What Is an FHA Loan?

Backed by the Government, These Loans Help More People Buy a Home

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 203k program
  • Fund a down payment with gift money or help from the seller

History of FHA Loans

Created in 1934 during the Great Depression, the FHA is a government agency that provides mortgage insurance to lenders. Before the FHA came into being, the housing industry was struggling. Only four in ten households owned their homes, and home loans had burdensome terms. For example, borrowers could only finance about half of a home’s purchase price (as opposed to today, when they can put just 3.5% down), and loans typically required a balloon payment after three to five years.

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

Currently, the agency insures 7.95 million single-family homes and more than 14,000 multifamily properties. This program helped move homeownership rates in the U.S. to a high of 69.2% in 2004; the 2008 mortgage crisis spurred a slight decrease of about five percentage points.

Benefits of FHA Loans

With FHA loans, private lenders like banks and credit unions can issue you the loan, and the FHA guarantees it will cover the loan in the event you don't pay.

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

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. 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%. 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% 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.

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

Also, sellers can pay up to 6% 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. That can be a big plus for subprime borrowers; harsh prepayment penalties can affect them when trying 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: 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 a property that needs upgrades, those programs make it easier to fund both your purchase and the improvements with just one loan.

How Do You Qualify for an FHA Loan?

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

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

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 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 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, they're 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 standard requirements, it is best to keep your monthly housing payments below $1,085 (because $1,085 is 31% 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 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 580.

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.

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 the Department of Housing and Urban Development's website to find local maximums. If you need more money, consider jumbo loans, but be aware that you need good 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?

To get an FHA 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 you a fee as the borrower.

  1. Homebuyers who use FHA loans pay an upfront mortgage insurance premium (MIP) of 1.75%.
  2. Borrowers also pay a modest ongoing fee with each monthly payment, which 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% to 1.05% annually. Most borrowers with a small down payment and 30-year loan pay 0.85% (or 85 basis points). 

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

No changes to FHA fees under Trump: The FHA charges fees to borrowers who take out these loans. Under the Obama administration, a fee reduction of 0.25% in annual insurance premiums was set to go into effect on January 27, 2017. This would have saved homeowners with FHA loans an average of $500 a year (or more for those with larger loans). However, the Trump administration announced a reversal of those rate cuts on President Trump’s first day in office, leaving the higher rates in place for existing and new home loans.

How FHA Loans Compare to Conventional Mortgages

While FHA loans come with appealing features, it’s still worth comparing them to conventional loans. 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. But it’s much easier to cancel PMI on conventional loans as you build equity.

Interest rates: In theory, FHA loans should have lower interest rates because the lender takes less risk. But the difference is typically minimal (0.17%, in recent years), and FHA rates might even come in higher. In early 2019, Ellie Mae reported that the average FHA rate was 5.1%.

Low down payment: FHA loans make it easy for most people to buy with very little down. But you might also be able to buy a house with a conventional loan and a small down payment. Especially if you have good credit, you can find competitive offers that beat FHA loans, including loans that would require even less than 3.5% of your own money down. With those programs, you could be able to eliminate any mortgage insurance eventually by building equity in your home.

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

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. Speaking with a mortgage professional will help you figure out which programs are right for your situation.