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 at surprisingly competitive interest rates.

The great majority of lenders make these mortgages, and one out of every five new home loans is now backed by the FHA according to Ellie Mae, a California-based mortgage technology firm.

There are serious limits on how much you can borrow with an FHA loan — 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.

But if the amount you need falls within those 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 – and the average down payment on an FHA home loan is about 5%, according to Ellie Mae.

That's far less than the 20% average 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 borrower’s 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 FICO 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.

Now borrowers with such bad credit obtain fewer than one out of every 10 FHA loans.

Indeed, the average FICO score for rejected FHA applicants is 665, a score that would have landed in the top half of FHA borrowers just a few years ago.

Most of the money currently goes to home buyers who have below-average, but not terrible, credit. The average credit score for successful applicants is running at 685 so far this year.

But let's be clear. That's still way below the average score of 755 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 36% to 45% of their pretax income on all debts, including mortgage payments, student loans, credit card bills and auto loans. The limit depends on the borrower’s down payment and credit score.

With an FHA mortgage, you can stretch that ratio to 47% — or even a little higher in some instances.

“We’ve actually had loans approved over 50%, but they have excellent credit, good job stability, skin in the game and money in the bank after closing,” says Greg Cook, a mortgage broker who specializes in helping first-time home buyers in Temecula, California.

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 applicant has a debt-to-income ratio of 46.5%, while the typical approved applicant had a debt-to-income ratio of 41%, according to Ellie Mae.

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 more expensive than what you would pay for private mortgage insurance on a non-FHA mortgage unless you have poor credit.

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, borrowers can usually drop private mortgage insurance once the loan balance is down to 80% of the purchase price and after only one year.

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

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