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What is FHA Financing? - Definition & Requirements

Instructor: Shawn Grimsley
Homebuyers short on cash with a few dings on their credit report may qualify for FHA financing. In this lesson, you'll learn about FHA financing and its requirements. You'll also have a chance to test your knowledge with a short quiz.

FHA Financing Defined

Mark and Chloe are newlyweds that want to start a family and purchase their first home, but they have a problem. The couple doesn't have nearly enough money for the 20% down payment required by the bank for conventional financing. Their personal banker recommends that the couple try for FHA financing.

Federal Housing Administration (FHA) financing involves a loan made by an FHA approved lender. The FHA insures the lender against the borrower's default of the loan. Since the FHA insures the loan, lenders under the program are willing to provide financing to folks like Mark and Chloe who don't have enough money for a substantial down payment. FHA financing is available for both single family and multiple family residences up to four units, such as a duplex.

Qualifications

Mark and Chloe will have a much easier time qualifying for an FHA insured mortgage than a conventional loan. Instead of the typical 20% down payment, they may be able to get an FHA insured loan with a down payment equal to just 3.5% of the purchase price of the house. For example, a 20% down payment on a $150,000 house is $30,000, but the down payment can be as low as $5,250 with an FHA insured loan. This is crucial because saving up for a downpayment is one of the biggest hurdles facing first time homebuyers. Additionally, borrowers typically can have lower credit scores than with conventional lending. In fact, it may be possible to qualify for an FHA insured loan merely two years after receiving a discharge in bankruptcy.

Like any other type of loan, Mark and Chloe will have to establish a history of steady income sufficient to pay the loan. Their credit scores and credit history will be examined along with their assets and outstanding debt, but the loan approval criteria for an FHA loan is more forgiving to borrowers than the criteria for conventional financing.

Advantages & Disadvantages

Like most things in life, FHA financing has both advantages and disadvantages. As we discussed above, it's easier to qualify for the loan because a substantially lower down payment is required and the loan requirements are more forgiving of people with less than perfect credit. Another big advantage is that FHA insured loans are assumable. This means that if Mark and Chloe decide to sell their home, the buyer can assume, or take over, the loan payments. This is a great advantage if the interest rate on the current home loan is lower than the interest rates for new loans.

FHA financing does have some negatives. A big one is the mortgage insurance premiums (MIPs) that borrowers must pay. In fact, Mark and Chloe will have to pay two different MIPs if they decide to take out an FHA insured loan. They'll have to pay an upfront mortgage insurance premium at closing equal to 1.75% of the loan value. For example, if Mark and Chloe take out a $150,000 loan, they'll have to pay an upfront MIP of $2,625. They'll also have to pay a periodic MIP that is added to their monthly loan payment.

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