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Understanding FHA Mortgages Can Help You Get One On Your First Try

The road to homeownership is paved with a plethora of possibilities. Thanks to low-interest financing and closing costs that sellers often agree to pay or split with the buyer, many deals are available if you know where to look and work in close consultation with your lender. In fact, in a recent survey conducted by the National Association of Realtors, nearly two-thirds of Americans believe that the current market is a favorable one to buy. Such optimism may be due to a variety of encouraging developments, such as higher incomes, favorable lending terms and growth in available inventory.

However, with so many loan options out there, it can be difficult to determine which mortgage avenue to pursue. A good place to start is with an FHA mortgage. You've probably heard of this mortgage type before, as it's one of the longest-running home loans out there, around since way back in the 1930s. But have you ever wondered how to actually get an FHA mortgage? The easiest way is by understanding what they're all about. That's what you're about to find out, which can help you better determine if this potential pathway to homeownership is worth traveling down.

But before we get into that, it's helpful to understand what the FHA is and how this government organization works in partnership with private lenders to help more people achieve what remains the American dream.

What is an FHA loan and what's required in order to qualify?

An arm of the Department of Housing and Urban Development, the Federal Housing Administration is a government organization whose primary role is one of oversight. Established in 1934 during the Roosevelt administration, the government agency created FHA loans the same year it debuted.

Instead of selling mortgages directly, the FHA insures FHA loans that are made available through private lenders upon approval. By "insure," this means that should an FHA loan borrower default, the agency provides assurances to the lender that whatever amount remains outstanding will be paid off in its entirety. This added certainty is part of what makes FHA loans popular with first-time homeowners because the terms tend to be looser, which also makes it a bit easier to qualify for an FHA loan versus a conventional loan, for example.

FHA loans require many of the same qualifications that conventional loans do - such as proof of employment, bank statements, two years' worth of tax returns and details of your credit history. However, the extent or degree of those requirements aren't as strict.

Take your credit score as a classic example. Generally speaking, the higher your credit score is, the greater your chances are of being approved, provided the other aspects of your finances all check out. But if your credit score isn't quite as high as you'd like it to be, you may still be approved for an FHA loan.

How does an FHA mortgage compare to a conventional mortgage?

There are a lot of similarities that FHA loans have to conventional loans. Understanding this fact can provide further instruction on how to get an FHA mortgage and determining which  mortgage product is the right one for you.

In addition to both being highly popular mortgage products, their interest rates come as either fixed or variable, down payments are highly affordable - as low as 3.5% for FHA loans - and the length of the loan periods can run between 10 and 30 years.

Overall, though, FHA loans and conventional loans actually have more differences than likenesses. The biggest distinction lies in the fact that conventional loans aren't guaranteed by the federal government. This means that if you were to default, your lender would be on the hook for what has yet to be paid off. As a result of this, it's generally more difficult to gain approval for a conventional loan than it is for an FHA loan.

How long do borrowers have to pay FHA mortgage insurance?

Mortgage insurance is another way FHA loans and conventional loans differ, assuming your down payment was for less than 20% of your prospective property's purchase price (the typical cutoff in determining whether private mortgage insurance is required).  With a conventional mortgage, you don't necessarily have to pay for mortgage insurance for the life of the loan. It can be canceled after a certain period if you have accumulated enough home equity.

This isn't an option with an FHA loan; you have to make monthly payments for mortgage insurance in perpetuity assuming the down payment was for less than 10% of the purchase price.

If, however, you paid 20% or more, then the mortgage insurance requirement is waived.

How does debt-to-income factor into obtaining an FHA mortgage?

There's no magic number, action or sheet of paper when it comes to how to get an FHA mortgage as seamlessly as possible. Every person, situation and FHA loan differs. One of the factors used in approval assessment is your debt-to-income ratio, or DTI. This is a calculation that assesses how much of your earnings goes toward paying down debt on a percentage basis. The higher the figure, the more that you spend on payments. For purposes of mortgages, "debts" are considered credit card bills, credit lines, auto loans, unpaid tuition and other installment loans. Utility bills are not factored into this equation.

Again, there's really no magic number in terms of what DTI ratio you need to be approved for an FHA loan. However, it may not be as low as you think it needs to be. According to the previously referenced FHA report, in 2018, roughly 1 in 4 FHA loans -  went to applicants with a DTI ratio of 50% or more. This represents the largest percentage of FHA loans with DTI ratios above this threshold since the turn of the century. This doesn't necessarily mean anyone with a DTI at or higher than 50% will be approved, of course, but it does further the point that FHA loans are designed to be more lenient when it comes to approval, especially as they compare to conventional loans.

You can calculate your DTI on your own by adding up all your monthly payments (not including utilities, as previously mentioned) and dividing that total by how much you earn each month before taxes are taken out.

What does loan-to-value ratio mean and how does it apply to buying a house?

Another ratio FHA lenders use when evaluating mortgage borrowers' potential purchase of a home is the loan-to-value ratio or LTV.  Like DTI, the LTV ratio is another financial calculation that lenders use, only this one occurs closer to the actual purchase of a house you're interested in. Although it may sound complicated, it's actually pretty simple: It's the size of the loan you seek to obtain versus how much of the house you're interested in buying out of pocket. You divide the amount of the loan by the house's value to get your answer.

Here's an example that can provide added clarity. Say the house you're interested in has a purchase price of $250,000 and you want to put 5% toward it as a down payment, or what amounts to $12,500. The LTV ratio in this scenario would be 95% because you're coming up with 5% of the property's cost.

The higher the percentage, the more risk the lender assumes. For FHA loans, the maximum loan-to-value ratio allowed is 96.5%. This means that you can make a down payment of as little as 3.5% with a loan backed by the Federal Housing Administration.

Is there a maximum loan amount with an FHA mortgage?

If one overarching rule applies to real estate in general, it's the fact that there's a lot of flexibility as it pertains to obtaining a mortgage. A classic example of this is FHA loan limits, which have been known to fluctuate over the years.

For example, the FHA loan limit ceiling rose in high-cost areas last year to $726,525, the government agency announced last December. That's up from a previous ceiling of $679,650. For low-cost areas, the limit among single-family units also rose, to $314,827.  However, in places like Alaska and Hawaii - where the cost of living tends to be a bit more expensive - the maximum loan amount is $1.08 million.

The reason for the wide variation in FHA loan limits is due to the disparity in asking prices from one portion of the country to the next. For instance, in the Northeast, the median price for a single-family residence this past August was $303,500, according to the latest data available from the NAR. But in the Midwest, a median-priced residence went for $220,000. That's substantially below the Northeast, despite jumping over 6.5% from a year earlier.

In short, if you're wondering how much mortgage you can get for your money, your best course of action is to ask your FHA lender. They'll give you a more precise figure, which will largely depend on where you plan on buying. The same goes for closing costs you may accrue. What those are and their amounts will largely hinge on the state you live in or plan on moving to if you're purchasing a place the next state over or one on the opposite side of the country. Generally speaking, as the loan amount increases, so too do average closing costs.

Armed with these facts and figures, you should have all the information you need for how to get an FHA mortgage and whether your current circumstances make you an ideal candidate. If you're still unsure, your loan officer  will be more than happy to point you in the right direction toward the right loan that will lead to success.