For many homeowners or buyers, securing a conventional loan can be a daunting task, particularly if you don’t fit the mold of a “conventional” borrower. Having a low credit score or an unconventional income source can make it difficult for a home buyer to find home financing.
This is why the federal government created FHA (Federal Housing Administration) loans: to make mortgages and home loans more accessible.
Today, several different types of FHA loans are available, depending on the borrower’s needs and financial situation. This guide will review five of the more common types of FHA loans as well as some possible alternatives.
What Are FHA Loans?
Federal Housing Administration (FHA) loans are government-backed mortgages that were established in 1936 by the Department of Housing and Urban Development (HUD). The FHA home loan was created to stimulate the housing market and make housing more affordable for Americans. The FHA loan program works by reducing down payments and closing costs while increasing mortgage loan access, despite poor home buyer credit.1
Although these mortgages are insured by the FHA—which protects lenders against losses in the case of a borrower defaulting on their payments—they’re underwritten and administered by FHA-approved, third-party mortgage lenders.
Today, FHA loans help first-home buyers, seniors, and other borrowers who may find it difficult to obtain financing or a line of credit from private lenders. They tend to offer more lenient credit score and income requirements and lower down payments, making financing more accessible to everyone.
How Do FHA Loans Work?
FHA loans are typically available in one of two options: a 15-year or 30-year loan term with fixed interest rates. But, because lenders tend to see FHA borrowers as riskier, the FHA requires that borrowers pay for FHA mortgage insurance, which includes two specific FHA mortgage insurance premiums (MIP):
- Upfront MIP – 1.75% of the loan amount must be paid when the borrower receives the loan.
- Annual MIP – Depending on the loan term, amount, and initial loan-to-value ratio, a borrower may need to pay a monthly premium.
Generally speaking, shorter terms and larger down payments will lower MIP costs. Here’s how the FHA breaks it down:2
FHA Loans Over 15 Years
|Base Loan Amount||LTV||Annual MIP|
|≤ $625,500||≤ 95%||80 bps (0.80%)|
|≤ $625,500||> 95%||85 bps (0.85%)|
|>$625,500||≤ 95%||100 bps (1.00%)|
|> $625,500||> 95%||105 bps (1.05%)|
FHA Loans Under 15 years
|Base Loan Amount||LTV||Annual MIP|
|≤ $625,500||≤ 90%||45 bps (0.45%)|
|≤ $625,500||> 90%||70 bps (0.70%)|
|> $625,500||≤ 78%||45 bps (0.45%)|
|> $625,500||78.01% to 90%||70 bps (0.70%)|
|> $625,500||> 90%||95 bps (0.95%)|
Common Types of FHA Loans
To increase accessibility to financing to as many Americans as possible, the FHA loan program has created several different types of FHA loans, including:
#1 FHA 203(b) Standard Loan: Basic Home Mortgage Loan
The most common and traditional type of FHA loan, a 203(b) is a loan type designed for people who want to refinance or purchase a principal residence, ranging from a one- to four-unit structure, such as:
- Single-family homes
- Small apartments
With this standard FHA loan, the borrower is eligible for 96.5% financing of the home’s value with a down payment as low as 3.5% and a seller contribution of up to 6% of the purchase price.3
#2 FHA 203(k) Home Improvement Loan
How does a 203(b) vs 203(k) loan differ? Also known as rehab mortgage insurance, a 203(k) enables homeowners or buyers to finance and then fix up their homes by bundling both the financing and renovation costs into a single loan type. How does a 203(k) loan work? There are two types of 203(K) loans:4
- Standard – Has zero limitations on repairs, which is ideal for larger reconstruction projects. Borrowers can finance up to 96.5% of the home’s value.
- Limited – Allows homeowners and buyers to finance up to $35,000 into their mortgage to make minor repairs, improvements, or upgrades to the home.
Types of improvements that borrowers can make using Section 203(k) include:
- Making structural changes and conducting reconstruction work.
- Enhancing the home’s functionality by modernizing and making improvements.
- Eliminating any health and safety hazards present in the home.
- Improving the appearance of the home and removing any obsolete features.
- Reconditioning or replacing plumbing, as well as installing septic systems or wells.
- Installing, replacing, or repairing roofs, gutters, and downspouts.
- Adding or replacing floors and other floor treatments.
- Making significant landscape changes and site improvements.
- Enhancing accessibility for people with disabilities.
- Making energy conservation improvements.
#3 Home Equity Conversion Mortgage (HECM)
More popularly known as a reverse mortgage, a home equity conversion mortgage (HECM) is available to senior homeowners who are older than 62 and have built up equity in their home they want to draw on to supplement their income. It allows retirees to convert home equity into cash, either as a lump sum or a monthly payment. There’s a variety of HECM benefits. That said, how much cash is available will vary from one borrower to another, depending on factors like:
- Age of the youngest borrower or eligible non-borrowing spouse
- Current interest rate
- Lesser of appraised value, or the HECM FHA mortgage limit or the sales price
#4 FHA Energy Efficient Mortgage
The FHA Energy Efficient Mortgage was designed to promote sustainability in residential buildings by allowing borrowers to finance energy-efficient upgrades to their home that would help them save on utilities. This operates similarly to a 203(k) but is primarily focused on energy packages.
To qualify for this loan, the borrower must obtain a home energy assessment in order to identify opportunities for improving energy efficiencies and then establishing and testing for cost-effectiveness.5
#5 Section 245(a) Loan
Do you expect your income to rise in the near future?
A 245(a) loan is designed for borrowers who currently have a limited income but believe that their pay will rise over time. It follows a graduated-payment mortgage model that begins with lower monthly payments that increase over the first 5 to 10 years. According to the FHA:
“As the mortgage payments grow, the additional payment is applied toward the principal on the loan, thus reducing the mortgage term. Growing-Equity Mortgages also allow homeowners who are interested in further reducing the term of their mortgage to apply scheduled increases in their monthly payments to the outstanding principal balance.”6
This type of mortgage is available to any person who believes their earnings will increase appreciably and want to use the property as their home residence.
The Residential Sale-Leaseback: A Different Option
FHA loans can be a temporary financing solution for non-conventional financing candidates who might have lower credit, a nontraditional income type, or a high debt-to-income ratio. However, these mortgages can come with high premiums, a high interest rate, and unfavorable terms.
The emergence of residential sale-leaseback has provided a different solution that allows homeowners to convert their home’s equity without moving.
A typical leaseback will be a two-part agreement:
- The homeowner sells the property to the buyer
- The buyer leases back the home to the original homeowner
How long the lease will go and how much rent payments will be are agreed upon before the sale is finalized. Depending on the contract, the seller may also have the option to repurchase the home at a later date.
Advantages of the Sale-Leaseback
Why would a homeowner prefer a sale-leaseback over an FHA loan or conventional loan? Some of the sale-leaseback benefits include:
- Asset liquidity – Selling your home and then renting it back allows you to convert your home equity into cash without changing your lifestyle. This makes it possible to pursue your financial dreams or pay for an unexpected expense and stay in your home for as long as you want.
- Early retirement – Homeowners can’t qualify for a reverse mortgage until they’re 62. A sale-leaseback would enable an early retiree to draw on the value of their home at a much earlier stage.
- Time to plan – In a typical home sale, the previous homeowner is often required to vacate the property as soon as possible, leaving little time for planning their next move, such as relocating or constructing a new residence. However, a sale-leaseback option allows the homeowner to stay put for a specified period, which lets them plan their next steps without feeling rushed.
- Flexibility – A sale-leaseback agreement contract is a flexible arrangement between the buyer-lessee and seller-lessor. The homeowner may have bargaining power over terms like rental prices and lease duration.
The Bottom Line
FHA loans are loans provided by private lenders that are regulated and insured by the FHA, which increases access to financing for unconventional borrowers. That said, they tend to be more expensive than conventional loans since borrowers are viewed as riskier. It’s important to take this into consideration when choosing between a conventional renovation loan vs 203(k).
While each of the five types of FHA loans has some merit, increasingly, more homeowners are instead turning to a residential sale-leaseback program. This type of novel financing program allows them to convert their home equity into cash without leaving their home until they’re ready. And the best programs will provide options for extended leases and home repurchasing options.
Before you apply for an FHA loan or sale-leaseback, speak to an experienced broker who can help you decide what program would be the best fit for your financial circumstances and goals.
- HUD. Let FHA Loans Help You. https://www.hud.gov/buying/loans
- FHA. FHA Requirements. https://www.fha.com/fha_requirements_mortgage_insurance
- HUD. Basic Home Mortgage Loan 203(B). https://www.hud.gov/program_offices/housing/sfh/ins/sfh203b
- HUD. 203(K) Rehab Mortgage Insurance. https://www.hud.gov/program_offices/housing/sfh/203k/203k–df
- HUD. Energy Efficient Mortgage Program. https://www.hud.gov/program_offices/housing/sfh/eem/energy-r
- FHA. FHA Growing Equity Mortgages. https://www.fha.com/growing_equity