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How do FHA loans work?

When you are considering your first home purchase, you may be receiving a lot of advice from family, friends, and people you trust about what home financing options worked best for them. Grandpa Fred recommends a conventional loan. Your sister, Joyce, just bought her dream home with the help of an FHA loan. Obtaining a mortgage is a crucial step in purchasing your first home and the numerous financing options available can be overwhelming for first-time home buyers. In this week’s blog, Michele Harmon Team breaks down what an FHA loan is so that you can have a basic understanding of what is available to you and if it is the best option for your personal circumstances.

According to bankrate.com, “an FHA loan is a government-backed mortgage insured by the Federal Housing Administration.” FHA loans are popular among first-time home buyers because they typically allow for lower minimum credit scores and down payments than most conventional loans. Although FHA loans are insured by the government, they are underwritten and administered by third-party mortgage lenders.

FHA loans are available in 15-year and 30-year terms with fixed interest rates. In addition, borrowers are required to pay FHA mortgage insurance, which protects the lender from a loss if the borrower defaults. There are two mortgage insurance premiums that FHA loans require the borrower to pay.

  1. Upfront mortgage insurance premium: 1.75% of the loan amount, paid when the borrower obtains the loan. The premium can be rolled into the financed loan amount.
  2. Annual mortgage insurance premium: 0.45% to 1.05%, depending on the loan term, the loan amount, and the initial loan-to-value ratio, or LTV. This premium is divided by 12 and paid monthly.

If you are considering an FHA loan, here are a few questions you may want to reflect on prior to applying.

  • What is your budget for a home?
  • How much money can you put toward a down payment?
  • What is your credit like?
  • Do you want to buy a new build?
  • Are you okay with paying more each month for mortgage insurance?
  • Do you have a preferred lender?

After considering the answers to these questions, weigh out the pros and cons of obtaining an FHA loan.

Pros:

  • It is okay to have a low credit score: If you have had some issues with completing on-time payments or if you do not have an established credit history, the minimum credit score required for a conventional mortgage may seem impossible to achieve. While a conventional mortgage requires a 620 credit score, most FHA-approved lenders only require a minimum of 580.
  • You can make a lower down payment: FHA loans give you the option of a smaller down payment. If you have a credit score of at least 580, you can put as little as 3.5% down. However, if your credit score is between 500-579, you may still be able to qualify for an FHA loan, but they may require you to make a 10% down payment.
  • You can stop renting sooner: Since FHA loans make it easier for you to buy a home, you can start building equity sooner! Instead of continuing to rent while saving money or improving your credit score, an FHA loan can grant your wish of becoming a homeowner sooner rather than later.

Cons:

  • Mortgage insurance is unavoidable: Since your credit score is low, you are a risk to the lender. Mortgage insurance will keep the lender protected. It is possible to roll the upfront insurance premium into closing costs, but your annual premiums will be divided into 12 monthly installments that will appear on your mortgage bill. If your down payment is less than 10%, you will be required to pay these annual premiums for the entire life of your loan. If you obtain a conventional loan, you will no longer have to pay private mortgage insurance once you build up 20% equity.
  • There are specific property requirements: Properties that are purchased through an FHA loan will be required to meet some eligibility requirements, including the price. FHA-backed mortgages are not allowed to exceed certain amounts, which vary based on location. You will also be required to live in the property. FHA loans are not applicable for second homes or investment properties. Click here to find the FHA mortgage limit for the area you wish to purchase in.
  • You may end up paying more: When comparing mortgage rates, you may notice interest rates on FHA loans are lower than conventional loans. It is important to keep in mind that the annual percentage rate (APR) is the better comparison point because it represents the total cost of borrowing. The APR for FHA loans can sometimes be higher than conventional loans.

Regardless of your situation, it is important to shop carefully among lenders to find a loan that is best for you. Always consider all of your options before making a long-term commitment. Click here to download Michele Harmon Team’s list of lending and financial help partners or click here to contact them through our website! We have personally worked with each of them and we highly recommend getting in contact with them. Please let them know Michele Harmon Team sent you! For questions or more information on the home buying process, please give us a call at 713-818-1330. We love helping first-time buyers!

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