What Is an FHA Loan?

What You Need to Know About an FHA Loan

Home buyers with real estate agent in empty home
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FHA loans are loans issued by private lenders but backed by the Federal Housing Administration (FHA). Because they're insured by the FHA, these loans bring home ownership into reach for low- or moderate-income buyers who might otherwise have a hard time getting approved by conventional lenders.

These loans are not right for everybody, but they have several appealing features, allowing buyers to:

  • Make down payments as small as 3.5%
  • Get approved despite thin credit or credit history problems
  • Buy not only single-family homes, but condos, multi-unit properties, or manufactured homes
  • Get funding beyond the amount of purchase for renovations and repairs through the FHA 203(k) program
  • Fund a down payment with gift money or help from the seller

How Do FHA Loans Work?

The FHA promises to repay the lender if a borrower defaults on an FHA loan. To fund that obligation, the FHA charges borrowers in two different ways.

  • Homebuyers who use FHA loans pay an upfront mortgage insurance premium (UMIP) of 1.75% of the value of the loan. You can pay the UMIP at the time the loan is granted, or it can be added to the total amount of money you owe in your mortgage.
  • Borrowers also pay a monthly mortgage insurance premium (MMIP), the percentage of which depends on the level of risk the FHA is taking with your loan. Shorter-term loans, smaller balances, and larger down payments result in lower MMIPs. Those premiums may range from 0.45% to 1.05% annually. Most borrowers with a small down payment and 30-year loan pay 0.85% (or 85 basis points).

The Obama administration had initiated a 0.25% reduction in annual insurance premiums for new mortgages that was set to go into effect on January 27, 2017. However, the Trump administration announced a reversal of the rate cut on President Donald Trump’s first day in office.

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.

Advantages of FHA Loans

The main appeal of FHA loans is that they make lenders more willing to give low- and middle-income borrowers a mortgage because of the FHA's guarantee to cover payments. But there are other advantages to obtaining one.

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

If you have more than 3.5% available to put down, consider doing it. A larger down payment gives you more borrowing options, and you’ll save money on interest costs over the life of your loan.

Using other people's money: It’s easier to use a gift for your down payment and closing costs with FHA financing. In addition, a motivated seller can pay up to 6% of the loan amount toward a buyer’s closing costs.

No repayment penalty: There is no penalty for repaying your loan early. That can be a big plus for subprime borrowers; harsh prepayment penalties can affect them when they try to sell their home or refinance a mortgage, even if their credit has improved.

Assumable loans: If you sell your home, 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: An FHA loan makes it easier for you to get approved if you have a recent bankruptcy or foreclosure in your history. You typically need to wait only one to three years after your financial hardship to qualify for an FHA loan.

Home improvement and repairs: Certain FHA loans can be used to pay for home improvements, through the FHA 203(k) Rehab Mortgage Insurance program. If you’re buying a property that needs upgrades, that program makes it easier to fund both your purchase and the improvements with just one loan.

Disadvantages of an FHA Loan

There can be some pitfalls that go along with this type of loan.

Mortgage insurance: With FHA loans, the upfront mortgage insurance premium may increase your loan balance, and monthly FHA premiums can cost more than private mortgage insurance would cost. What’s more, in many cases, it’s impossible to cancel mortgage insurance on FHA loans.

Loan limits: The FHA may not be able to provide enough funding if you need a large loan. The amount you can borrow depends on the county in which you live. The U.S. Department of Housing and Urban Development's FHA Mortgage Limits website lets you look up that amount.

You can get an FHA loan only for your primary residence: the home you will live in. You can not get one for a vacation home or an investment property.

How to Get an FHA Loan

To get an FHA-backed loan, you might start with a local loan originator, online mortgage broker, or loan officer at your financial institution. Analyze all of your options, and decide on the right loan for your needs.

You will need to fill out many documents and provide lots of information to obtain an FHA loan. To begin with, you will need to complete Form 1003, the Uniform Residential Loan Application. You will also need to fill out Form HUD-92900-A, the HUD/VA Addendum to the Uniform Residential Loan Application. And you will have to provide, among other items, your social security number; verification of employment, such as pay stubs or W-2 forms; and your last two federal income tax returns.

In addition, there are several steps to take and things to consider when you're going about the process of getting the loan.

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.

Income limits: No minimum level of income is required. You just need enough income to demonstrate that you can repay the loan. FHA loans are geared toward lower-income borrowers, but if you have a higher income, you aren’t disqualified, as you might be with certain first-time homebuyer programs.

Debt-to-income ratios: To qualify for an FHA loan, you need reasonable debt-to-income ratios. That means the amount you spend on monthly loan payments should be relatively low compared to your total monthly income. Typically, lenders are looking for you to spend less than 31% of your income on housing payments and 43% (or less) of your income on your total debt (which includes car loans, student loans, and other debt in addition to your home loan). But in some cases, it’s possible to get approved with ratios closer to 50%.

For example, assume you earn $3,500 per month.

  • To meet the typical requirements, it's best to keep your monthly housing payments below $1,085 (0.31 x $3,500).
  • If you have other debts (such as credit card debt), all of your monthly payments combined should be less than $1,505 (0.43 x $3,500).

To figure out how much you might spend on payments, learn 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 than other types of loans. If you want to make a 3.5% down payment, your score can be as low as 580. If you’re willing to make a bigger down payment, you may be able to have a score that's lower still. A 10% down payment is typical for FICO scores between 500 and 579.

Again, lenders can set limits that are more restrictive than FHA requirements. If you have low credit 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.

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

FHA Loan vs. Conventional Mortgage

In theory, FHA loans should have lower interest rates than conventional loans because the lender takes on less risk. However, Ellie Mae reported that in September 2020, the average rate on a 30-year FHA loan in the U.S. was only 1 basis point lower than the average rate for a conventional mortgage: 3.01% versus 3.02%. Those rates were down from 3.10% and 3.12%, respectively, in August 2020 and represented historic lows.

Nonetheless, if you have a credit score of 620 or higher, a debt-to-income ratio of 50% or less, and you can put 20% or more down, you might be better off getting a conventional home loan. Putting at least 20% down will free you from having to pay for mortgage insurance.

If you put less than 20% down on your conventional mortgage, you will be able to stop shelling out for mortgage insurance premiums once you have reached the 20% threshold through your monthly payments.

History of FHA Loans

Before the FHA came into being in 1934 during the Great Depression, the housing industry was struggling. Only four in 10 households owned their homes, and home loans had burdensome terms. For example, borrowers could finance only about half of a home’s purchase price, and loans typically required a balloon payment after three to five years.

By using an FHA loan, more borrowers were able to buy their homes, and homeownership rates climbed over the next several decades.

The agency currently covers 8 million single-family homes and almost 12,000 multifamily properties. The FHA loan program helped move homeownership rates in the U.S. to a high of 69.2% in 2004; from there, it fell 4.5 percentage points through the end of the Great Recession caused by the 2008 mortgage crisis.

Key Takeaways

  • FHA loans are issued by private lenders but backed by the Federal Housing Administration, which guarantees the mortgage payments.
  • You can get an FHA loan with a down payment of as little as 3.5%.
  • You don't need a high credit score to get an FHA loan.
  • Through the FHA 203(k) program, you can get an FHA loan that covers the cost of renovations or repairs.
  • An FHA loan requires you to pay upfront for mortgage insurance as well as make monthly mortgage insurance premiums.

Article Sources

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