Borrowers who don’t have a 20% down payment or have a low credit score can get a loan backed by the Federal Housing Authority (FHA). FHA loans are especially good at helping borrowers avoid foreclosure. They provide multiple options to help you keep your home if you default on your payments.
Written by Attorney William A. McCarthy.
Updated December 31, 2021
FHA home loans are often a good option if you don’t have a 20% down payment or you have a low credit score. While these loans aren’t for everyone, when it comes to avoiding foreclosure, FHA loans have some advantages. This article will explain the pros and cons of FHA loans and the special loss mitigation “waterfall” the loans have that can keep you from losing your home if you default on your payments.
The Pros & Cons of FHA Loans
The Federal Housing Administration (FHA) was created in 1934 to stimulate the housing market by making homeownership more affordable. It became part of the U.S. Department of Housing and Urban Development (HUD) in 1965 and continues to help homeowners get mortgage loans today. The FHA doesn’t actually loan you money. It provides mortgage insurance to approved lenders to protect them against loss. If you default on your mortgage, the government steps to pay the unpaid balance. This makes the loan less risky for lenders, so they’re able to offer loans to more borrowers.
Other types of loans, called conventional loans, aren’t insured by the government. Lenders take on more risk with conventional loans. If you default, the lender has to foreclose and sell your house to recover the unpaid balance. This takes time and money, and the lender doesn’t always recoup their full costs.
As a borrower, FHA loans have some advantages over conventional loans when it comes to qualifying for a home loan. The pros include:
Smaller down payment: You can get an FHA loan with a 3.5% down payment. With a conventional loan, you have to pay private mortgage insurance (PMI) if your down payment is less than 20%. You’ll pay an insurance premium on the FHA loan, but it will likely be a smaller payment.
Borrowers may also have more flexibility in the source of their down payment. HUD is more lenient on gifts being used, for example.
More lenient credit requirements: You’ll be eligible for the 3.5% payment if your credit score is 580 or higher (a higher score means better credit). If your score is between 500 and 580, you’ll need to put at least 10% down. For a conventional loan, you typically need a score closer to 620.
Lenders of both types of loans will also look at how much of your monthly income goes to debt repayment. This is called the debt-to-income (DTI) ratio, and it’s calculated by dividing your total monthly debt payments by your monthly income. A lower ratio is better because it means you’ll have more money to pay off the new debt. You can get an FHA mortgage with a ratio as high as 43% (or more in some cases), which is typically higher than for a conventional loan.
Help with closing costs: You can have the seller pay more of your closing costs – up to 6%.
FHA loans also have some downsides, though. The cons include:
Mortgage insurance: You pay two types of premiums: an upfront premium of 1.75% and an annual mortgage insurance premium (MIP) paid in monthly installments over the life of the loan. The annual premium will depend on the amount and length of your loan and can range from .45% to 1.05%. You can’t avoid the insurance payment with 20% down (or by building up 22% equity in your home) like you can with most conventional loans.
Restrictive housing standards: HUD has its own property guidelines and the standards can be more stringent than for other loans. Dwellings must be safe, secure, and structurally sound. If problems are found, they must be corrected before the loan will be approved. Major fixer-uppers won’t make the cut.
Loan limits: There are loan limits based on where you live. Lower cost areas have a lower limit, for example.
Several other federal agencies offer government-backed loans. The U.S. Department of Agriculture (USDA) and the Department of Veterans Affairs (VA) both offer loans with different eligibility requirements and terms. USDA loans have rules regarding the location of the property, and VA loans are only available to service members and veterans.
The requirements for conventional loans are often dictated by Fannie Mae and Freddie Mac, both of which are government entities. Banks often want to sell their real estate loans to Fannie Mae or Freddie Mac, so they conform to their standards.
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How FHA Loans Work
FHA loans are available from most banks, but you’ll want to shop around. You’ll be dealing with an approved private lender, so the interest rate, costs, and services may vary. You’ll first want to make sure the property qualifies. The home must be your primary residence and not an investment property. But you’re allowed to purchase a home through a foreclosure sale.
The bank will check your credit history after you apply for a real estate loan as part of the approval process. While credit requirements for FHA loans are more flexible, you’ll still have to meet certain requirements. This will include a credit score of at least 500, stable employment, and a debt-to-income ratio typically less than 43%.
Also, consider requesting a loan estimate for both an FHA and a conventional loan. This will allow you to compare the mortgage insurance costs over the entire term of the loan. If you have enough to put 20% down, a 30-year conventional mortgage could save you some money.
Finally, if you’ve previously had a home foreclosed on, you’ll need to wait three years before you can qualify for an FHA loan.
FHA Loans & Foreclosure Protections
HUD offers several ways to help you avoid foreclosure if you fall behind on your house payments. Mortgage servicers are required to follow the rules, and you’ll have a federal agency in your corner if there’s a problem. There are similar loss mitigation options available for conventional loans, but they’re determined by state law and can vary.
The rules require your mortgage servicer to consider you for loss mitigation alternatives in a specific order. By design, the options where you give up your home are at the end of the list. The list is referred to as the loss mitigation “waterfall” because you go down the waterfall of options until you get to one that fits your situation. The options include:
Loan Modification: A loan modification is a change to one or more loan terms to make the monthly mortgage payments more affordable (lower interest rate, longer loan term, etc.).
Partial Claim: A partial claim is an interest-free loan for the unpaid balance of your debt.
Combination Loan Modification and Partial Claim: This option combines the prior two prior options.
Forbearance: Loan forbearance is a temporary reduction or suspension of your payments.If you’re unemployed, this one moves to the top of the waterfall.
PFS: HUD’s pre-foreclosure sales (PFS) program allows you to sell a house for less than the unpaid balance on the loan. Unlike some conventional loans, the mortgage servicer can’t get a deficiency judgment requiring you to pay the unpaid balance.
Deed-in-Lieu of Foreclosure: This is where you sign over the deed to your home in exchange for being released from further payment obligations.
COVID-19 Recovery Waterfall
On July 23, 2021, HUD released a new streamlined COVID-19 Recovery waterfall to help homeowners financially impacted by the pandemic. These were announced as foreclosure moratoriums were expiring and borrowers were reaching the end of their forbearance periods.
It adds the following options at the top of the list:
A COVID-19 Recovery Standalone Partial Claim, which helps homeowners resume making their monthly payments by converting the unpaid balance into a zero-interest loan payable when the mortgage terminates.
The COVID-19 Recovery Modification, which helps homeowners who can’t resume making their monthly payments. This extends the term of the mortgage to reduce the monthly payment amount. It also includes a partial claim (loan) if the homeowner can afford it.
Navigating the loss mitigation options can be challenging even for experienced homeowners. And you may also run into problems with the company servicing your loan. The FHA has a hotline for questions. You can also contact a HUD-sponsored housing counseling agency in your state. But, with your house at stake, you may want to seek help from an experienced local attorney or legal aid office.
FHA loans are less risky for mortgage lenders because the government steps in and pays the lender in the event of a default. As a result, they’re typically easier to qualify for than conventional loans. But that government backing comes with a price, namely an insurance premium. You’ll want to consider all the pros and cons before you decide which type of loan to choose.
FHA loans come with very good alternatives to a foreclosure if you’re unable to make the payments. There’s a loss mitigation waterfall designed to help you get back on track with your payments. They include a loan modification, a partial claim, and forbearance.