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Why Do First-Time Home Buyers Flock to FHA Loans?

SANTA ANA, CA--(Marketwired - Apr 22, 2013) - With real estate prices rising and interest rates not far from record lows, many are wondering how they can buy a first home before today's window of opportunity closes. The answer? FHA financing with little down, a mortgage so safe and secure that generations of first-time buyers have used it to enter the housing market.

"More than 2.8 million first-time buyers have purchased homes using FHA financing since 2009," said Ray Brousseau, Executive Vice President with Carrington Mortgage Services, a lender active in more than 40 states. "In fact, in the past year a big majority of FHA purchase mortgages -- more than 75 percent -- have gone to first-time buyers."

The central attraction of the FHA loan program is straight-forward: Qualified borrowers can buy a home with just 3.5 percent down. That means for a $150,000 property a buyer needs just $5,250 in cash plus closing costs.

It is worth pointing out that the FHA is not a lender. Instead, it insures mortgages for borrowers who meet certain standards. FHA insurance is so reliable that lenders are comfortable allowing borrowers to finance with as little as 3.5 percent down instead of the standard 20 percent generally-required up-front.

So why are FHA loans so popular among first-time borrowers? Let's take a look.

Down Payments: First-time FHA borrowers are generally required to put down just 3.5 percent of the purchase price but there are exceptions: if you have a credit score below 580 then the program requires 10 percent down. Also, HUD has proposed that if you borrow more than $625,500 then at least 5 percent down will be required. Interested parties can check with a Carrington Mortgage Services mortgage professional for the latest details of HUD's FHA program.

"One of the great attractions of the FHA program is that loans must be used to purchase a primary residence," Brousseau explained. "However, a 'primary residence' can include a home that has anywhere from one to four units. As long as one of the units is owner-occupied, FHA financing can be considered. This means first-time owners can also become first-time investors with just 3.5 percent down if they meet FHA guidelines."

Gifts: FHA borrowers may need less cash up front if they can obtain a gift from family, friends, or other sources.

"Gifts can be equal to some or all of the down payment, in fact gifts that exceed the down payment are allowed," said Brousseau. "The extra money counts toward reserves."

Credit Scores: In recent months the typical FHA borrower has had a 696 credit score, however the FHA also insures loans for borrowers with lower credit scores.

"The FHA has recently moved toward tighter credit standards," said Brousseau. "As of April 1st, when the debt-to-income ratio exceeds 43 percent and the borrower has a credit score of 620 or less the loan application must be manually reviewed. Manual underwriting can be useful because it allows lenders to consider compensating factors when looking at a loan."

Debt Ratios: You can get an FHA loan if you have monthly debts; there is no FHA requirement to be debt free.

Generally there are two debt standards to consider: first, homeownership costs -- generally mortgage principal, mortgage interest, property taxes and property insurance, also known as "PITI" or the "front-end ratio" -- can equal no more than 29 percent of gross monthly income. Second, borrowers can qualify for FHA financing when all regular debts -- the back-end ratio -- do not exceed 43 percent of gross monthly income. The back-end ratio includes PITI, car loans, credit cards, education loans, etc.

Gross monthly income is the money you earn before income taxes. If you earn $60,000 a year that's $5,000 a month. If PITI can be as much as 29 percent of your gross monthly income it means basic homeownership costs can total as much as $1,450 per month while overall debts -- the "back-end ratio" can be as much as $2,150 per month (43 percent) in this example.

Brousseau said that "sometimes debt ratios can even be higher. For instance, if you have an FHA energy-efficient mortgage you're allowed to have higher debts because ownership costs are expected to be lower."

Mortgage Insurance: Just like auto insurance or health coverage, the FHA insurance program requires premium payments. In the case of the FHA there is an upfront mortgage insurance premium and an annual mortgage insurance premium (MIP).

As an example of how the premium system works, imagine that you borrow $175,000 with 3.5 percent down. The up-front MIP is equal to 1.75 percent of the amount borrowed; however this sum can be added to the mortgage balance and paid off over time. The annual MIP is 1.35 percent of the outstanding balance and 1/12th of the annual MIP is paid each month. Because the FHA insurance formula changes from time to time, and because different rates can apply in some situations, borrowers should speak with a Carrington Mortgage Services professional for the latest information and specifics.

"We pay insurance all the time as a hedge against risk, whether it's home insurance, car insurance or health insurance," Brousseau explained. "FHA mortgage insurance allows a borrower to purchase a home now without waiting until a 20 percent down payment has been saved, which might take several years. In a market with historically low interest rates or generally rising prices, buying now can mean buying at a lower cost than in the future."