FHA Loan Basics: Pros and Cons of Borrowing With FHA Financing

Low Down Payment and Credit Requirements

Home buyers with real estate agent in empty home
••• David Sacks / Getty Images  

FHA loans bring home ownership into reach for buyers who might have a hard time getting approved with conventional lenders. These loans are not right for everybody, but they have several appealing features:

  • Make a down payment as small as 3.5 percent.
  • Get approved to borrow with thin credit or problems in your credit history.
  • Buy single-family homes, condos, multi-unit properties, and manufactured homes with FHA backing.
  • Get extra funding (above and beyond your purchase loan) for renovations and repairs with the FHA 203k program.
  • Fund your down payment with gift money or help from the seller.

We’ll cover all of the details below. To get an FHA loan, speak with a local or online lender and ask about FHA programs.

What Is an FHA Loan?

An FHA loan is a home loan that the U.S. Federal Housing Administration (FHA) guarantees. Private lenders like banks and credit unions issue the loans, and the FHA provides backing: If you don’t repay your loan, the FHA will pay the lender instead.

Because of that guarantee, lenders are willing to make substantial mortgage loans in cases when they’d otherwise be unwilling approve loan applications.

Benefits of FHA Loans

FHA loans aren’t perfect for everybody, but they are an excellent fit in some situations. The main appeal is that they make it easy to buy property. But remember that these benefits always come with tradeoffs.

The most attractive features include:

Small down payment: FHA loans allow you to buy a home with a down payment as low as 3.5 percent. Other (conventional) loan programs may require a larger down payment, or they require high credit scores and high incomes to get approved with a small down payment.

If you have more than 3.5 percent available, you might be better off making a more substantial down payment.

Doing so gives you more borrowing options, and you’ll save money on interest costs over the life of your loan.

Other peoples’ money: It’s easier to use gifts for your down payment and closing costs with FHA financing.

Also, sellers can pay up to 6 percent of the loan amount toward a buyer’s closing costs. You’re most likely to benefit from that in a buyer’s market, but even in strong markets, you can potentially adjust your offer price enough to entice sellers.

Prepayment penalty: There is none (a big plus for subprime borrowers).

Assumable loans: A buyer can “take over” your FHA loan if it’s assumable. They pick up where you left off, benefiting from lower interest costs (because you’ve already gone through the highest-interest years, which you can see with an amortization table). Depending on whether or not rates change by the time you sell, the buyer might also enjoy a low interest rate that’s unavailable in the current environment.

A chance to reset: With a recent bankruptcy or foreclosure in your history, FHA loans make it easier to get approved. Two or three years after financial hardship is typically enough to qualify for financing.

Home improvement and repairs: Certain FHA loans can be used to pay for home improvement (through FHA 203k programs).

If you’re buying property that needs upgrades, those programs make it easier to fund your purchase and improvements with just one loan.

How do you Qualify for an FHA Loan?

When compared to conventional loans, FHA loans are typically easier to qualify for.

The FHA makes homeownership accessible to people of all income levels. With the government guaranteeing the loan, lenders are more willing to approve applications.

Check with several lenders: Lenders can (and do) set standards that are stricter than minimum FHA requirements. If you’re having trouble with one FHA-approved lender, you might have better luck with a different one. It’s always wise to shop around anyway.

Income limits: No minimum income is required. You just need enough income to demonstrate that you can repay the loan (see below), but FHA loans are geared toward lower-income borrowers.

If you have a high income, you aren’t disqualified, as you might be with certain first-time home buyer programs.

Debt to income ratios: To qualify for an FHA loan, you need reasonable debt-to-income ratios. The amount you spend on monthly loan payments should be relatively low, compared to your monthly income. Typically, it’s best to be lower than 31/43. But in some cases, it’s possible to get approved with D/I ratios closer to 50 percent.

Example: Assume you earn $3,500 per month.

  • To meet standard requirements, it is best to keep your monthly housing payments below $1,225 (because $1,225 is 31 percent of $3,500).
  • If you have other debts (such as credit card debt), all of your monthly payments combined should be less than $1,505.

To figure out how much you might spend on payments, see how to calculate a mortgage payment or use an online loan calculator to model your payments.

Credit scores: Borrowers with low credit scores are more likely to get approved for FHA loans. If you want to make a 3.5 percent down payment, your score can be as low as 580. If you’re willing to make a bigger down payment, your score can potentially be lower still (a 10 percent down payment is typical for FICO scores between 500 and 580).

Again, lenders can set limits that are more restrictive than FHA requirements. If you have low scores (or no credit history at all), you may need to find a lender that does manual underwriting. That process lets lenders evaluate your creditworthiness by looking at “alternative” credit information, including on-time rent and utility payments.

Loan amount: The FHA limits how much you can borrow. In general, you’re limited to modest loan amounts relative to home prices in your area. Visit HUD’s Website to find local maximums. If you need more money, consider jumbo loans, but be aware that you need strong credit and income to qualify.

Worth a try: Even if you think you won’t get approved, talk with an FHA-approved lender to find out for sure. When you don’t meet standard approval criteria, compensating factors—like a large down payment that offsets your credit history—can help you qualify.

How do FHA Loans Work?

Private lenders issue FHA loans, and the FHA provides the lender with a guarantee to reduce the lender’s risk. To get a loan, start with a local loan originator, online mortgage broker, or loan officer at your financial institution. Discuss your options, including FHA loans and alternatives, and decide on the right program for your needs.

Mortgage insurance: The FHA promises to repay lenders if a borrower defaults on an FHA loan. To fund that obligation, the FHA charges borrowers (that’s you) a fee.

  • Home buyers who use FHA loans pay an upfront mortgage insurance premium (MIP) of 1.75 percent.
  • Borrowers also pay a modest ongoing fee with each monthly payment. The amount you pay depends on the risk the FHA takes with your loan. Shorter-term loans, smaller balances, and larger down payments result in lower monthly insurance costs. Those charges range from 0.45 percent to 1.05 percent annually.

FHA loans are available for multiple types of properties. In addition to standard single-family homes, you can buy duplexes, manufactured homes, and other types of properties.

Why Avoid FHA Loans?

While they come with appealing features, you may find that FHA loans are not for you.

Loan limits: In some cases, FHA doesn’t provide enough funding when you need a large loan. If you buy particularly expensive property or you’re looking in a hot market, FHA might not work for you.

Mortgage insurance: The upfront mortgage insurance premium and ongoing premiums can cost more than private mortgage insurance would cost. In some cases, it’s impossible to cancel mortgage insurance on FHA loans. But it’s much easier to cancel PMI on conventional loans as you build equity.

Low-down-payment alternatives: You might be able to buy a house with very little down using a conventional loan—without FHA backing. Especially if you have good credit, you can find competitive offers that beat FHA loans. With those programs, you may be able to eliminate any mortgage insurance more quickly by building equity in your home.

It’s always wise to shop around. Compare offers from several different sources—including FHA loans and conventional loans—before you decide to take action. Speak with a mortgage professional to get guidance on which programs are right for your situation.

For more details on the pros and cons of government loans, see FHA Loan Pitfalls.