FHA Loan Basics: Pros and Cons of Borrowing With FHA Financing
Low Down Payment and Credit Requirements
Loans from the Federal Housing Administration (FHA) are popular because they allow you to buy a home with a relatively small down payment. Designed to promote home ownership, FHA loans make it easier to qualify for a mortgage—even with less-than-perfect credit. But FHA loans are not right for everybody, so it pays to understand how they work and when they work best.
What is an FHA Loan?
An FHA loan is a home loan that is issued by a private lender and insured by the FHA.
The U.S. government, through the FHA, provides a guarantee to lenders: If you fail to repay the loan, the FHA will reimburse the lender for you. Because of this guarantee, lenders are willing to make substantial mortgage loans in cases when they’d otherwise be unwilling approve mortgage applications. With the taxing authority of the U.S. Treasury behind it, the FHA has the resources to deliver on that promise.
Why are They so Great?
FHA loans are not perfect, but they are a great fit in some situations. The main appeal is that they make it easy to buy property. But remember that those benefits always come with tradeoffs. Here are some of the most attractive features:
Small down payment: FHA loans allow you to buy a home with a down payment as low as 3.5 percent. Other loan programs may require a larger down payment, or they may require high credit scores to get approved with a small down payment.
If you happen to have more than 3.5 percent available, you might be better off making a larger down payment. Doing so will give you more options, and you’ll probably 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 might be able to adjust your offer price enough to entice sellers.
Assumable loans: A buyer can “take over” your FHA loan if it’s assumable. That means they’ll 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 have changed 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: If you’ve recently come out of bankruptcy or foreclosure, it’s easier to get an FHA loan than a loan that does not come with any government guarantee. Two or three years after financial hardship is typically enough to qualify for FHA financing.
Qualification: When compared to conventional loans, FHA loans can be easier to qualify for.
How do you Qualify for an FHA Loan?
The FHA makes it relatively accessible. Again, the government guarantees the loan, so lenders are more willing to approve applications. However, 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.
Even if you think you won’t get approved after reading this page, talk with an FHA-approved lender to find out for sure. Even if you don’t meet all the criteria, compensating factors—for example, a large down payment to offset your credit history—can help you qualify.
Income limits: No minimum income is required.
You’ll need enough income to demonstrate that you can repay the loan (see below), but these loans are geared towards lower income borrowers. If you’re fortunate enough to 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’ll need to have reasonable debt-to-income ratios. The amount you spend on monthly loan payments needs to be “reasonable” when compared to your monthly income. Typically you have to be better than 31/43, but in some cases, it’s possible to get approved with D/I ratios closer to 50%.
Example: Assume you earn $3,500 per month.
- To meet the 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.
Credit scores: Borrowers with low credit scores are more likely to get approved if they apply for an FHA loan. Scores can go as low as 580 if you want to make a 3.5 percent down payment. If you’re willing and able to make a larger down payment, your score can potentially be lower still. Again, lenders can set limits that are more restrictive than minimum FHA requirements. If you have low scores (or no scores at all), you may need to find a lender that does manual underwriting.
Loan amount: There are limits on how much you can borrow. In general, you’re limited to modest loan amounts relative to home prices in your area. To find the limits in your region, visit HUD’s Website. If you need more, consider Jumbo loans, but be aware that you’ll need strong credit and income to qualify.
How do FHA Loans Work?
Private lenders issue FHA loans—the FHA just backs them. 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 pay lenders if a borrower defaults on an FHA loan. To fund this obligation, the FHA charges borrowers 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 to pay for mortgage insurance. 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.
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 Not Use an FHA Loan?
While they come with appealing features, you may find that FHA loans are not for you. For example, they may not provide enough funding if you need a large loan. But the main drawback is that the upfront mortgage insurance premium and ongoing premiums can cost more than private mortgage insurance would cost.
In some cases, you can still buy a house with a very little down using a standard loan—not an FHA loan. Especially if you have good credit, you might 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 if you want guidance on which programs may be right for your situation.
For more detailed discussion, see FHA Loan Pitfalls.