The FHA Home Loan Process - A Video Explanation

Between 2008 and 2011, the FHA loan has become one of the most popular financing tools for home buyers. The primary reason is that you can make a smaller down payment, as little as 3.5 percent of the purchase price. This appeals to first-time buyers in particular. But many people don't fully understand how an FHA loan works. That's where this video comes in.

Video transcript: Today we're going to talk about the FHA home loan and how it works. There are three parties involved here. The first one is the FHA, obviously. This abbreviation stands for the Federal Housing Administration, which falls under the Department of Housing and Urban Development, or HUD. So it's part of the federal government.

The second party involved is the bank. This is a "primary lender" such as Wells Fargo, Bank of America, or one of your local community banks. The third group involved is the actual borrowers. In the case of FHA home loans, these are the home buyers. You can think of it as a triangle relationship between the bank, the borrower and government.

So, when you apply for an FHA home loan, you'll actually approach the bank directly. A lot of people think they apply for the loan through the FHA, but that's not how it works. It's a common misconception. The applicant would go directly to the lender to apply for the loan program, assuming they meet all of the requirements.

The FHA Mortgage Process

So the lender gives the money to the borrower, as in a normal mortgage situation. The FHA insures the lender against losses resulting from default. So if the homeowners can no longer make their mortgage payments (perhaps due to job loss or affordability problems), the bank will be insured by the federal government though the FHA.

What does this mean to you, as a borrower? It means that you might have an easier time qualifying for an FHA loan than a conventional mortgage loan (one that lacks government backing). If your credit score is less than perfect, you may still qualify for an FHA loan. You can qualify with a smaller down payment, as low as 3.5% for an FHA loan. You won't find a down payment this low on a conventional mortgage loan.

These are some of the key benefits of using the FHA program -- easier qualification process, smaller down payment, and a higher likelihood of being approved. Why do you have a better chance for approval? Because the bank knows the FHA will cover them for any losses resulting from the borrower defaulting on payments. This insurance makes the bank more willing to lend money through this program, so you stand a better chance of getting the loan.

This is how the FHA home loan works. You apply for the loan through a lender in the primary mortgage market. If you meet the minimum requirements and get approved for the loan, the federal government will insure it against losses. This insurance protects the lender -- not you.

Requirements: Credit Scores and Down Payment

It's a common misconception that anyone can qualify for an FHA loan. This is not the case. The Federal Housing Administration took huge losses during the housing crisis. They had to make insurance payments on thousands of mortgage loans that went bad. As a result, their capital reserves fell below the level required by Congress. Over the last couple of years, they've been making certain changes to the FHA loan process to make up for these losses.

For one thing, they've implemented a minimum credit-score requirement that pertains to your down payment. If you want to take advantage of the low 3.5% down-payment option, you'll need a FICO credit score of 580 or higher. But some lenders will require a score even higher than this. If you get approved for an FHA loan with a score below 580, you'll be required to put at least 10% down (which sort of defeats the purpose of using the FHA program).

Starting in April 2011, borrowers will also face higher insurance premiums for FHA mortgage loans. This is another move designed to replenish the Federal Housing Administration's capital reserves, which plummeted during the housing crash. You can learn more about the insurance premiums here. 

There are also certain disadvantages to the FHA mortgage process. We already talked about the additional amount you'll pay for mortgage insurance. This comes in two forms, actually-- there's an upfront premium that's due at closing, plus an annual premium that's added onto your monthly mortgage payments. You'll probably pay a higher interest rate as well, when compared to a conventional loan. If you're in a situation where there are multiple offers on a house, an FHA loan could actually be a liability for you. Learn more about the disadvantages of this strategy.

How to Find a Lender

Applicants can find a lender by visiting the HUD website and searching for an FHA-approved lender in their area. Just do a Google search for "find FHA-approved lender" and you'll find the appropriate page of the HUD website where you can search for lenders in your area.