During the great depression of the 1930s, the government stepped in and came with an innovative loan to help the banking industry recover, thus putting the whole economy back on track. FHA stands for Federal Housing Administration, so FHA loans, by definition, are home loans backed by government insurance. In this way, lenders are protected in the event of a foreclosure. Since lenders are insured against loss, FHA encourages them to generate loans that otherwise would have been deemed too risky. Today, FHA loans are a last resort for low-income households, who otherwise would have to rent.
So, an FHA mortgage is the best choice for people with a low credit score and very little savings for a down payment. The ideal FICO® credit score for this type of loan is 580 which allows a down payment of only 3.5%. For credit scores between 500 and 579, the down payment raises to 10%. Higher credit scores could offer lower interest rates and a conventional mortgage might be cheaper over time.
A very important indicator taken into consideration is the debt-to-income (DTI) ratio. It should be lower than 43%, but ideally, a family shouldn’t spend more than 30% on housing. Be aware that the home financed through an FHA loan must be the primary residence, so no FHA loans for vacation homes or investment properties.
The private mortgage insurance is going to increase the total cost of the loan and is not negotiable. For some loans, it must be paid during the whole life of a loan, while for other loans, it may no longer be required once the borrower repays 78% of the loan or makes at least five years of payments. The first premium is paid upfront, and is 1.75% of the loan and is usually included in the loan amount. Then, borrowers have to pay a 0.85% premium every year.
FHA loans give a second chance to homeownership to those who have filed for bankruptcy or have defaulted on a previous loan. After filing a Chapter 7 bankruptcy, at least two years shall pass before applying for a new mortgage. Foreclosures result in a three-year waiting period, but it is still shorter than the seven-year waiting period imposed for conventional loans.
FHA loans have the advantage that they can be assumed by a qualified buyer. It is possible to sell a house with an FHA mortgage at a rate below the current market by allowing the buyer to assume the old mortgage, while conventional loans carry due-on-sale clauses that require the loan to be repaid when the house is sold.