Criteria for FHA Loan Approval

Reader question: "You probably get this question a lot, but here it goes anyway. I'm a first-time buyer, and I want to use an FHA mortgage loan to buy a house. I've read that this is a good financing option for people without a lot of money for the down payment. Can you tell me what it takes to get an FHA loan approval these days? Has it gotten harder to get approved for these loans, as it has with regular loans?"

Yes, the FHA loan program is well suited for first-time buyers. The biggest advantage is that it reduces your down-payment expense. In fact, you won't find a lower down-payment requirement than what the FHA offers (unless you use a VA or USDA loan with zero-down financing). This is why the program appeals to first-time buyers who don't have any proceeds from a previous home sale.

Of course, there are some disadvantages to this program as well. It's not all peaches and cream. I'll talk about the disadvantages later on, after we discuss the FHA loan approval criteria.

In a nutshell: You'll need to make a down payment of at least 3.5 percent of the purchase price. Most lenders will require you to have a FICO credit score of 620 or higher. Some lenders may work with borrowers with scores below that point. (The FHA credit-score requirement actually starts at 500 ... more to follow on this). You'll also need a debt-to-income ratio below a certain level. Your combined debts, including housing costs, should not account for more than 41 percent of your income.

These are the basic guidelines for FHA loan approval. We will discuss each of these items in more detail below. Please note that none of these items are written in stone. Okay, maybe some of them are. But there's also some flexibility built into the program. For example, a lender might be more lenient on your debt ratios if you have an excellent credit score.

Before we go any further, I need to bring the rest of the class up to speed. Here's a basic definition of FHA home loans for those who are not familiar with the program.

Definition of an FHA loan

An FHA loan is simply a mortgage that's insured by the Federal Housing Administration. This organization falls under the Department of Housing and Urban Development (HUD), which is part of the federal government.

The government insures the lender against losses that occur when a borrower defaults on the loan. HUD does not loan money directly to consumers. They only insure the loans. So technically, your loan approval will come from two sources -- the lender and the FHA.

You can learn more about the relationship between lenders, borrowers and the FHA in the in this video lesson.

Basic Eligibility Requirements

Let's start with the administrative nuts and bolts. In order to be eligible for an FHA home loan, you must be a legal resident of the United States. You'll also need a valid Social Security Number during the application process. You'll need to be the legal age for signing a mortgage in your state. Check with your applicable state laws to find out what this age is.

Mortgage lenders will also verify your income and assets, as well as your debts. It's not enough to say you make a certain amount of money. They'll want to see documentation that proves how much you make. This verification can be done with pay stubs, tax returns, and other items that show your assets and liabilities. We will talk more about these documents below

These are the basic criteria for eligibility. Just keep in mind that being eligible for a loan doesn't necessarily mean you'll be approved. In order to get an FHA loan approval, you'll need to go through an extensive underwriting process. This is when an FHA program specialist reviews your loan application and all of your supporting documents. They might even request additional documents during the underwriting process.

Now that we've covered the basics, let's talk about the specific criteria for approval:

Specific Criteria for Loan Approval

The first thing you must know is that there are exceptions to every rule. This is true for any type of mortgage loan, including the FHA program. So don't take any of this as gospel. These are the general guidelines used by lenders -- but they're not written in stone.

Additionally, these rules and guidelines change from time to time. For example, HUD has implemented a wide variety of changes since the housing crisis began in 2008. It can be hard to keep up with, at times. The information below was current as of 2011. You should speak to an FHA-approved lender to get the most up-to-date information available. 

With that disclaimer out of the way, here's what you might need for FHA loan approval.

1. Down Payment

You will have to make a down payment of at least 3.5 percent (of the purchase price or appraised value). The FHA will finance up to 96.5 percent of the home, but no more than that. You might have to put more money down if your credit score is below a certain point. See related item below.

2. Credit Score Requirements

In order to qualify for the 3.5-percent down payment, you'll need a FICO credit score of 580 or higher. If your score falls below that level, you will have to put at least 10 percent down -- if you can get approved at all. Most lenders today will not approve borrowers with FICO scores below 600. But there are exceptions to every rule.

Remember, you must meet two sets of credit guidelines for FHA loan approval. You must meet the minimum criteria established by HUD, as well as the lender's requirements. Here's the difference:  

FHA Requirements Lender Requirements
The FHA has two requirements for credit scores. To be eligible for the program, you'll need a FICO score of 500 or higher. To qualify for the 3.5-percent down-payment option, you'll need a score of 580 or higher. Mortgage lenders usually impose their own credit guidelines, on top of those used by the FHA. These are referred to as "overlays." Some lenders require a FICO 640 or higher, while others allow lower scores.

3. Loan Limits

The house you are buying must fall within the FHA loan limits for your area. These are limits on the value of the house. You won't get an approval for a home that exceeds these limits. You can research the limits for your city on the HUD website. These limits are scalable. That is, areas with higher housing costs have higher limits. For example, consider the difference between the low- and high-cost areas below.

  • The FHA loan limit for Round Rock, Texas is $288,750.
  • The limit for San Diego, California is $697,500.

You can find the limits for your area on this page:
https://entp.hud.gov/idapp/html/hicostlook.cfm

4. Debt-to-Income Ratios

During the application process, you'll hear the term "debt-to-income ratio" used a lot. Some lenders call them "debt ratios" for short. This is a comparison between your gross monthly income and the amount you spend toward your monthly debts. It shows how much of your income is going toward your various debts. Obviously, this is something a lender needs to know before approving you for a mortgage.

When it comes to FHA loan approval, there are actually two ratios you need to be concerned with. There's a front-end ratio and a back-end ratio. Here's the difference.

Your front-end ratio only includes your housing-related debt (i.e., your monthly mortgage payment). For the FHA program, most lenders will set this limit at 29 percent. That means your mortgage payment cannot account for more than 29 percent of your gross monthly income.

The math is pretty straightforward:

  • My monthly payment will be $875.
  • My gross monthly income (before taxes) is $4,250.
  • I divide 875 by 4250 and get .205, or 20.5 percent.
  • My front-end debt ratio is 20.5 percent. Well below FHA limits!

Your back-end ratio is similar to the one explained above, but it also includes your other monthly debts. This ratio includes your mortgage payment, as well as your credit card payments, car loan, student loan, etc. Basically, anything that shows up on your credit reports. For FHA approval, most lenders set the bar at 41 percent. This means your combined debts cannot account for more than 41 percent of your monthly income.

Again, the math is easy to do:

  • My monthly mortgage payment is still $875.
  • My other monthly debts add up to $1,200 a month.
  • This makes my total monthly debt equal to $2,075.
  • Again, my gross monthly income is $4,250.
  • I divide 2075 by 4250 and get .488, or 49 percent.
  • My back-end ratio is higher than the 41-percent FHA limit.

Now you can see the difference between these ratios, and how they can affect your FHA loan approval. In this scenario, my front-end ratio was fine. But once I added in my other debts, my back-end ratio exceeded the 41-percent mark. This happens a lot actually. In such cases, the underwriter might tell you to pay off a credit card or something. Of course, if both of your debt ratios are fine, you'll sail on through to the next checkpoint.

5. Employment

The FHA does not have any specific rules or requirements for employment. So the standard employment requirements for other mortgage loans apply here as well. Lenders will want to see that you've been gainfully employed for at least two years.

If you have a gap in employment resulting from school or military service, the lender might ask for documentation to serve as evidence. Likewise, they might ask you to explain any gaps in employment longer than 30 days. 

You will have to prove your employment with documentation. This can be a letter from your employer and/or pay stubs.

6. Insurance Premiums

Your loan approval will largely depend on the five items listed above (down payment, credit score, loan limits, debt ratios and employment). But there's another important topic we need to discuss. When you use the FHA program to finance a home, you will have to pay mortgage insurance. In fact, you'll have to pay two different premiums -- an upfront premium, as well as an annual premium. This is one of the disadvantages of this program.

  • The upfront insurance premium equals 1 percent of the loan amount (e.g., $2,500 on a $250,000 mortgage loan). You can pay it at closing or finance it into the loan, in most cases.
  • The annual premium equals 1.1 - 1.15 percent for 30-year loans, and 0.25 - 0.50 percent for FHA loans with a term of 15 years or less. This will be added onto your monthly mortgage payments.

Both of these premiums will drive up the cost of your loan. It's the price you pay for the smaller down payment! If you can afford to put down 20 percent on a conventional loan, you can avoid mortgage insurance altogether.

Documents Needed for FHA Mortgage Loans

FHA loan approval starts and ends with documents. From a qualification standpoint, nothing you say is acceptable. It must be supported with documentation. And, as you would expect from a government agency, there's a lot of paperwork to wade through. Here are some of the documents you'll have to provide in your quest for mortgage approval. This list is not complete. Your lender may request additional documents that are not listed below.

Document

Notes

FHA loan application

When you apply for an FHA loan, you will have to complete the standard mortgage application (Fannie Mae form 1003). You'll also have to fill out an addendum that is specific for the FHA program (HUD form 92900-A). You can find both of these documents online with a quick Google search, if you'd like to see what they include.

Evidence of SSN

You'll have to show the lender proof of your Social Security Number. You can prove your SSN with any IRS or income documents (W-2 forms, tax returns, pay stubs, etc.). The mortgage lender can also validate your SSN electronically, through the FHA's computer system.

Credit Report

The lender will request a copy of your credit report, and anyone else who is going to be listed on the mortgage. These documents must be submitted with your application package. 

Loan Underwriting Summary

This document contains basic information about the borrower as well as the mortgage. It includes information used to grant (or deny) FHA loan approval, such as your income, debts and estimated closing costs. It is signed by the underwriter and sent in with your other documents. 

Federal Income Tax Returns

Self-explanatory. The lender uses these to verify your income and employment.

Deposit Verification

The lender uses this, along with your most recent bank statements, to make sure you have enough funds for closing. This is an optional item -- the lender might just request bank statements for the last two months.

Employment Verification

Your FHA loan approval will also depend on your employment status. We talked about this earlier. You can provide a letter from your employer, along with pay stubs that prove your employment.

Completed Sales Contract

This is the purchase agreement / contract between the buyer and seller. It must be signed by both parties, and it must include any addendums or amendments. The lender will use this document during the appraisal, to make sure the home is worth what you've agreed to pay for it. The FHA needs a copy of it as well.

Real Estate Certification

This document is sometimes used as an amendment to the purchase agreement. It states that all information within the sales contract is true and accurate. It must be signed by the borrower / buyer, the seller, and the seller's agent. It might include other agreements as well, in addition to the standard sale of the property.

Appraisal Report

Your loan approval will also depend on the value of house. The home must be worth the amount you've agreed to pay for it. So the lender will send a professional home appraiser to determine the current value of the property. The appraiser's report must be submitted along with your other loan documents. 

Rent verification or payment history on previous mortgage loans

The lender needs to document your previous rent or mortgage payments. They can do this with (A) written verification from a landlord or mortgage company, (B) credit report entries, or (C) cancelled checks for previous payments. 

Explanatory Statement

If needed, your lender can provide additional information or documents that might help with FHA loan approval. They must also submit a statement that explains what these items are, and how they support the lender's decision.

This article explains some of the most important factors for FHA mortgage approval. This is a comprehensive lesson, but there is still more to learn on this subject. I recommend that you get pre-approved by a lender. This is a great way to find out where you stand, in terms of qualifications.

You can find a lender on this page of the HUD website:
http://www.hud.gov/ll/code/llslcrit.cfm

If you would like to learn more about this subject, you can use the search tool provided at the top of this page. We have dozens of FHA-related articles on this website.