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What Is an FHA Loan and How Does It Work?
By Susan Doktor MONEY RESEARCH COLLECTIVE
With real estate costs skyrocketing in many U.S. cities, many wonder whether homeownership will ever be in the cards for them.
FHA loans might offer a way forward for at least some potential borrowers. These loans are especially attractive to those who are having a hard time saving up the large down payments often required for conventional loans.
So what is an FHA loan and how does it work? Read on to learn more about the pros and cons of this type of mortgage, borrowing requirements and whether one could be a viable financing option for you.
What Is an FHA Loan?
An FHA loan is a mortgage that’s insured by the Federal Housing Administration — a division of the Department of Housing and Urban Development (HUD). These loans are issued by private lenders but backed by the federal government, reducing the risk for lenders and allowing them to offer FHA borrowers a lower interest rate.
If homeowners default on their FHA mortgage, the FHA will cover the unpaid principal balance. Because this protects lenders against default, they are generally more willing to issue mortgages to people with less-than-perfect credit. However, homebuyers will still need to meet specific FHA loan requirements and have a minimum credit score to qualify
Types of FHA loans
Though a traditional mortgage, also known as the FHA 203(b) loan, is the most common FHA home loan type, there are also other kinds of FHA loans:
FHA 203 (k) Rehab Mortgage
The FHA 203(k) mortgage loan program was created to help people who want to purchase a house that needs major repairs or finance the rehabilitation of their existing home. With this loan type, borrowers won’t need to pay for their home repairs out-of-pocket. However, HUD requires that properties financed with this type of loan meet basic structural and energy efficiency standards.
FHA Energy Efficient Mortgage
An energy-efficient home can save homeowners a lot of money in utility bills and operating costs. With this in mind, FHA’s Energy Efficient Mortgage program helps homeowners finance energy-efficient improvements to their property, including weatherizing the home through insulation, smart thermostats, and wind or solar electric systems.
Title I Home Improvement Loans
FHA Title I Home Improvement Loans are secondary loans that homeowners can take out in addition to their existing mortgage to finance specific home improvements and rehab projects. This type of loan differs from the 203(k) Rehabilitation Mortgage program in that it can only be used to fund the necessary renovations and not the purchase of the home. However, since the Title I Home Improvement Loan is a secondary mortgage, borrowers can use it in conjunction with a 203(k) Rehabilitation Mortgage.
203(h) Disaster Victims Mortgage
FHA’s 203(h) Disaster Victims Mortgage is a mortgage insurance program that provides home financing assistance to victims of presidentially-declared disasters. Eligible applicants are homeowners whose homes were destroyed or suffered major damage due to a disaster, and who wish to rebuild or purchase a new home. Typically, borrowers can receive 100% financing with zero money down.
Home Equity Conversion Mortgage (HECM)
A HECM, or Home Equity Conversion Mortgage, is a type of reverse mortgage that allows seniors to convert a portion of the equity in their home into cash. Only homeowners over the age of 62 with equity in their property are eligible for this program. The amount they can withdraw will depend on their current interest rate and the property’s appraised fair market value, among other factors.
Section 245(a) Loan
A Graduated Payment Mortgage (GPM) is a type of mortgage that allows borrowers to make monthly payments that increase over time — which could be a great option for those who need more time to advance in their careers or build up their savings to make larger loan payments. Typically, the payments will increase from 7% to 12% each year until the maximum payment amount is reached.
Pros and cons of FHA loans
Taking out a mortgage is a major financial decision with both pros and cons. Here are some things you should keep in mind before submitting an FHA loan application:
Pros of FHA loans
- Low down payment amount – With a 3.5% minimum down payment for applicants with a fair credit score, FHA loans allow you to qualify for a home loan more easily than conventional mortgages. That makes it a great loan option for first-time homebuyers or anyone who doesn’t have a lot of money saved for a down payment.
- Low credit score requirement – To get a 3.5% down payment on an FHA loan, you must have a minimum credit score of 580 or above. However, you may still qualify with a credit score between 500 and 579 if you put 10% down. This flexibility allows borrowers who aren’t eligible for a conventional loan to have a chance at homeownership.
- Assumability – Another benefit of FHA loans is that they are assumable, meaning the loan can be transferred to a new buyer if the original borrower decides to sell their home. That can be a valuable feature, particularly in a market where interest rates are rising.
Cons of FHA loans
- Strict property eligibility requirements – To be approved for an FHA loan, the property must meet specific eligibility requirements. Moreover, an FHA loan can only be used to purchase a primary residence, which means you can’t use it to buy investment properties or vacation homes.
- Mortgage insurance premiums – If you put less than 10% down on your home with an FHA loan, you have to pay mortgage insurance premiums for the life of the loan. Mortgage insurance consists of an upfront mortgage insurance premium (UFMIP) — 1.75% of the total loan amount — due at closing or that can be folded into your monthly mortgage payments. A separate annual mortgage insurance premium must be paid monthly and will depend on factors such as your total loan amount and loan term.
- Limited loan terms – FHA loans are generally either 15- or 30-year fixed-rate mortgages. They’re not ideal if you’re looking for an interest-only loan or a short-term adjustable-rate mortgage.
It’s important to note that despite their drawbacks, first-time homeowners may still opt for an FHA loan and later refinance it if their financial situation changes.
For example, if your credit improves after taking out the loan and you want to get rid of mortgage insurance, you can refinance your FHA loan into a conventional mortgage with any of the best mortgage refinance companies. To do so, you must have at least 20% equity in your home and a minimum credit score of 620.
If you’re still on the fence about refinancing your FHA loan, consider using a refinance calculator to determine how much you could save and speaking to a financial advisor who can help you make an informed decision.
And if you qualify for both an FHA loan and a VA loan, contact any of the best VA loan lenders for more details on the benefits of this type of mortgage. For example, unlike FHA loans, VA loans don’t require a down payment or mortgage insurance and have no minimum credit score requirements — although lenders may set their own.
FHA mortgages vs. conventional mortgages
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How Do FHA Loans Work?
You can use an FHA loan to purchase a single-family home or multifamily property — provided you’re occupying one of the units. Additionally, these loans are for purchasing a primary residence, so you may not use them to finance vacation homes.
One of the most significant advantages of FHA loans is that you don’t need good credit or a large down payment to qualify. You can get an FHA loan with a credit score as low as 500, provided you put at least 10% down on your home. Those with a credit score of 580 and above can put down as little as 3.5%.
If you put down less than 10% on an FHA loan, however, you’ll have to make annual mortgage insurance payments for the life of the loan (unless you refinance to a conventional mortgage). That is in contrast to conventional loans, which typically require a 20% down payment to avoid private mortgage insurance (PMI). And even then, you can cancel PMI on a conventional loan after reaching 20% equity in your home.
How to qualify for an FHA loan
Though the borrowing criteria of an FHA loan are much more lenient than those that apply to conventional loans, you’ll still need to meet certain requirements to be approved:
- A minimum credit score of 500
- A 3.5% minimum down payment if you have a FICO credit score of 580 or higher
- A 10% minimum down payment if you have a credit score between 500 and 579
- A maximum debt-to-income ratio (DTI) of 43%
- A consistent and reliable source of income
- A valid social security number
- You must occupy the property within 60 days of loan closing.
- The property must meet FHA guidelines and be your primary residence.
- The loan amount can’t exceed FHA loan limits in your county.
How to apply for an FHA loan?
To apply for an FHA loan, search for a qualified FHA lender in your area by either using the HUD Lender List Search or checking out this list of the best mortgage lenders.
Once you’ve found a few lenders you like and have filled out their online applications, you should compare loan estimates and quotes from each. By doing this, you can make sure you’re getting the best terms and rates possible.
FHA Loans FAQ
Is an FHA loan good or bad?
Everyone's financial situation is different, so whether an FHA home loan is good or bad will depend on the individual. But, overall, an FHA loan could be a great fit for those who don't have a good credit score or can't afford a large down payment.
But suppose you don't have enough money to put 10% down on your home and aren't financially ready to pay monthly mortgage insurance premiums. In that case, you can potentially sabotage your credit and financial health by taking out an FHA loan. Knowing the risks of overextending yourself — i.e., taking out an FHA loan that you can't afford — can keep you from getting into financial trouble.
Why you should not get an FHA loan
In a competitive housing market where sellers are overwhelmed with offers, many sellers frown upon FHA loans — some even refuse those bids — because they permit low down payments. Sellers may believe that if a potential buyer can put more money down upfront, they're automatically more qualified than those who can only put down 3.5%. Moreover, FHA loans' reputation of having a strict appraisal and inspection process can often make sellers hesitant to accept such offers.
Do you pay back an FHA loan?
Yes, just like any type of financing, you'll have to pay back your FHA loan over a 15 or 30-year period. If you're not sure whether you can afford to finance a home with an FHA loan, use a mortgage calculator to estimate monthly payments depending on the purchase price and interest rate.
What is the maximum loan amount for an FHA loan?
FHA loans limit how much you can borrow — determined by the median sales price of houses in your county and your property type. If you want to look up the loan limits in your area, simply head to the FHA Mortgage Limits Database and input the requested information.
In 2023, the loan limit for a one-unit home in a low-cost area is around $472,030, while the ceiling in high-cost areas is $1,089,300.
How much is an FHA loan?
The cost of your FHA loan will depend on the amount you're borrowing and other factors such as mortgage insurance premiums and closing costs.
Let's say you've decided to take out a $100,000 30-year FHA loan on a $125,000 home at an interest rate of 5.2%. Along with the down payment of 3.5%, upfront mortgage insurance premium of 1.75%, and annual mortgage insurance premium of 0.85%, you can expect to pay a total of $194,220 by the payoff date. Remember that this number doesn't include the closing costs, which can be 2% to 5% of the loan balance — in this case, between $2,000 and $5,000.
What is the interest rate on an FHA loan?
Since mortgage rates can change daily, it's best to check the most up-to-date FHA loan rates with your preferred lender or financial institution. Generally, average FHA loan rates tend to be lower than conventional mortgage rates. However, your actual rate will depend on your financial situation (how much money you can put down, for example), your credit score and the mortgage insurance premium on your loan (if applicable).
Summary of Our Guide to FHA Loans
- FHA loans make homeownership possible for those who don’t have enough money for a large down payment or have a lower credit score and poor credit history.
- FHA loans are backed by the federal government and offer more flexible lending guidelines than conventional mortgages.
- To qualify for an FHA loan, you need a credit score of at least 580 to make the smallest allowable 3.5% down payment. But if your credit score is between 500 and 579, you’ll need to put down at least 10%.
- Unlike conventional mortgage loans, you can only use FHA loans to purchase a primary residence.
- One major downside of an FHA loan is that — depending on your down payment amount — you may need to pay monthly mortgage insurance premiums (MIP) and an upfront mortgage insurance premium (UFMIP).
