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Consider an FHA Loan

The agency is eager to serve subprime borrowers.

Editor's note: As a special feature for April, is offering a series of 20 stories on everything you need to know about real estate. Today's story is the third installment.

Just because the subprime mortgage industry is in trouble doesn't mean a poor or limited credit history will keep you from buying a home.

Subprime lenders are closing up shop or tightening their lending standards, making it tougher for people who are first-time homebuyers or have impaired credit to get financing. But the Federal Housing Administration, which ceded market share during the go-go years, wants to help fill the void being left as subprime lending slows.

The agency is cutting red tape and speeding up processing in an effort to expand its business.

The FHA, which is part of the U.S. Department of Housing and Urban Development, doesn't lend money. Instead, it insures loans, allowing borrowers to obtain cheaper financing than they might get otherwise.

Unlike subprime mortgages, these loans have no prepayment penalties and no teaser rates. And the interest on FHA-insured loans is currently around three percentage points less than on subprime loans.

There are some major drawbacks. The FHA currently can't insure loans over $363,000. So if you live in high-cost markets such as California, Florida and much of the Northeast, an FHA loan might not even get you a starter home. Last year, the FHA insured just 2,599 mortgages in California, down 98% from 2000.

It can also be difficult for condominium projects to get FHA approval.

And, for now at least, you need a down payment of 3%, although homebuyers can use gifts from family members, nonprofit groups or employers to make their entire down payment.

Another difference is that you can't just state your income; you'll have to document how much you earn. And the FHA won't insure exotic mortgages that let you pay only interest for an initial period, or even worse, make minimal payments that may not even cover all of the interest that accrues each month.

But that means you're unlikely to get saddled with a home you can't really afford. A lot of people who took out mortgages with low teaser rates are facing foreclosure now that the rates have reset, pushing the monthly payments higher. They might have been better served by an FHA mortgage that offered lower payments over the life of the loan.

Until recently, however, the FHA was a tough sell. Even if the loan limits weren't a problem, many borrowers balked at putting down 3% of the purchase price when they could take out another loan to finance the down payment.

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Slower processing was another impediment; in hot markets where bidding wars often erupted, having an FHA loan could put a borrower at a distinct disadvantage.

And as long as housing prices kept rising, people assumed they could always refinance the loan, or in the worst case, sell their home and pay it off if they ran into trouble.

As a result, the FHA's market share fell to less than 4% in 2006 from just under 14% in 2000.

Now that subprime lenders are pulling in the reins, FHA loans are starting to look more competitive. The red tape isn't such a big deal in a buyer's market, when every block seems to sport at least one "for sale" sign.

Endorsements are on the rise in the current fiscal year, particularly for refinance loans.

A proposed revamp would make the FHA even more competitive. The administration wants to increase the loan limits, allow zero-down payments and set insurance premiums commensurate with the risk of the loans, so lower-credit borrowers would pay higher rates and higher-credit borrowers would pay lower rates.

The Expanding the American Homeownership Act, also known as FHA reform or FHA modernization bill, was passed in the House of Representatives last year but stalled in the Senate. It has been reintroduced in the House.

In the meantime, if you want an FHA mortgage, you may need to ask for it specifically. To find a qualified lender, go the

FHA's Web site.

Going through a mortgage broker is probably not your best bet. The National Association of Mortgage Brokers estimates that less than 18% of its members are approved to originate FHA loans, although recent surveys indicate many more would if there were no financial barriers.

Coming up next: How to avoid foreclosure.

Allison Bisbey Colter joined in 2006 from the New York office of Dow Jones Newswires, where she spent the previous seven years covering consumer finance, mutual funds and hedge funds. Prior to that, she worked in Europe for Dow Jones covering transportation from London and Italian capital markets from Milan. She is a graduate of Wesleyan University, where she received a BA in government.