FHA Loans: Salvation For First Time Buyers

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I want to state that I am in no way shape or form an FHA loan guru. Between my general knowledge of loans and this information from someone who is an FHA guru, I think I can make some sense on the subject. Besides, one of the best ways to understand something better is trying to explain it to someone else.

FHA will guarantee loans up to 96.5% of the purchase value, not 100%. This means that you do need a minimum of 3.5% down from some source. The FHA will allow seller paid closing costs only of up to 6%, and the really cute thing is that they will also allow the down payment component to be a gift from family members or government agencies (provided they are not otherwise involved in the transaction). FHA loans can also be interfaced with some types of locally based first time buyer programs, although whether there is money in the budget at the time you apply for those programs is subject to funding, which usually goes quickly.

The first thing you need to understand about FHA loans is that they are intended to enable people to transition from renting to ownership of a primary residence. They are not intended to help anyone grow a real estate empire. For this reason, they will not work with investment property except in the case of non-profit organizations. Individuals looking to buy property via FHA loan must plan for it to be owner occupied. Second homes are only allowed where you already own a home elsewhere and can show an employment related need. Vacation homes are not allowed.

Refinancing is possible for existing FHA loans, up to a maximum of 95% (see Mortgagee Letter 2005-43) loan to value ratio, provided it was purchased via FHA owner occupied loan. The only exception allowing FHA refinance of non FHA loans is the FHA Secure plan. There is no prepayment penalty on FHA loans, and they can be refinanced into conventional loans anytime you can qualify for conventional financing. Most folks do refinance FHA loans into a conventional conforming loans as soon as they can, because FHA rates aren't as good as conforming and conforming loans don't carry financing insurance. It's something to be decided on a case by case basis, on the basis of what is best for a given homeowner.

I did say conforming loans. FHA had loan limits which has precluded them being a big player in most areas for at least a decade. With the decrease in housing prices that has hit many areas and new legislation raising the conforming and FHA loan limits, they are now a major player for first time buyers and people getting back into the market. Especially since traditional lenders are seemingly more fearful every day. Truthfully, I anticipate FHA loans as being what saves the bacon of traditional lenders and provides the upwards impetus to the market that will cause traditional lenders' fears to ease and relax their restrictions.

With loan limits preventing them from lending upon most single family residences these past few years, you'd think FHA would be friendlier to condominiums. Unfortunately, government bureaucracy being what it is, condos have to be approved by the FHA before they will fund loans upon them. Since relatively few developers care to do that, that means that most developments don't have blanket approval from the FHA. Some people think that if theirs is one of the few with FHA approval, this gives them a lock on FHA buyers and they attempt to extort a huge premium in the form of purchase price. I have seen people who intend FHA loans advised to get a list of FHA approved projects and work only from that list. This is nonsense.

Just because the FHA hasn't issued blanket approval to a condominium development doesn't mean that you can't get spot approval. The requirements, in addition to the usual ones, are no ongoing class action suits open or pending, and 60% or more owner occupancy for the complex. This last tends to be the most difficult requirement, as it's a little unusual that a particular complex has 60% owner occupancy, but there are many condominiums out there that can qualify even though the complex does not have pre-existing approval.

Like all government programs, FHA loans require full documentation of sufficient income to afford the loan. No stated income or lesser documentation loans will be funded or ever have been by this program. This is another reason they were unpopular in the Era of Make Believe Loans, as mortgage products for those with eyes bigger than their wallets proliferated, and agents and loan officers became accustomed to qualifying people for properties and loans far beyond their means. Now that that's all over and we're all back to solid fundamentals as far as loan qualification, you can decide to stay within the budget for a loan you can prove you can afford, you can put a significantly larger down payment on the property to qualify for conventional financing, or you can do without buying any property at all. But FHA does not do stated income loans and never has.

Matter of fact, the FHA doesn't do "interest only" financing, either. All FHA loans are fully amortized. However, the FHA does accept some hybrid ARMs as well as fixed rate financing. But no interest only, no stated income, no negative amortization. You must qualify for an FHA loan based upon the fully amortized payment and full documentation of income only, which eliminates most of the ways that people were being qualified for loans beyond their means during the Era of Make Believe Loans, and is one more reason why the FHA was not a major provider of loans in for several years.

Allowable debt to income ratios are 31% front end and 43% back end, according to the written guidelines. However, both can be individually waived upwards, higher even than conventional loan qualifying ratios of 36 and 45% respectively in the case of strong credit , high reserves, and a stable job, with high reserves being probably the most important factor. For instance, owner of a stable business of long standing. Nobody fires owners. Large amounts of money in retirement accounts is one way of getting the default debt to income ratio increased. The range of 45-49% (back end) is supposed to be reasonably possible to get the FHA to approve. Beyond that, exceptions are fewer and significantly harder to get. In my professional opinion, making it difficult to go higher is a good thing.

There is no requirement for reserves with an FHA loan at all. With that said, however, having reserves can be a major point in your favor, particularly above 43% back end ratio. People with hundreds of thousands of dollars in retirement accounts that they could fall back upon if they had to is something the FHA will consider while traditional lenders would not. They'll even allow non-monetary reserves, the most memorable example given to me being a collector of old motorcycles which could be sold. Jewelry, automobiles, and other non-liquid assets may be considered. Of course, it's a very good idea to source and season every dollar you're using to justify the transaction, but the FHA has even been known to accept "mattress money" for down payments (not generally reserves), which is unheard of in other loans.

Here's the really cool part about an FHA loan: It's not FICO driven. You technically don't even have to have a credit score in order to be approved. With that said, however, even when underwriting was at its loosest a sub-600 credit score made it difficult to get approved, and these days we're looking at 640 to 680 as a reasonable minimum. You can also use alternative credit , of which utility bills are probably the best example. Especially in some cultures, credit can be a thing that people aren't accustomed to having or using, so these capabilities are very helpful. You don't even have to be a citizen, but you do have to have the right to work in the United States. This is reasonable: If you don't have the right to work, how are you supposed to pay it back?

Prior bankruptcy is allowable. Chapter 7 with two years of seasoning and re-established credit, chapter 13 with one year payment history and court approval.

Even prior foreclosure is not an automatic disqualification from an FHA loan. They will, however, require documentation of extenuating circumstances such as major illness. Job transfer is explicitly disallowed as an acceptable extenuating circumstance, so people who walk away from properties thinking they're going to get an FHA loan are going to be disappointed. What the FHA really seems to be looking for is debilitating illness, either one which you personally went through, or one where you had to care for an immediate family member.

For how easy they are to work with for individuals, however, loan providers find themselves with many additional requirements, which is yet another reason FHA loans had been less popular while there were other choices. As of right now, in addition to everything else, in order to originate FHA loans, originators have got to go though an annual audit with an accountant who's specially certified FHA auditor. This audit costs a minimum of about $5000 just for the auditor, never mind the cost of the originator's own time or that of anyone else they may have to pay. The audit requirement is in the process being relaxed for originators (finally). The FHA does not permit an agent to hang their license with one broker for real estate and another for loans, either, and your FHA loan officer can not be your real estate agent. If your broker does both, however, it may be permitted. The extensive paperwork means fewer providers - especially discount providers - are interested due to the increased costs, which drives things exactly opposite to what you'd expect the government to want - it drives prices of FHA loans up, by restricting the supply of those willing to do them. It is hoped by many that FHA modernization will change some aspects of this, but that has been stalled in Congress for a very long time. It's pointless to speculate as to what will and will not be included in FHA modernization until Congress sends an actual bill to the president.

One thing not likely to change is the FHA's blacklist. It's not called that, but that's what it is. Once a real estate agent or loan provider is on their list, they are on it for life, and the FHA scrutinizes all transactions for anybody affiliated with it being on their "naughty" list. If someone should default on an FHA loan, the insurer is going to look for a reason not to pay the guarantee, which insures that every FHA foreclosure gets scrutinized for fraud and a number of other offenses. If the agent or loan officer was involved in such an offense, onto The List they go, and they are forever barred from transactions involving an FHA loan. For this reason, it's probably a good idea for consumers to ask about this in their first meeting with a prospective loan officer or real estate agent - on the phone would be better. Just say that you're going to be needing an FHA loan, so if they're on the FHA's "naughty" list, they might as well tell you now, because they're going to be wasting their time. If they try and talk you out of an FHA loan, well, that should tell you everything you need to know. FHA loans are equal or superior to anything that isn't conforming A paper, and if you haven't got the qualifications for that, FHA beats Alt A, and beats subprime like a drum (OK, so the VA is a better deal than FHA as well).

The FHA does not normally permit secondary financing, either in the form of second trust deeds or seller carrybacks. The one exception to this is in the FHA Secure program, which will have to be another article.

One final thing: FHA loans aren't free. There is an upfront cost of 1.75 points to fund the loan. This is over and above all other loan related fees. This pays for an insurance policy that insures the lender against loss, much like private mortgage insurance on conventional loans. In addition, there's an annualized cost of 0.55% on top of principal, interest, taxes, insurance, etcetera - and this is included in debt to income ratio calculations. This will continue until the loan to value ratio is 78% or less, and if the loan period is over 15 years, cannot be removed for five years. If the loan period is 15 years or less and the loan to value ratio is initially less than 90%, there will be no continuing (i.e. the annual component) mortgage insurance charged, but the only way to elude the 1.75 point initial charge is by having a loan to value ratio of 80% or less. Since in any of these cases, it's overwhelmingly likely there will be better choices available to the consumer, essentially all FHA loans are going to have this financing insurance. The continuing cost is one of the main reasons people refinance to non-FHA mortgages, incidentally.

With lenders fearful and paranoid about the state of the market, FHA loans are an excellent way to qualify someone for financing that's at least close to 100%. Given the state of the housing market, particularly the starter market, and the legislation increasing FHA limits, the FHA loan is a very powerful force for market stabilization, leading to market recovery. It's a good alternative for consumers who cannot currently qualify for conventional loan financing.

When I originally wrote this, there were down payment assistance programs in effect to enable what was essentially 100% financing. Those have been essentially dead since April 2008, when Congress did away with the provisions that allowed it except in the case of government agencies. Figure you're going to have to come up with your down payment out of your own funds somehow.

Finally, a caveat. Many sellers don't want to work with FHA or require higher offers in order to do so. They aren't as bad as they used to be, but FHA requirements for financing are still tougher than conventional financing rules - especially if you've got a condo that needs so-called "spot approval". This costs sellers money, and means their transaction isn't as certain as a conventional loan. If you're looking for a bargain or even just a better than average deal on purchase price, it's a good idea to avoid an FHA loan for that reason. Furthermore, many agents still have their heads in the old days when FHA financing was a nightmare for the seller. Especially if there are competing offers, expect seller preference to work against you if you're making an offer that includes FHA financing, and be prepared to need to offer significantly more than the competition if you want them to choose your offer over theirs. When I'm listing a property and the offers are otherwise equivalent, I would still prefer the buyers who are intending any other sort of financing over FHA loan buyers - and I explain why, in detail, to seller clients who are evaluating multiple offers.

Caveat Emptor

Original article here


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FHA limits, the FHA loan is likely to be a very powerful force for market stabilization, leading to market recovery. It's a good alternative for consumers who cannot currently qualify for conventional loan financing. - I totally agree, it's really scary sometime because of the financial crisis. Thanks for sharing your insights

Jugg said:

Great article. I am currently have a condo under contract, but just found out yesterday the owner occupancy is 47%. Do you know if FHA will make exceptions/exemptions for this? It does not seem like anyone will lend with less than 50% owner occupancy. Do you know what my options are?

Dan Melson Author Profile Page said:

I don't know of any waivers granted for owner occupancy ratio

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This page contains a single entry by Dan Melson published on September 16, 2020 7:00 AM.

Loan Qualification: Time In Line of Work was the previous entry in this blog.

First Time Home Buyer Assistance Programs: Locally Based is the next entry in this blog.

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