How to tell when an FHA loan is right for you

FHA loans are well-known for helping families of modest financial means buy a home.

Since the home mortgage crisis, the FHA has tightened up some rules. But for many home buyers, FHA loans are still the most surefire way to finance a purchase.

The loan limits for single-family homes range from $417,000 in most parts of the country to as high as $729,750 in high-cost regions such as New York and San Francisco.

The higher limits for FHA loans remain at up to $729,750 despite the lowering of the limit for conventional non-jumbo loans last fall.

The Federal Housing Administration, a division of the Department of Housing and Urban Development, was created 78 years ago to help low- and moderate-income families obtain financing for home ownership.

The FHA doesn't actually make home loans. It guarantees repayment to lenders, so they know they won't lose money on the deal.

That lets banks or mortgage companies offer competitive mortgage rates on loans that are easier to qualify for than conventional home loans.

With an FHA-backed loan you can have:

A smaller down payment. Most FHA mortgages require a 3.5 percent down payment  -- that's $3,500 for every $100,000 you borrow. If your FICO credit score is below 580, you'll have to come with a 10% down payment.

Most non-FHA loans require a down payment of at least 5%, and often as much as 20 percent, of the purchase price.

Your down payment can also be a gift from a relative, friend or an organization that provides financial assistance.

Borrowers are allowed to work with state and local programs that provide help with down payments, closing costs and low-rate loans. Your lender will be glad to explain how these work.

Some of the shadier "down payment assistance programs" of the past were shut down by the Housing and Economic Recovery Act of 2008. These programs were basically shams where builders inflated home prices and "donated" money to organizations that turned around and provided the down payments.

"This crackdown in gift funds is directed to non-related parties and stopped builder subsidies and all the funny business of a few years ago," according to Mary Tootikian, a mortgage broker and author of Stunned in America: Sub-Crime Mortgage Crisis.

It doesn't prevent mom and dad from contributing to your purchase. "Parents can still gift to children," she says.

Many conventional mortgages do not allow that, requiring down payment to come from a borrowers' savings or other assets, such as proceeds from the sale of another home.

Surprisingly poor credit. The government allows lenders to establish their own minimum credit score to qualify for an FHA loan, and it's usually quite low, typically between 580 and 620. (Anything below 620 is considered a subprime score.)

Borrowers with credit scores between 500 and 580 may qualify if they meet other underwriting standards, but they must make a larger down payment. Borrowers with credit scores under 500 are not eligible for FHA financing.

To get a loan, you need two things: a two-year history of on-time bill payments and two years of steady employment. Even with these requirements, exceptions are made.

In the past, few things could automatically disqualify you for an FHA loan. If you:

1. Declared bankruptcy, you must wait two years from the date of discharge.
2. Lost a home through foreclosure, you must wait three years.
3. Are delinquent on a federal debt, such as a student loan or back taxes.

A new rule that was supposed to take effect in April would have disqualified many borrowers with more than $1,000 in unresolved debts that are in dispute or in collections.

But the FHA is taking a second look at that requirement and delayed its implementation until July at the earliest.

More debt. To obtain most non-FHA loans, borrowers must be spending no more than 36 percent of their pretax income on all debts, including mortgage payments, student loans, credit card bills and auto loans.

With an FHA loan, lenders will allow you to spend up to 41 percent of your pretax income on debt. Some lenders will stretch that to 43 percent for borrowers with an excellent payment history. (Use your own discretion on whether you should stretch your budget to spend that much of your pay on debt payments.)

Mortgage insurance. The big disadvantage to FHA financing is the mortgage insurance you have to pay up front. It's the price you pay for having the government stand behind your loan.

All borrowers, regardless of the term of their loan or the size of the down payment they make, must pay the 1.75 percent upfront mortgage insurance premium at closing.

That means that you pay a $1,750 insurance premium on every $100,000.

While that can be added to your loan amount, it's still an extra charge.

Most borrowers will also have to pay monthly insurance premiums, which are comparable to what you would pay for private mortgage insurance on a non-FHA loan.

For a 30-year loan with a down payment of less than 5 percent, your premiums will be 1.25 percent of the outstanding balance each year. If you put more than 5 percent down, your annual premiums will be 1.20 percent.

That cost is typically divided into 12 monthly payments and added to your mortgage payment.

You'll have to carry this insurance for at least five years on all loans longer than 15-years until the balance on your mortgage is down to 78 percent of the original purchase price (not counting any financed upfront mortgage insurance premiums).

On non-FHA loans, private mortgage insurance can usually be dropped after the balance of the loan is down to 80 percent of the purchase price and after a minimum of only one year.

Private mortgage insurance also allows you to count appreciation toward obtaining the needed equity. FHA loans do not.

Self-employed individuals can apply for FHA loans. If you are a sole proprietor, be prepared to show business financial statements and more documentation than you would need if you were an employee.

You can apply for an FHA-backed loan from most banks and mortgage companies.