How to get an FHA loan

hand holding a toy house for sale

Do you have too much debt to qualify for a conventional mortgage? Less than stellar credit scores or not much cash for a down payment?

You should consider buying a home with an FHA loan.

The Federal Housing Administration, a division of the Department of Housing and Urban Development, was created 80 years ago to help low- and moderate-income families obtain financing for home ownership.

The FHA doesn't actually make home loans. It guarantees that lenders will be repaid if you default on the loan.

That guarantee allows banks and mortgage companies to work with borrowers who might not be able to qualify for conventional home loans, and it means you can get a surprisingly competitive mortgage interest rate.

The great majority of lenders work with the government to make these loans, and you'll find they allow applicants to buy homes with a smaller down payment, below-average credit and more debt.

About 19% of new loans in 2013 (purchase and refinance) were FHA loans, according to Ellie Mae Inc., a California-based mortgage technology firm whose software many lenders use.

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But, while new and existing home sales are expected to increase in 2014, the growth in home sales won’t necessarily mean an increase in the number of borrowers taking out FHA loans, says Rosemarie Ashley, a senior loan officer in Warren, Mich., with Top Flite Financial, a lender that specializes in borrowers with less-than-perfect credit.

FHA loans will have tighter underwriting requirements in 2014, she says, and the required mortgage insurance makes these loans more expensive than conventional loans.

FHA loan limits have changed this year, too.

In 2014, you can borrow up to $271,050 for single-family homes in most parts of the country, or as much as $625,550 in high-cost cities such as New York and San Francisco. While the low-end limit is the same as it was in 2013, the high-end limit is down significantly from the $729,750 you could borrow in 2013.

Buyers purchasing over the limit for their city will need to have at least 5% down, because they’ll have to apply for a conventional loan instead of an FHA loan. In more expensive markets that are seeing a more significant drop in maximum loan amounts, buyers might need to turn to jumbo loans.

If the home you want to buy falls within the FHA’s pricing guidelines, here’s what you need to know about getting an FHA loan:

They have smaller and more lenient down payment requirements.

Most FHA mortgages require a 3.5% down payment — that's $3,500 for every $100,000 you borrow. If your FICO credit score is below 580, however, you'll need to put 10% down.

The average down payment on an FHA loan was 5% last year, according to Ellie Mae. It was 20% for non-FHA loans.

Your down payment can be a gift from a relative, a friend or an organization that provides financial assistance.

Many conventional mortgages require the down payment to come from a borrowers' savings or other assets, such as proceeds from the sale of another home.

You can qualify with below-average credit.

Before the financial crisis, FHA loans were for borrowers with bad credit.

And we mean bad credit. Applicants with credit scores below 640 scooped up more than half of all FHA-backed mortgages, while those with credit scores below 580 received about a quarter of them.

But no more.

Borrowers with credit that bad now qualify for fewer than one out of every 10 FHA loans.

Most of the money goes to home buyers who have average, or somewhat below average, credit.

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Ellie Mae says the average FICO credit score for FHA-backed purchases was just under 700 last year.

The average FICO score of rejected FHA loan applicants was 667, a score that would have placed those borrowers in the top half of FHA borrowers just a few years ago.

The advantage is that the average FICO score for successful applicants was still considerably lower than the 754 average for non-FHA loans.

So what’s the secret to qualifying if you have a credit score in the low 700s or high 600s?

Successful applicants usually have a two-year history of steady employment and paying their bills on time.

You can get an FHA loan if you're self-employed. Just be ready to document your income with tax returns and financial statements from your business.

The same big financial problems that derailed FHA applications in the past continue to do so. If you:

You’re allowed to carry more debt.

To obtain a non-FHA loan, borrowers must be spending no more than 43% of their pretax income on all debts, including mortgage payments, student loans, credit card bills and auto loans.

With an FHA mortgage, you can stretch that ratio as far as 45% to 50%.

A borrower might be approved with a debt-to-income ratio above 45% "if the down payment and closing costs are coming from their own funds, they've been on the same job more than two years and will have money in the bank after closing, and their new monthly payment will not be significantly more than their current housing expense," says Greg Cook, a mortgage broker and first-time home buyer specialist in Temecula, Calif.

If your credit score is below 580, however, debt-to-income ratio can’t exceed 43%.

Just because you can be approved with a higher debt ratio doesn’t mean you will be. The typical rejected FHA applicant had a debt-to-income ratio of 43% to 47% last year, while the typical approved FHA applicant had a debt-to-income ratio of 38% to 41%, according to Ellie Mae.

5 biggest mortgage mistakes9 biggest mortgage mistakes: These pitfalls can keep you from getting a mortgage or from grabbing the cheapest one possible. And, in some cases, making one of these mistakes can lead to potential financial ruin. Our guide will turn you into a savvy borrower so that owning your home will be a joy, not a burden, and will help you achieve long-term financial security.

The biggest drawback of FHA loans

The big disadvantage to FHA financing is the mortgage insurance. It's the price you pay for having the government stand behind your loan.

All borrowers, regardless of loan term or down payment, must pay the 1.75% up-front mortgage insurance premium at closing.

That means that you pay a $1,750 insurance premium on every $100,000 borrowed.

While that sum can be added to your loan amount so you don’t have to bring more cash to the table, it's still an extra charge. And if you finance it, you’ll pay interest on it, too.

Most borrowers will also have to pay monthly insurance premiums, which are comparable to what you would pay for private mortgage insurance on a non-FHA mortgage.

For a 30-year loan with a down payment of less than 5%, your premiums will be 1.35% of the outstanding balance each year. If you put more than 5% down, your annual premiums will be 1.30%. That cost is typically divided into 12 monthly payments and added to your mortgage payment.

It used to be that you only had to carry this insurance for at least five years on all loans longer than 15 years, or until the balance on your mortgage was down to 78% of the original purchase price, whichever took longer.

Now, FHA borrowers must pay these premiums for the life of the loan. If you keep your FHA financing for 30 years, higher mortgage insurance premiums for a longer period of time will cost you significantly more money.

On non-FHA loans, private mortgage insurance can usually be dropped after the balance of the loan is down to 80% of the purchase price and after a minimum of only one year.

Conventional loans also allow you to count home-price appreciation toward obtaining the needed equity. FHA mortgages do not.

"With increasing home values and conforming products that allow for only 5% down with lower private mortgage insurance than FHA loans, it does not always make sense to take out an FHA loan," says Neena Vlamis, president and co-owner of A and N Mortgage Services in Chicago.

Here's where to find the FHA loan limits in your area.