What is an FHA Loan and How Do They Work?

FHA loans are regulated and insured by the Federal Housing Administration (FHA).

Exterior of a modern house

FHA loans are government-backed mortgages geared towards people with low credit scores or low-to-moderate income. They are incredibly popular among first-time homebuyers with limited capital for a down payment or do not qualify for a conventional mortgage. If you are considering an FHA loan, we’ll break down what they are, their requirements, and their pros and cons.

Key Takeaways

  • The federal government insures FHA loans provided by FHA-approved lenders and banks. They are geared toward borrowers who have difficulty obtaining conventional loans.
  • To take out an FHA loan, you need to meet certain requirements for the down payment, credit score, DTI ratio, property type, etc.
  • There are different types of FHA loans you can apply for, including the FHA 203(b) loan, FHA streamline refinance, FHA cash-out refinance, and more.

What is an FHA Loan?

An FHA loan is backed by the Federal Housing Administration (FHA), an agency under the Department of Housing and Urban Development. That means your mortgage is guaranteed by the government in case you default on your loan.

Even if you do not meet the requirements for a conventional loan or filed for bankruptcy in the past, you can still qualify for an FHA loan. You can use the loan to buy or refinance several types of homes, including single-family homes, two- to four-unit multifamily homes, condos, and certain manufactured homes. Specific types of FHA loans can also help finance new construction or renovate an existing home. However, all the properties must undergo an FHA appraisal and meet government standards beforehand.

While FHA loans are designed for people with lower income, anyone can get an FHA loan, even those who can afford conventional mortgages. In general, if you have good credit and strong financials, you’ll be better off with a standard mortgage. But, if you have poor credit, tons of debt, or a low down payment, an FHA loan may make more sense.

How Do FHA Loans Work?

FHA loans are issued by private lenders approved by the FHA, including banks, credit unions, and online lenders. The FHA itself does not issue FHA loans, but it insures them, protecting lenders in case of default. That is why FHA lenders are more willing to offer loans to borrowers who may otherwise not be able to qualify for a mortgage.

If you have a credit score of 580 or higher, you can borrow up to 96.5% of the home’s value with an FHA loan. If your credit score is between 500 to 579, you can still qualify for an FHA loan with a 10% down payment. The down payment can come from your savings, a family member, or a grant from a down payment assistance program.

History of FHA Loans

The FHA was created by Congress in 1934 during the Great Depression. Back then, the housing industry was in a dire situation. With rising default and foreclosure rates, 50% down payment requirements, and unfavorable mortgage terms, most people could only afford to rent. As a result, only one in 10 households owned their homes.

During the 1940s, FHA assisted veterans and their families with military housing and homes. From the 1950s to 1970s, FHA helped create millions of units of privately owned apartments for the elderly, handicapped, and lower-income borrowers. During the recession in the early 1980s, FHA helped stabilize home prices and provide potential borrowers with financing. To date, FHA actively insures over $1.3 trillion in properties.

FHA Loan Requirements

FHA Loan Down Payments

There is a minimum down payment of 3.5% for borrowers with a credit score of 580 or higher, significantly lower than the standard 20% for a conventional loan. If you have enough to make a 10% down payment, your credit score can be between 500 to 579.

Luckily, you do not have to rely solely on your savings for the down payment. You can use gift assistance for an FHA loan as long as the donor provides a letter with their contact information, relationship to you, gift amount, and a statement that the money is a gift. This process ensures that you are not taking out another loan for the down payment.

FHA Mortgage Insurance

When you get an FHA loan, you’ll need to pay two types of mortgage insurance premiums (MIP) — an upfront mortgage insurance premium payment and annual insurance payments. The upfront MIP is 1.75% of the base loan, which you can roll into the total loan amount. For instance, if your home loan is $500,000, you’ll pay an upfront MIP of 1.75% x $500,000 = $8,750. The recurring MIP payments range from 0.15% to 0.75% annually of the base amount.

With a conventional loan, you can stop paying private mortgage insurance once you have 20% equity in your home. However, you can’t cancel FHA mortgage insurance in the same way. The length of your monthly payments depends on the size of your down payment. If your down payment is less than 10%, you will need to pay your FHA mortgage insurance premiums for the entire loan duration. If your down payment is more than 10%, you’ll need to pay FHA mortgage insurance for 11 years.

The insurance protects the FHA against potential losses. These payments get deposited into an escrow account managed by the U.S. Treasury Department. If you default on your loan, the funds get used to pay the mortgage.

FHA Loans and Credit Score

You’ll need a minimum credit score of 500 for an FHA loan. However, some lenders may require a higher minimum credit score. By comparison, you’ll need a credit score of at least 620 to qualify for a conventional mortgage, plus a down payment of 3% to 20%. Generally, the lower your credit score and down payment, the higher the interest rate you’ll need to pay on your mortgage.

Other factors lenders consider include your income, payment history, existing debt, and prior bankruptcies or foreclosures. If you don’t meet the credit score requirement, you can build your credit by paying your bills on time, having a mix of different loans, and using less of your available credit line.

Debt-to-Income Ratio (DTI)

Your debt-to-income ratio (DTI) measures your monthly debt payments versus your pretax income. That includes car loans, student loans, and credit card balances. Lenders usually prefer borrowers with a lower DTI when issuing loans.

DTI requirements for FHA loans depend on your credit score and financial situation. If your credit score falls between 500 and 579, the FHA generally requires a DTI of 43% or less. There are instances where you can get an FHA loan with a DTI higher than 50%, but you may need to meet other conditions. If you have a good or excellent credit score, you may be able to qualify with a higher DTI.

To calculate your DTI ratio, divide your total monthly debt payments by your monthly gross income, or your monthly income before taxes. For example, if you have to pay $600 a month toward your student loans and $400 a month toward your car loan, and your income is $5,000, your DTI is 20%.

FHA Loan Limits

FHA has lending limits depending on where you want to purchase the property. For example, the minimum FHA lending amount for a 1-unit home in a low-cost area is $472,030, while the maximum mortgage loan amount for a high-cost area is $1,089,300. For 2-unit to 4-unit homes, the loan limits are higher.

Interest Rates

Since an FHA loan is backed by the government, the interest rates are fairly competitive. The exact rate you’ll get depends on several factors, including the prevailing interest rates, income, credit score, loan amount, down payment amount, DTI ratio, etc.

Income Requirements

While there are no specific minimum income requirements, you must prove that you have a stable income. Your lender may ask you for pay stubs, W-2s, federal tax returns, and bank statements to confirm that you have a steady employment history.

If you are self-employed, you’ll need to prove that you have at least a 25% stake in the company and that your business has been operating for at least two years. Other documents the lender may request include the last two years of tax returns, this year’s profit and loss (P&L) statements, and personal bank statements.

FHA Appraisal

An FHA appraisal ensures that the home you want to buy is a good investment and meets safety and livability standards. This appraisal is different from a home inspection, typically conducted by a home inspector to evaluate the home’s physical structure and systems. Additionally, the property must be your principal residence and owner-occupied. You cannot use an FHA loan to buy investment or rental properties.

Common Types of FHA Home Loans

There are several different types of FHA loans you can choose from. The type of FHA loan you pick will limit the type of home you can purchase and how you can spend the money.

FHA 203(b) Loan

An FHA 203(b) loan is the standard FHA loan. You’ll need to get an appraisal for the property, which includes a site analysis, property analysis, and property valuation. For the site analysis, the appraiser examines the home’s value relative to the surrounding neighborhood and confirms that the property meets all zoning requirements. For the property analysis, they will assess the home’s condition to ensure it meets FHA standards. After the site and property analysis, the appraiser generates a report detailing the property’s value. If the home doesn’t meet FHA requirements, they will provide a cost estimate for the repairs.

FHA Streamline Refinance

FHA streamline refinances are a quick way for homeowners to refinance their existing mortgages and potentially get a lower rate. They require less documentation, including reduced appraisal requirements and limited employment and income verification.

Generally, to qualify for an FHA streamline refinance, your existing mortgage must be an FHA-insured loan. You also need to have a minimum of six months of payments on your current loan, and you cannot have any late payments in the past six months. Additionally, you can only have one 30-day late payment max within the past year. Though an FHA streamline refinance may have fewer upfront costs, you’ll still need to pay closing costs and mortgage insurance.

FHA Cash-Out Refinance

An FHA cash-out refinance allows you to borrow against the equity in your home. It involves swapping out your current home loan with a new, bigger one insured by the FHA. The amount you can get depends on how much equity you have in your home, what you still owe on your current mortgage, and how much money you need. Ideally, you should try to get a lower interest rate.

You must meet minimum cash-out refinance requirements, including having at least 20% equity in your property after the refinance. When taking out an FHA cash-out refinance, you’ll also need to pay for other costs, such as mortgage insurance premiums, an appraisal fee, and closing costs.

FHA 203(k) Loan

FHA 203(k) loans, also known as “rehab loans,” allow you to purchase a home and finance renovations on a single loan. It’s a great option if you don’t mind buying a fixer-upper and putting some sweat equity in your home.

Typically, the application process for a 203(k) loan is lengthier than a standard mortgage loan application. You’ll need a credit score of at least 620, a DTI ratio below 43%, and must live in the home as a primary residence. You’ll also need to find a 203(k)-approved lender and provide income verification, tax returns, and renovation plans.

There are two different types of 203(k) loans: Standard 203(k) and Limited (203(k). The Standard 203(k) is best suited for larger, more complicated projects, such as landscaping and structural work. The minimum FHA 203(k) loan balance for a limited 203(k) is $5,000, which can go towards projects such as replacing old flooring, adding central air conditioning, installing a new roof, or making accessibility improvements.

Home Equity Conversion Mortgage (HECM)

A home equity conversion mortgage (HECM) is a reverse mortgage program that allows seniors aged 62 and up to convert their home equity into cash while retaining the home’s title. The amount you can borrow depends on the home’s appraised value. No payments need to be made until the home is sold or the borrower(s) pass away.

HECMs usually offer lower interest rates, and the maximum loan limit for 2023 is $1,089,300. While you do not need to make monthly payments, you must pay closing costs and mortgage insurance premiums. The home must be a primary residence, and you can’t be delinquent on any federal debt.

Federal Housing Administration (FHA) Loan Relief

If you have an FHA loan and recently experienced a legitimate financial hardship, such as a loss of income or a rise in living expenses, you may be eligible for mortgage relief. Previously, if you couldn’t make your monthly mortgage payments because of COVID-19, the government allowed for COVID-19 Forbearance from October 1, 2021 to May 31, 2023.

If you are unemployed and can’t make your monthly payments, you may qualify for Special Forbearance (SFB)-Unemployment. The FHA Home Affordable Modification Program (HAMP) helps you avoid foreclosure by lowering your monthly mortgage payment to a more affordable level. However, this program is temporarily suspended through October 30, 2024.

FHA vs. Conventional Loans

Here are the key differences between the two loans:

  • Credit score and history: FHA loans have lower credit score requirements, making it easier to qualify for an FHA loan if you have credit problems.
  • Mortgage insurance: All FHA loans require mortgage insurance, which varies depending on the size of your down payment. Conventional loans do not require mortgage insurance if you make a 20% down payment or if you have 20% equity in your home.
  • Funding source for down payments: FHA rules are more lenient in terms of using gift money from family, employers, or charitable organizations for your down payment.
  • FHA appraisal: To qualify for an FHA loan, the property must undergo an FHA appraisal to ensure it meets government standards for health and safety. Conventional loans do not require an appraisal, though it’s recommended to get one.
  • Closing costs: FHA loans may have additional closing costs that usually aren’t required by conventional loans.

Applying for an FHA Loan

You can apply for an FHA loan directly with FHA-approved lenders or banks of your choice. Most banks and mortgage lenders are approved for FHA loans but confirm with them before applying. The lender will ask for personal and financial documents, including your Social Security number, proof of U.S. citizenship or legal permanent residency, bank statements, credit reports, and employment records.

Once the lender gathers enough financial information, they will let you know how much money you can borrow. If you are on the fence, you can apply for pre-approval first, which gives you a sense of how much you can realistically borrow without committing yourself to a mortgage.

The Bottom Line

The FHA loan is geared towards people who have low-to-moderate income, poor credit, or a low down payment. If you can afford to put down a substantial down payment or have excellent credit, you may be better off applying for a conventional mortgage. That way, you can avoid the upfront and annual mortgage insurance premium and get a more competitive interest rate.

We are not financial advisors. The content on this website and our YouTube videos are for educational purposes only and merely cite our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!

Leave a Comment