How do I get an FHA loan? What are the basic steps?

Reader question: “I’ve started talking to a real estate agent because I plan to buy a house in a few months. She said I should consider getting an FHA loan instead of a regular mortgage, because they are easier to qualify for. I’m really not sure how I ‘stack up’ as a borrower. But I like the idea of an easier approval process. My question is, how do I get an FHA loan? Like what are the basic steps involved? I would welcome any direction or guidance, because I am totally new to all of this?”

Your agent is partly correct in stating that the FHA program is easier than conventional mortgage financing. But the program has gotten more strict over the last couple of years. The qualification standards for borrowers are higher today than in the past. This is a direct result of the housing crisis, which spawned major financial losses for the agency.

So, how do you get an FHA loan in today’s stricter lending environment? The first thing you need to understand is the difference between personal and property requirements. The FHA has certain guidelines for borrowers, such as credit scores and debt ratios. But they also have requirements for the property itself. In this article, we will focus on the personal qualifications – i.e., the borrower’s qualifications.

Let’s start by talking about the “big 4″ qualifying factors. If you want to get an FHA loan, you need to measure up in these four areas: (1) income, (2) down payment, (3) debt level, and (4) credit score. Here’s what you need to know about these four factors.

1. Basic Income Requirements

In order to get an FHA loan in 2013, you will need to prove your ability to repay the debt. This has always been necessary. But a new rule created by the federal government recently makes it even more important. The so-called Ability to Repay rule requires lenders to verify a borrower’s ability to repay the loan. So you can expect the lender to verify and document your current income level. They will do this by looking at your bank statements, tax returns, and other financial documents.

You also need a sufficient level of income to meet the FHA’s (and the lender’s) debt-to-income requirements. During the application and approval process, they will compare your gross monthly income to your monthly recurring debts. This is referred to as the debt-to-income ratio, or DTI. The FHA doesn’t have any hard rules for a minimum DTI ratio. But mortgage lenders do.

If you want to get an FHA loan, you will probably need a total debt-to-income ratio below 43%. This means that your total monthly debts (including the mortgage payments) should use up no more than 43% of your gross monthly income. This rule is not set in stone. But it does reflect current lending standards.

2. Down Payment Needed to Get an FHA Loan

Income is one important aspect of how to get an FHA loan. The down payment is another. If you want to get approved for an FHA-insured mortgage, you will need to make a down payment of at least 3.5%. In other words, the loan can account for no more than 96.5% of the home’s value.

There is no way around this requirement. Other government lending programs, such as the VA and USDA loan programs, offer 100% financing for certain borrowers. But this is not the case for the FHA program. In order to get an FHA loan, you will need to make a down payment of at least 3.5%. If your credit score is below 580, you may be required to put down 10%. Learn more here

3. Debt-to-Income (DTI) Ratio

I mentioned debt-to-income ratios earlier, in section 1. But it’s an important part of the mortgage approval process, so we should discuss it in more detail.

This requirement is usually imposed by the lender, more so than the FHA. Lenders can impose their own guidelines on top of those issued by the Department of Housing and Urban Development (HUD), the federal department that oversees the FHA loan program. Earlier, I mentioned that many mortgage lenders set the bar at, or near, 43% for total or “back-end” debt ratios. This means that if your combined debts, including your monthly mortgage payments, exceed 43% of your monthly income, you might not be able to get an FHA loan.

In 2013, HUD announced a new rule regarding credit scores and debt ratios. FHA borrowers with credit scores below 620, and back-end debt ratios above 43%, must undergo a stricter underwriting process. (Reference: HUD Mortgagee Letter 2013-05)

In depth: 2013 DTI guidelines for the FHA program

4. Credit Score Needed to Get An FHA Loan

Thus far, we have covered three important aspects of how to get an FHA loan. We talked about basic income requirements, down payment guidelines, and debt-to-income ratios. There’s one more element we need to talk about, and that is the all-important credit score.

Your credit score is a three-digit number that indicates how much risk you carry, as a potential borrower. Ideally, you have a credit score that is either average or above average. This will improve your chances of getting an FHA loan. A high score tells the lender that you have borrowed and repaid money responsibly in the past.

A low score tells them the exact opposite. A low credit score usually indicates that a person has had problems repaying their debts in the past. For example, a person who frequently neglects to pay his or her bills on time will generally have a below-average credit score. The same goes for people who have filed bankruptcy or been foreclosed upon recently.

So, what credit score you need to get an FHA loan these days? HUD has three official numbers. They are 500, 580, and 620. The minimum credit-score cutoff is 500. In order to qualify for the 3.5% down payment option (which is the main reason people use FHA loans in the first place), you will need a credit score of 580 or higher. In section 3 above, where we talked about debt ratios, I mentioned the new rule regarding credit scores below 620.

But here’s the kicker. Most mortgage lenders require scores above these minimums. They can set the bar higher than the Federal Housing Administration if they choose. This is a frequent practice within the lending industry. It’s referred to as a lender “overlay.” The bank is laying their own requirements on top of HUD’s requirements, hence the term overlay.

What does this mean to someone like you, who simply wants to get an FHA loan? It means the lender might require you to have a minimum credit score of 620, or even higher. This number varies from one mortgage company to the next. Based on everything I’ve read in recent months, many lenders today are setting the bar at 620 or above for FHA loans. But this number is not set in stone. It may be possible to get an FHA loan with a score below that level. The only way to find out is to apply.

Speaking of the application process, that will be our next topic of discussion. In the follow-up to this tutorial, we will walk through the FHA application process in step-by-step fashion. You may also wish to read this article about the standard FHA loan application (the actual document that is used).

References:

• HUD Handbook 4155.1, “Mortgage Credit Analysis for Mortgage Insurance on One- to Four-Unit Mortgage Loans”
• HUD Mortgagee Letter 2013-05, “Manual Underwriting for Loans with Decision Credit Score Below 620 and Total Fixed Payments to Effective Income Ratio Exceeding 43.00%”
• HUD Mortgagee Letter 2008-23, “Revised Downpayment and Maximum Mortgage Requirements”

Important Disclaimers: This article answers the question, How do I get an FHA loan? The information provided in this article is based on current lending standards, as of March 2013. The Department of Housing and Urban Development has made several changes to the FHA loan program over the last couple of years. We expect additional changes going forward. As a result, there is a chance the information presented above may become outdated or inaccurate over time. We encourage you to visit the official HUD website for the latest guidelines and requirements. In particular, I would refer you to HUD handbook 4155.1. This handbook can be found online with a quick Google search. When it comes to mortgage loans, there are exceptions to almost every rule. Not all of these guidelines are written in stone. The only way to find out for sure if you can get an FHA loan is to apply for one. You’ll find a list of approved mortgage lenders on the HUD website.