If you purchased your home via a Federal Housing Administration loan, you might eventually want to take out an FHA home equity loan, also known as a Home Equity Line of Credit or HELOC. The FHA does not provide FHA equity lines of credit per se, but they are available through private lenders, such as banks, credit unions, mortgage brokers and savings and loan institutions.
Home Equity Loan Definition
The equity a person has in their home is the amount remaining after a homeowner subtracts all mortgages from the property’s fair market value. For example, if a house has a fair market value of $300,000, and the homeowner has a $150,000 balance on their original mortgage loan, their home equity is $150,000. They can borrow against the equity in the dwelling, but it is in effect a second mortgage. Although home equity loans and HELOCs are often used interchangeably, there is a difference between the two. The homeowner receives a home equity loan in a lump sum, so they can use the funds for renovations or other purposes, such as paying a child’s college tuition. Home equity loan payments are similar to a mortgage, in that the homeowner begins to repay the loan monthly right away at a fixed interest rate for the life of the loan. Home equity loans generally range between five and 15 years.
As a line of credit, a HELOC is similar to a credit card. The homeowner can draw on this line of credit for a specified period, usually up to 10 years. The repayment period, however, may last for 15-to-20 years. HELOCs make more sense for those who want to take out money for various projects over a period of years, rather than one major project. Unlike home equity loans, which have fixed interest rates, HELOCs have variable interest rates. That means you could save money on your repayments if interest rates trend downward, but you could end up paying a lot more if interest rates spike upward.
With an FHA mortgage, the borrower is required to put down just 3.5 percent of the purchase price if their credit is good. Those with lower credit ratings must put down at least 10 percent of the purchase price, but in either case, that down payment automatically becomes part of their equity. With a conventional mortgage, lenders like to see borrowers put down at least 20 percent of the purchase price. Those who cannot come up with that much of a down payment must pay mortgage insurance until they reach the 20-percent equity point. With an FHA mortgage, the borrower must pay mortgage insurance for the life of the loan, even if their equity is above 20 percent.
FHA Home Equity Loan Criteria
FHA home equity loans feature lower interest rates than an unsecured loan, as the borrower uses the equity in their home as collateral. To qualify for an FHA home equity loan, the homeowner must have a good credit rating, including no more than two late payments over the prior two years. The loan, combined with the mortgage, cannot account for more than 30 percent of the homeowner’s total monthly gross income. The applicant must also provide evidence they have worked steadily in the same profession for at least two years. A self-employed homeowner must have had their own business for at least two years, and furnish tax returns, the business' profit and loss statements and similar documentation to verify their income.
All FHA home equity loans are made by private lenders approved by the FHA. You should shop around to determine the best rates and terms for your home equity loan. However, your current lender may turn out the best choice since you have a history with them. There is also the fact that your current lender holds your primary mortgage. Should you declare bankruptcy or end up unable to pay your mortgage, resulting in foreclosure, that mortgage is paid first. A second mortgage is only paid from the proceeds of the foreclosure if sufficient funds are available. In that worst case scenario, your lender has additional leverage if they hold both the first and second mortgages.
FHA Title 1 Home Improvement Loan
Another option is the FHA Title 1 home improvement loan. This loan is available for financing home repairs and improvements. The latter must substantially “protect or improve the basic livability or utility of the property,” according to the U.S. Department of Housing and Urban Development. HUD oversees the FHA mortgage program.
Properties eligible for this loan include any home that has been occupied by the homeowner for at least 90 days. Also eligible are repairs or improvements for a nonresidential structure, such as a garage, that is already functional. Such a structure must have been completed before the owner’s loan application. The FHA Title 1 home improvement loan is also available for those who want to finance a new nonresidential structure. HUD per se does not process these loans, but applicants may obtain financing from Title 1 approved lenders.
203(k) Rehab Mortgage Insurance
Another alternative for a homeowner is the 203(k) rehab mortgage program. This type of insurance permits homeowners to finance the purchase and refinancing of a property and necessary rehabilitation via one mortgage. As HUD points out, when a home buyer wants to purchase a home requiring extensive repairs or upgrades, the process can become complicated. Available loans usually have higher interest rates and shorter repayment schedules. The 203(k) program insures mortgages covering home purchase or rehabilitation for properties at least 12 months old. Minimum rehabilitation costs must total at least $5,000.
Eligible rehabilitation runs the gamut from minor, although within the cost minimum, to the virtual reconstruction of the dwelling. Qualifying rehabilitation projects include modernization of the home; appearance improvement; health and safety hazard elimination; structural alterations, including changing the number of residential units in a dwelling from one to up to four; replacement or repair of wells, septic or plumbing; roof and gutter replacement; energy conservation improvements; major landscaping and site renovations and addition or replacement of floors. Retrofitting a home to accommodate a person with disabilities is also an approved use for the 203(k) rehab program.
FHA Cash Out Refinance
Homeowners with an FHA loan may want to consider an FHA cash-out refinance as a method for obtaining money for home improvements. You must live in your home for several years before eligibility for this program kicks in. Between monthly mortgage payments, which help pay down the principal, and rising market value, the homeowner may accrue a fair amount of equity in their property. Like a home equity loan, the FHA cash-out refinance loan has a fixed interest rate. Just as with other FHA loans, homeowners must pay mortgage insurance on an FHA cash-out refinance, no matter how much equity they have. For that reason, homeowners with more than 20 percent equity in their residences may pay less if they opt for a conventional cash-out loan offered by banks and other lenders.
However, conventional cash-out loans require higher credit scores than FHA cash-out refinances. The latter has the same criteria as original FHA loans, which includes a regular employment history, property as the primary residence and approval by an FHA appraiser. A homeowner with a foreclosure on their record would have to wait at least seven years before qualifying for a conventional cash-out loan, while an FHA cash-out loan may prove available within three years of the foreclosure.
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