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FHA Basics: What is FHA, and how does it work?

Keith Gumbinger

FHA mortgage basics: What is FHA?

The Federal Housing Administration (FHA) is a government-created entity that essentially runs and manages an insurance pool to help lenders manage mortgage risks.

The insurance fund program was created in 1934 as part of the National Housing Act. Its creation came in the wake of the Great Depression and a wave of bank failures that made getting a mortgage nearly impossible. The FHA's premise is that in exchange for making mortgages under common standards, lenders would be indemnified against losses on mortgages they made. The FHA was the mainstay of the mortgage industry until the creation of Fannie Mae (1938) and Freddie Mac (1970), whose mortgage missions were different and whose roles in the market have changed over time.

How does FHA work?

It's pretty simple, actually. Lenders who meet FHA criteria make mortgages using their own funds that meet FHA underwriting standards. All FHA-backed mortgage borrowers pay insurance premiums into a pool called the Mutual Mortgage Insurance Fund (MMIF); premiums are collected at the time the loan is originated and during its life. In the event that a borrower fails to make payments on the loan, the lender is given his money back from the MMIF pool, FHA takes ownership of the property (usually via foreclosure) and then sells the property to recover (hopefully all) of its money.

How does the FHA guarantee help you?

Because a lender has no risk of losing money, they are more willing to make loans to borrowers whose credit isn't all that great; borrowers are also allowed to put less money down than might be necessary without FHA backing. It's well known that weak credit scores and small downpayments create a greater risk of delinquency or default, and without the MMIF to back them up, a lender probably wouldn't make a loan to these riskier borrowers -- or would require stronger credit or charge higher insurance costs, such as those found in the "conventional" mortgage market.

What kinds of properties do FHA loans cover?

The most common program, called FHA 203(b) covers single-family homes, condos, up to four-unit residential buildings and other properties. Special programs cover mobile and factory-built housing with permanent foundations, entire mobile home parks, condo developments and more. FHA offers insurance to cover traditional "forward" mortgages, mortgages with construction-to-permanent components, purchase-and-rehabilitation mortgages (FHA 203k) and even reverse mortgages for senior homeowners.

Can an FHA loan be used to purchase or refinance a home?

Yes, of course. FHA-backed loans are a popular option for first-time and low-to-moderate income homebuyers, as they can have lower barriers to borrowing than conventional or private loans. For refinancing, FHA offers a very popular FHA-to-FHA Streamline Refinance program, and there can be times when refinancing into the FHA program from a conventional or private mortgage is the best option available.

Who makes FHA mortgages?

While some banks, thrifts and Credit Unions do participate in the FHA program, most mortgage banking firms are active participants or even specialize in making FHA-backed mortgages. You should certainly compare options in your marketplaces, but if you want an FHA-backed loan, odds are pretty good you'll be working with a mortgage banking firm. Not to worry, though; many of these companies are among the largest originators of mortgages in the country.

Can FHA help me if I have trouble making payments?

If you have an FHA-backed loan and are experiencing trouble making payments due to a hardship, FHA does offer loan modification under the its version of the Home Mortgage Affordable Program (FHA-HAMP). A variety of methods can be used to make your mortgage payment more affordable and sustainable. For assistance, contact your loan's servicer, whose number or website address and contact information should be on your monthly mortgage statement.

I've heard that FHA loans are "assumable." What does that mean?

FHA-backed loans can be passed from one party to another, a process known as assumability. In essence, the loan is simply assigned from one party to another. This most often occurs when a parent "gifts" a home to their child (or a child inherits it) or when assets are split in a divorce. Assumability offers a lower-cost, more streamlined option than a full-blown refinance, and preserves key features of the loan, such as the interest rate, which could prove very valuable if market interest rates have risen. The person assuming the loan must meet standard underwriting requirements, and the original remaining loan balance cannot be increased, so this might mean a sizable down payment requirement for a prospective buyer if home values have appreciated.

Related: Learn the advantages of FHA-backed mortgage loans

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