U.S. Federal Housing Administration (FHA) loans are one of the best mortgage deals around for qualified borrowers. The FHA loan down payment is just 3.5 percent of the home’s purchase price, far below the 20 percent standard conventional mortgage lenders want to see. As with other mortgage loans, there are closing costs, but there are methods for financing closing costs for an FHA loan.
What Is the FHA Loan Program?
First, it’s important to understand the FHA loan program and just what it entails. FHA stands for the Federal Housing Administration, and its mortgages are backed by the U.S. government, with the FHA providing insurance. The FHA does not lend funding directly but works with qualified lenders throughout the country.
Home buyers may qualify for FHA loans with much lower credit scores and down payments than traditional mortgages. A person may qualify for an FHA loan with a credit score as low as 500, although in that instance they must come up with a 10 percent down payment. For those with a credit score of 580 or above, the 3.5 percent FHA loan down payment applies. All FHA buyers must pay annual mortgage insurance, which protects the lender in case the borrower defaults. An FHA loan is only offered at a fixed rate. There is also a limit on the loan amount based on the region and the type of property. This limit is calculated by taking a county’s median home price and multiplying it by 115 percent. The resulting figure is the maximum FHA loan amount for that area.
Additional qualifications for FHA loan eligibility include working for the same employer for a minimum of two years and a debt ratio, not including a mortgage, that doesn’t exceed 31 percent of the applicant’s gross monthly income. Once the mortgage is factored in, the debt ratio should not exceed 43 percent of the applicant’s gross monthly income. Borrowers cannot have any delinquent federal debts, such as unpaid income taxes or student loans.
FHA loans are available only for primary residences, so you can’t qualify for such a loan if you want to buy a vacation home or investment property. FHA homes require an appraisal by an FHA appraiser and must meet certain guidelines regarding the property’s habitability. That includes no hazards in the dwelling, no evidence of lead-based paint if the house was built before 1979, adequate heating and drainage, working appliances, a roof in good repair and availability of all utilities.
FHA Closing Costs
Typically, the FHA closing costs are less expensive than those associated with a standard mortgage. FHA borrowers should expect to pay between 2 and 5 percent of the home’s purchase price in closing costs – and that amount adds up. Typical closing costs include loan origination fees, discount points, title search and appraisal fees, home inspection, surveying fees, credit report fees, courier costs and fees for the buyer’s attorney. An FHA loan requires certain additional fees, such as the Upfront Mortgage Insurance premium (UFMIP), which equals 1.75 percent of the loan amount and is paid immediately post-closing.
Financing Closing Costs for FHA Loan
Because the FHA mortgage program is geared to lower-income buyers, they may have additional problems coming up with funds for the closing and other costs. The FHA permits the seller to pay up to 6 percent of the home’s purchase price for closing costs. That isn’t really a gift per se, as most sellers will want the buyer to pay 6 percent more for the dwelling if they are going to foot part of the closing costs.
The program does allow for financing closing costs for FHA loans with gifts. Such monetary gifts may come from family, friends, your religious organization, labor union, a charitable organization or your employer. There is one strict caveat: The money is a gift and no repayment is expected. If the house is new construction, the builder may provide a credit to the home buyer for closing costs, although this is not a gift per se. Such a credit requires inclusion in the original sales contract.
Documenting Your Gifts
If you are the beneficiary of generous family or friends willing to pay your closing costs, you must document your gift. That involves receiving a gift letter signed by the donor, stating the amount and making it clear there is no expectation of repayment. You must also document your transfer of the gift into your account, but a deposit slip or your bank account statement will fill the bill. The last step may prove a bit more difficult, but you must request a copy of the donor’s bank account, which proves the person or entity indeed had the money available to give you. Make sure the amount of the gift and the amount you deposited into your account match exactly. The U.S. Department of Housing and Urban Development, which oversees FHA lending, requires such careful documentation because it must ensure that a gift for the closing costs or down payment did not come from any party that could benefit from the real estate sale, such as the seller or your real estate agent.
No Closing Costs Mortgages
Some FHA lenders may tout “no closing costs” mortgages. Once again, there is no such thing as a free gift from lenders, but this type of mortgage involves a higher interest rate in return for the closing cost payments. If you refinance your home within a few years, you can come out ahead with a no closing cost mortgage.
FHA Closing Costs Rolled into Loan
Use an FHA closing cost estimator to determine the amount of your closing costs to decide whether or not you should roll your FHA loan closing costs into the loan. You can find such a calculator online. You can roll up the closing costs and the loan together as the long as the two don’t exceed 96.5 percent of the home’s value. That’s where that 3.5 percent down payment comes in. You cannot roll your down payment into your FHA loan, but you may roll the UFMIP cost into the mortgage. The 96.5 percent, however, will also include your UFMIP should you chose to roll it into the loan, rather than pay it separately. There are other items, such as prepaid property tax insurance, that you must pay in addition to closing costs at the time of the closing. If you buy a bank-owned, foreclosed home, you are in a different situation. HUD allows buyers to put little cash down for such a property so you will more likely exceed the 96.5 limit when it comes to the rollover.
Keep in mind that you aren’t saving money per se when rolling your FHA loan closing costs into the loan. Such a rollover simply means you don’t have to pay those costs on the day of closing, but you pay for them not only via higher interest rates but also have to pay interest on that additional money.
Down Payment Gifts
The FHA also allows the same entities eligible to contribute gifted funds to closing costs to do so for the down payment. In addition to friends, family and the like, HUD permits down payment gifts from government agencies or other public entities that help first-time, low- to moderate-income individuals become home buyers. The rules for down payment gift letters are similar to those for closing cost gift letters.
- Rolling your closing costs into your FHA mortgage may save you the hassle of coming up with closing fees during escrow, but the convenience comes at a price. Your monthly mortgage payment will be higher since those closing charges will be added to your mortgage, along with incurred interest on the total.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Zack's, Financial Advisor, nj.com, LegalZoom and The Nest.