Today’s FHA loan is by far the most popular mortgage for first-time buyers. Why? There are multiple reasons but one of them is the low down payment required. The down payment for an FHA mortgage is just 3.5 percent of the sales price. The other two government-backed mortgage programs, VA and USDA, do not require a down payment but VA loans are restricted to only certain borrowers and USDA loans are used to finance rural properties.
There are no such restrictions for FHA loans. At the same time, credit guidelines for FHA loans are somewhat relaxed compared to conventional loans. However, the FHA loan can only be used to finance a primary residence whereas a conventional loan can be used to finance a second home or investment property. Only FHA approved lenders are authorized to underwrite and fund an FHA loan.
The government-backed feature of the FHA loan helps protect the lender in the event of default. A lower down payment loan has a higher risk factor compared to say a conventional loan with a 20 percent down payment. With an FHA loan, should the loan go into default, the lender is compensated for the loss. In the middle of the throes of the Great Depression in the 1930s, home foreclosure rates began to soar. With the creation of the FHA home loan program, foreclosure rates then began to fall and eventually stabilize over time.
The FHA loan guarantee was part of the original FHA program. The National Housing Act of 1934 was initially created to help increase new home construction and make more homes both more affordable and more available. As a result of increased construction and lower cost, one of the goals was to reduce unemployment and served that purpose well. The FHA does not make loans however but provides lenders with guidelines to follow to make sure the new FHA loan follows these guidelines and becomes an insurable loan.
The insurance on these loans comes in two different types- an upfront mortgage insurance premium that is rolled into the loan amount and an annual premium that is paid in monthly installments based on the outstanding loan balance. The annual premium is in place for the life of the loan. The rates for these premiums can vary based upon different factors, but with a 30-year term and the minimum 3.5 percent down payment, the annual premium is 0.55 percent and the upfront annual premium is now 1.75 percent of the loan amount.
The upfront premium can be paid for out of pocket but rarely is but instead rolled into the new loan. The upfront premium is collected by the mortgage company and then forwarded to the FHA. The annual premium is also collected by the lender and forwarded to the FHA.
FHA loan approvals were initially processed and approved manually. This meant accepting a loan application by mail or in person while at the same time collecting documentation from the applicant the lender may need. This included bank statements, paycheck stubs, income tax returns and anything else the lender could ask for. The complete package would then be delivered to the lender’s underwriter. The underwriter is the individual who verifies the loan package conforms to FHA requirements.
Today, the process is essentially reversed. Instead of documenting the entire file prior to sending the loan to the underwriter, the file is digitized and electronically submitted to an automated underwriting system which will deliver a decision in mere moments while simultaneously providing the lender with a checklist of what is needed to move forward with the loan. Historically, FHA loans were documented first and submitted second. Today they are submitted first and then documented based on the results of the electronic submission.
As it relates to credit, in the past a credit report would be pulled and included with the loan file. There were no credit scores reported then so the underwriter would have to make a personal judgment as to the creditworthiness of the applicant. There are no credit standards issued by the FHA other than to make that determination. Lenders could limit late payments to two or even three recent ones. It was completely up to the lender. Lenders had to be careful though if a loan went into default and the initial credit report showed late payments, the FHA could make the determination the loan guarantee would not apply.
Today, with the evolution of credit scores, lenders use these scores to make credit decisions. A credit report is ordered along with credit scores. The file is then submitted for an automated decision. The minimum credit score today for an FHA loan is 580 although individual lenders have the ability to increase their own minimum score requirements. Some banks and lenders require a minimum of 600 -620 credit for a max of 96.5% financing.
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