It’s a common misconception, but in fact, the FHA is not a lender. Nor does the FHA give people money to buy a home or set interest rates on home loans. Rather, the FHA, or Federal Housing Administration, is a federal government agency that offers mortgage insurance on loans originated by lenders that are approved by the agency. This insurance protects the lender in case the borrower defaults on the loan.

The FHA was set up in 1934 after the Great Depression and is a division of the U.S. Department of Housing and Urban Development, or HUD. FHA-insured loans enjoyed decades of popularity, but then fell out of favor during the recent housing boom in part because lenders began to offer subprime loans that had artificially low initial interest rates and monthly payments. These subprime loans have since proved disastrous. As a result, lenders have tightened their credit standards and borrowers have flocked to the comparative safety and familiarity of FHA-insured loans.

In 2007, the FHA backed about $60 billion of residential mortgages. In 2008, that figure is expected to skyrocket to almost $224 billion. That means FHA-backed loans now make up a huge segment of the U.S. mortgage market. For many borrowers, an FHA-insured loan is the only option they have to buy a home or refinance their current mortgage. Our FHA loan comparison questionnaire helps borrowers compare FHA loans with other types of loans.

Who should consider an FHA-insured loan?

According to the FHA’s Web site, FHA-backed loans are especially attractive for first-time homebuyers who fit certain criteria.

Buyers attracted to FHA-backed loans
  • Have a little cash for a down payment and closing cost.
  • Have imperfect credit
  • Want to keep their monthly payments as low as possible.
  • Are concerned that they may not be able to qualify for a loan.
  • Are concern about the possibility of monthly payment increase.
What are the advantages of FHA-insured loans?

There are several advantages to obtaining a loan backed by the FHA.

  • Competitive interest rates.
  • Smaller down payment required as a percentage of the purchase price.
  • A gift from a family member, employer or charitable organization can be put toward the down payment.
  • Minimum credit score not required, though some lenders expect a score of at least 580.
  • Lender can consider payment of utility bills, rent, auto insurance premiums and other items if the borrower doesn’t have an established credit history.

Compare these advantages to loans not backed by the FHA:

Loans not backed by the FHA
  • Offer a less competitive interest rate.
  • Require a larger down payment as a percentage of the purchase price.
  • Require a stronger credit history.

FHA-insured loans require mortgage insurance, which is the cost of the government’s guarantee to the lender that the loan will be repaid. Mortgage insurance also is required on most conventional loans if the borrower’s down payment is less than 20 percent of the purchase price or appraised value of the home. This private mortgage insurance may be more or less expensive than the FHA’s mortgage insurance.

The FHA has charged an upfront premium of 1.5 percent of the loan amount, plus an annual premium of 0.5 percent of the loan amount if the loan is for more than 15 years and has a loan-to-value ratio of more than 90 percent. However, the agency has announced plans to introduce a new pricing structure in which higher-risk borrowers will be charged more and lower-risk borrowers will be charged less than average-risk borrowers. Borrowers who have a stronger credit history generally are judged to be a lower risk of default.

The terms “upfront” and “annual” are misnomers, to some degree, because the upfront premium typically is included in the loan amount and the annual premium typically is paid in monthly installments.

This example illustrates how to calculate the cost:

Calculate cost
Mortgage amount $100,000
Upfront premium x 1.5%
Total: $1,500
Interest for 25 years (based on loan terms) x 6.5%
Total upfront premium per month: $9.48
Mortgage amount $100,000
Annual premium x 0.5%
Total: $500
/ 12 months
Total annual premium per month: $41.67
Total upfront premium per month: $9.48
Total annual premium per month: + $51.67
Subtotal per month: 51.15
Calculations figured using Bankrate’s mortgage calculator.
What kinds of loans does the FHA insure?

Most FHA-insured loans have a fixed interest rates and payments. However, the FHA also insures certain adjustable-rate mortgages, or ARMs, on which the interest rate and payment may change over the term of the loan. ARMs that are FHA insured usually have an annual adjustment cap of 1 percent or 2 percent and a lifetime adjustment cap of 5 percent or 6 percent. The FHA also insures purchase-and-rehab loans through its 203(k) loan program.

There are several types of new and existing property types that are eligible for FHA loans.

Eligible property types for FHA
  • Single-family home.
  • Duplex.
  • Triplex.
  • Four-unit residential building.
  • Condominium.
  • Manufactured or mobile home on a apartment foundation

Thousands of banks, mortgage companies, mortgage brokers, state finance agencies and credit unions have been approved to process FHA loans. This FHA search function may be used to locate these lenders.

What are the requirements to qualify

To be eligible for an FHA-insured loan, the borrower must pass certain requirements.

Depending on the state where the property is located, the maximum loan-to-value ratio for an FHA-backed loan is either 97.75 percent of the purchase price or 98.75 percent of the appraised value of the home, whichever is lower.

The temporary maximum loan amount for an FHA-insured loan is 125 percent of the median home value in the metropolitan area or county where the home is located or $729,750 in the nation’s most expensive housing markets. The Bankrate feature ” FHA loan limits by county” shows the current limits for each county. These limits will revert to previous lower levels at the end of 2008, unless the federal government extends that timeframe or makes higher limits permanent.

Borrower requirements for FHA loan
  • Valid Social Security number.
  • Proof of U.S. citizenship or evidence of lawful permanent residency or eligibility to work in the U.S.
  • A legal U.S. resident..
  • Old enough to sign a mortgage in the borrower’s home state.

Homeowners who need to refinance a non-FHA ARM but have little or no equity should consider the FHA Secure program, which has somewhat different requirements than other FHA-insured loans.

More information about FHA guidelines may be found on the agency’s Web site.

Marcie Geffner is a freelance writer in Los Angeles.

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