What Sellers Need to Know About FHA Loans When Fielding Offers

You’ve just received the first offer on your home — and it’s backed by an FHA loan. So what do you need to know about FHA loans as a seller?

The U.S. Department of Housing and Urban Development (HUD) created the Federal Housing Administration (FHA) loan program in 1934 to help more Americans afford houses with government insured home loans that are easier to qualify for than most conventional loans. Today, FHA loans represent a fair share of the mortgage market; in 2018, the FHA insured 12.1% of all mortgage originations.

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As a seller, you’re usually not taking on additional risk by accepting an offer from a buyer pre-approved for an FHA loan than you would with a buyer pre-approved for a conventional loan. In fact, it’s even possible for an FHA loan-backed offer to be the best offer in a multiple offer situation. Still, you need to know that the FHA has specific property and financial requirements that sellers need to meet in order for their buyer’s loan to close.

For all the details, HomeLight spoke with top real estate agent Jesse Dill from Portland, OR, who, as a first-time homebuyer specialist, has extensive experience working with buyers backed by FHA loans. We also reviewed government guidance for additional insights. Here are seven things sellers need to know about FHA loans:

1. FHA loans help make homeownership more accessible

When you get an offer from a buyer pre-approved for an FHA mortgage, it means they have received conditional approval from their lender, and that their loan size meets or exceeds the contract price. To obtain pre-approval, the buyer must meet a set of lending criteria for their mortgage following FHA requirements; these are generally easier to meet than those of conventional loans in several ways.

For example, FHA loan borrowers can qualify for a mortgage with a credit score as low as 500 with a 10% down payment, or 580 or above with a 3.5% down payment. By contrast, conventional loan borrowers will usually need a credit score of 620 or above.

In addition, an FHA-backed buyer may have a slightly higher DTI (debt to income) ratio, a calculation of their monthly debts divided by their gross monthly income. FHA loans allow for higher DTI than conventional loans, as high as 57% in certain cases, whereas a conventional loan might be capped at a DTI of 45 to 50%.

Mortgage insurance (MI) works a little differently for FHA loans, too. A buyer who puts less than 10% down with an FHA mortgage is going to pay MI for the life of the loan, and FHA buyers who put 10% or more down have to pay MI for 11 years.

All of this is good context to have but somewhat immaterial to you as a seller. As a seller you won’t be privy to all the details of your buyer’s loan, regardless of if they finance with an FHA loan or a conventional loan. Whether it’s an FHA or conventional loan, the funds coming to you at the end of the day will be whatever you negotiate with the buyer within their financial means, regardless of the loan type.

2. In some cases, an FHA loan may be your best offer

When evaluating offers, rest assured that a buyer pre-approved for an FHA loan is just as likely to close their loan as a buyer pre-approved for a conventional loan. Dill shares that it’s only a myth that FHA-backed offers are by default weak offers:

“They are strong and well-qualified buyers with steady income. They usually just don’t have the 20% [down payment] and can put down as low as 3.5%. We rarely see FHA deals fall through . . . It does happen, but we rarely see it.”

On that note, the FHA loan is not actually the loan type with the lowest minimum down payment. The Conventional 97 loan allows buyers to put down as little as 3%, though it requires them to have a credit score in the mid- to high-600s — higher than the FHA loan’s minimum score of 580. USDA and VA loans both go as low as zero down.

In a bidding war, it’s not usually advisable for the seller to weigh the strength of the offer based on the buyer’s loan type, whether it’s FHA or conventional. Instead the seller should primarily weigh the strength of the offer based on factors like the price and contract terms. If an offer backed by an FHA loan has a higher price and more desirable terms than other offers, it may be the best offer.

3. The appraisal process for FHA loans is stricter

If you have an FHA loan backed buyer, expect a thorough appraisal process. An official FHA loan appraiser must conduct the appraisal, following HUD’s designated guidelines.

Sellers must complete major repairs before closing

In the FHA appraisal process, the seller must complete repairs that are “necessary to maintain the safety, security, and soundness of the Property, preserve the continued marketability of the property, and protect the health and safety of the occupants” for the loan to close.

Examples of necessary repairs include:

• Inadequate forms of egress
• A leaking or worn out roof
• Foundation damage
• Defective paint surfaces in homes constructed pre-1978

The appraiser will not require the seller to complete cosmetic and minor repairs such as peeling paint or missing handrails, but they will report the defects and consider them when valuing the property.

Minor and major repairs cannot exceed $10,000 in costs

The appraiser also must report if the property is “insurable” and meets the minimum property standards (MPS) without needing repairs, or if it is “insurable with repair escrow” and requires repairs costing no more than $10,000.

If the home requires over $10,000 in repairs to meet the MPS, then the appraiser deems it “uninsurable.” In this instance, the FHA will not insure the loan, meaning the buyer’s loan will not close.

4. All included appliances must meet FHA guidelines

The FHA requires that appliances that “remain and that contribute to the market value opinion are operational.” In layman’s terms: If the appliance is staying, it must be functional. Appliances include refrigerators, ranges, ovens, dishwashers, disposals, microwaves, washers, and dryers.

The appraiser may test the appliances during the appraisal. If the utilities are not on at the time of the appraisal, the appraiser may require a re-observation at a later time when utilities are back on; or, they may “complete the appraisal under the extraordinary assumption that utilities and mechanical systems, and appliances are in working order.”

5. A low appraisal is more likely to jeopardize the sale

If the home’s appraised value comes in lower than the agreed sale price, you might be in a tighter bind with a buyer with an FHA loan than a conventional loan. Regardless of the loan type, the lender will only approve the borrower for a certain loan amount, based on the loan-to-value (“LTV”).  The LTV is calculated based on the downpayment and the property’s appraised value (for example, with a 5% downpayment, the lender has approved the borrower for a loan of 95% LTV). If the appraisal comes back and the sales price exceeds the final appraised value then the borrower may no longer qualify based on that LTV.

In this instance, the only options are for the seller to lower the sale price or the buyer to pay the difference in cash. However, since many buyers choose FHA loans for the low minimum down payment and credit score requirements, oftentimes, they do not have the additional cash to cover this difference.

Dill most often sees appraisal shortages of $5,000 to $15,000. The greatest difference he ever saw was a $65,000 shortage on a list price for a home listed around half a million. He advises sellers to discuss their lowest acceptable price with their real estate agent before the appraisal. This way, you have your next steps planned before emotions run high.

6. You can contribute up to 6% of your buyer’s closing costs

Sometimes a deal is so close to working out that the seller may want to throw in an additional incentive — known in real estate as a “concession” — to get everyone to the finish line. As with most lenders, the FHA sets limits on seller contributions. HUD establishes that the seller can pay closing costs for up to 6% of the home’s sale price.

7. Condos have additional special considerations

If you’re selling a condo unit, the entire condo complex, not just your unit, must meet the FHA’s certified condo qualification list for the buyer’s loan to close. To see if your condominium project is on the FHA-approved list, search for your property on HUD’s Condominiums page.

If your complex is not certified, you’ll probably want to consider other offers from non-FHA loan backed buyers unless you have time to spare. The buyer’s lender will need to coordinate with the condominium to get it approved; expect to receive a response in a few weeks and approval in 30 days.

“We have quite a bit of condos around Portland, and a lot are not on the list of FHA approved condos. The community has to work with the lender. It’s quite a process,” Dill shares.

When certifying new complexes, HUD considers aspects, such as “insurance coverage, financial condition, nature of title, the existence of any pending legal action or physical property condition, and other factors that may affect the viability or marketability of the project or its units.”

Make an informed decision on FHA loan backed offers

As a seller, you need to know about FHA loans before you accept an offer from an FHA-loan-backed buyer. While these buyers’ offers are legitimate, they will require you to jump through a few additional hoops than you would normally need to, especially during the appraisal process.

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