash to close or income to qualify.