What Is an FHA Loan?

Couple buying a house and closing the deal with the real estate agent
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DEFINITION
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.

FHA loans are issued by private lenders, but they're backed by the Federal Housing Administration (FHA). They're insured by the FHA, so these loans can bring home ownership into reach if you're a low- or moderate-income buyer who might otherwise have a hard time getting approved by a conventional lender.

Definition and Examples of FHA Loans

The housing industry was struggling before the FHA came into being in 1934 during the Great Depression. Only one in 10 households owned their homes at that time, and mortgages had burdensome terms. Borrowers could finance only about half of a home's purchase price, and loans typically required a balloon payment after three to five years.

More borrowers were able to buy their homes using FHA loans, and homeownership rates climbed over the next several decades.

The FHA had a history of discriminating against Black communities and individuals, contributing to a significant gap in homeownership between Black and White households through policies like redlining.

The agency 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, but it fell 4.5 percentage points through the end of the Great Recession that was caused by the 2008 mortgage crisis.

These loans aren't right for everyone, but they have several appealing features. They allow buyers to:

  • Make down payments as small as 3.5%
  • Get approved despite less-than-perfect credit or thin credit history
  • Buy not only single-family homes but condos, multi-unit properties, or manufactured homes as well
  • 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
  • Purchase a foreclosure

How Do FHA Loans Work?

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

  • Homebuyers who use FHA loans pay an upfront mortgage insurance premium (UFMIP) of 1.75% of the value of the loan. You can pay the UFMIP at the time the loan is granted, or it can be added to the total amount of money you borrow in your mortgage.
  • Homeowners 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. These premiums may range from 0.45% to 1.05% annually. Most borrowers with small down payments and 30-year loans pay 0.85% (or 85 basis points).

The Obama administration initiated a 0.25% reduction in annual insurance premiums for new mortgages that was set to go into effect on Jan. 27, 2017. 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. You can buy duplexes, manufactured homes, and other types of properties in addition to standard single-family homes.

An Alternative to FHA Loans

FHA loans should have much lower interest rates than conventional loans because the lender takes on less risk, but this isn't always the case. Ellie Mae, now ICE Mortgage Technology, reported that 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 in September 2020: 3.01% versus 3.02%. Those rates were down from 3.10% and 3.12%, respectively, in August 2020, and they represented historic lows.

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

Pros and Cons of FHA Loans

The main appeal of FHA loans is that they make lenders more willing to give mortgages to low- and middle-income borrowers because of the FHA's guarantee to cover payments. But there can be some pitfalls that go along with this type of loan.

Pros
  • Smaller down payment required

  • Use gift money for a down payment

  • No repayment penalty

  • More lenient credit requirements

  • Can cover home improvements and repairs

  • They're assumable loans

Cons
  • Mortgage insurance required

  • Loan amount limits

Pros Explained

  • Smaller down payment: FHA loans allow you to buy a home with a down payment of as little 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.
  • Use gift money for a down payment: It's easier to use gifted money for your down payment and closing costs with FHA financing. And a motivated seller can pay up to 6% of the loan amount toward a buyer's closing costs.

A larger down payment gives you more borrowing options, and you'll save money on interest costs over the life of your loan.

  • No repayment penalty: There's no penalty for paying off 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.
  • More lenient credit requirements: An FHA loan makes it easier for you to get approved if you have a recent bankruptcy or foreclosure in your credit history. You typically only have to wait for 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. The program makes it easier to fund both your purchase and improvements to the property with one loan if you're buying a property that needs upgrades.
  • They're assumable loans: A buyer can "take over" your FHA loan if it's assumable and you sell your home. They pick up where you left off, benefiting from lower interest costs because you've already gone through the highest-interest years. The buyer might also enjoy a low interest rate that's unavailable in the current environment if rates change by the time you sell.

Cons Explained

Mortgage insurance: The required upfront mortgage insurance premium may increase your loan balance, and monthly FHA premiums can cost more than private mortgage insurance would cost. It's impossible to cancel mortgage insurance on FHA loans in many cases, unlike private mortgage insurance when you reach a certain equity threshold.

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. You can look up that amount at the U.S. Department of Housing and Urban Development's FHA Mortgage Limits website.

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

How To Get an FHA Loan

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

You'll have to fill out numerous forms and documents and provide a good deal of information to obtain an FHA loan. You must complete Form 1003, the Uniform Residential Loan Application, and Form HUD-92900-A, the HUD/VA Addendum to the Uniform Residential Loan Application. You'll have to provide your Social Security number, verification of employment such as pay stubs or W-2 forms, and your last two federal income tax returns.

There are also 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. You might have better luck with a different lender if you're having trouble with one that's approved by the FHA. It's always a good idea to shop around.

Income Limits

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

Debt-to-Income Ratios

You'll need a reasonable debt-to-income ratio to qualify for an FHA loan. This means that the amount you spend on all your monthly loan payments should be a relatively low percentage of your total monthly income.

Lenders often look for less than 31% of your income spent on housing payments and 43% (or less) of your income on your total debt. This includes car loans and student loans in addition to your home loan. But it's possible to get approved with ratios closer to 50% in some cases.

Let's assume that you earn $3,500 per month.

  • It's best to keep your monthly housing payments below $1,085 (0.31 x $3,500) to meet the typical requirements.
  • All your monthly payments combined should be less than $1,505 (0.43 x $3,500) if you have other debts, such as credit card debt or an auto loan.

You can use an online loan calculator to model your payments to figure out how much you should spend. Keep in mind that your lender could foreclose, just as with any other mortgage loan, if you're unable to make your mortgage payments.

The FHA doesn't impose any actual income requirements or restrictions, just loan amount limits.

Credit Scores

Borrowers with low credit scores are more likely to get approved for FHA loans than other types of mortgages. Your score can be as low as 580 if you make a 3.5% down payment. You may be able to have a score that's lower still if you can make a larger down payment. A 10% down payment is typical for FICO scores between 500 and 579.

However, lenders can set limits that are more restrictive than these FHA requirements. You may have to find a lender that does manual underwriting if you have a low credit score or no credit history at all. This process lets lenders evaluate your creditworthiness by looking at alternative information, such as on-time rent and utility payments.

It's Worth a Try

Talk with an FHA-approved lender to find out for sure if you don't think you'll be approved. Compensating factors such as a large down payment that offsets your credit history can help you qualify if you don't meet standard approval criteria.

Key Takeaways

  • FHA loans are issued by private lenders, but they're backed by the Federal Housing Administration, which guarantees that the mortgage payments will be made.
  • 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.
  • You can get an FHA loan that covers the cost of renovations or repairs through the FHA 203(k) program.
  • An FHA loan requires that you pay upfront for mortgage insurance, and you must pay monthly mortgage insurance premiums as well.

Article Sources

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  3. Freddie Mac. "Why Are the Experts Pessimistic About the Future of Homeownership?"

  4. Federal Deposit Insurance Corporation. "203(b) Mortgage Insurance Program," Page 23.

  5. Rocket Mortgage. "What Is an FHA Mortgage Insurance Premium?"

  6. Congress.gov. "Congressional Record, House - January 23, 2017."

  7. ICE Mortgage Technology. "September Ellie Mae Origination Insight Report Data Shows Interest Rates Drop to New Historic Lows; Refinances Continue To Gain Traction."

  8. Consumer Financial Protection Bureau. "FHA Loans."

  9. U.S. Department of Housing and Urban Development. "Section B. Acceptable Sources of Borrower Funds," Pages 10-17.

  10. Rocket Mortgage. "What Are Seller Concessions?"

  11. GovLoans.gov. "Basic FHA Insured Home Mortgage."

  12. Federal Deposit Insurance Corporation. "FDIC Law, Regulations, Related Acts."

  13. Assurance Financial. "What You Need To Know About FHA Loans."

  14. U.S. Department of Housing and Urban Development. "203(k) Rehab Mortgage Insurance."

  15. U.S. Department of Housing and Urban Development. "Chapter 7 - Assumptions."

  16. U.S. Department of Housing and Urban Development. "HUD 4155.1, Mortgage Credit Analysis for Mortgage Insurance, Section B. Documentation Requirements," Pages 9-17.

  17. Quicken Loans. "Conventional Loan vs. FHA: What's the Difference?"

  18. Experian. "What Is an Ideal Debt-to-Income Ratio?"