Understanding FHA Loans
FHA home loans have helped many first-timers buy a home with a small down payment. FHA also offers flexible underwriting for people with lower credit scores. This guide will show you how FHA loans work, FHA loan qualifications, pros and cons of FHA financing and how to apply for an FHA mortgage.
How FHA Home Loans Work
FHA mortgages are administered by the Federal Housing Administration, an agency in the US Department of Housing and Urban Development (HUD). The FHA does not actually lend money to homebuyers. Instead, it insures loans made by private, FHA-approved lenders.
Here is how the program works:
Borrowers apply for FHA home loans with lenders like banks, credit unions and mortgage companies. The lenders underwrite the loans based on FHA guidelines and their own policies.
If approved, the loans are funded by the lender and insured by the FHA. The homebuyer pays for FHA mortgage insurance. With the mortgage insured against default, the lender‘s risk of losses is reduced significantly. Therefore, the lender is able to approve mortgages for homebuyers with smaller down payments.
Trying to decide between an FHA and a conventional (non-government) home loan? Run the numbers with MoneyGeek’s FHA vs Conventional Loan Calculator.
FHA Loan Pros and Cons
FHA mortgages have advantages and drawbacks. You’ll want to compare FHA and conventional home loans to choose the mortgage that best meets your needs.
FHA Loan Pros
- Low minimum Down Payment.
For many would-be buyers, the down payment is the largest obstacle to homeownership. FHA's minimum down payment is 3.5 percent. The money can come from the borrower's own funds, a gift or a loan from an acceptable source.
- Low Minimum Credit Score.
FHA minimum credit scores are low -- 580 for a loan with a 3.5 percent down payment and just 500 with 10 percent down. This allows underwriters to approve mortgages to applicants whose credit was damaged by circumstances beyond their control, applicants with low scores who have successfully re-established credit or prospective homebuyers with low scores but acceptable credit histories.
- Underwriting Flexibility.
FHA guidelines are more forgiving of credit mishaps than most other programs. Underwriters are instructed to distinguish between applicants who habitually misuse credit and those with valid reasons for their lapses. Consumers with past bad credit who have established good payment patterns are normally treated more leniently. In addition, FHA guidelines allow higher debt-to-income ratios (expenses divided by gross income) than most conventional programs.
- Streamline Refinance.
FHA's streamline refinance program allows homeowners to easily refinance their mortgage to a home loan with better terms. Lenders are not required to verify the borrower's income or employment, no appraisal is necessary, and there is no minimum credit score to qualify. This allows homeowners whose property values, incomes or credit scores have dropped to improve their financial positions by refinancing.
- Chapter 13 Bankruptcy.
Most mortgage programs require borrowers to wait for several years after a bankruptcy discharge before they are eligible for financing. That makes sense for those who immediately wipe out their debts with a Chapter 7 filing. However, those in Chapter 13 bankruptcy spend up to five years in their plans repaying their creditors before they receive a discharge. The FHA recognizes the difference and allows applicants in Chapter 13 to be eligible for financing after making 12 monthly on-time payments to the plan, as long as their bankruptcy trustee approves it.
- Chapter 7 Bankruptcy.
With many mortgage programs, applicants must wait four years (two if there are extenuating circumstances) after discharging a Chapter 7 or 11 bankruptcy before they are eligible for home financing. With FHA mortgages, that waiting period is cut in half for most applicants and just one year if there are documented extenuating circumstances (for example, the death of a wage earner or an employer going out of business) and applicants have re-established a good credit history.
A homeowner who sells a property that was bought with an FHA loan can allow the buyer to take over the mortgage. This move can eliminate thousands in closing costs for the buyer. This can be a powerful advantage for the seller when the interest rate on the FHA loan is lower than what the seller would pay on a new mortgage. For the buyer, an assumable loan can translate into a higher selling price or swifter sale.
FHA Loan Cons
- Mortgage Insurance Costs.
FHA mortgage insurance premiums (MIP) are on the high side. FHA borrowers pay an upfront fee of 1.75 percent of the loan amount, which can be paid in cash or added to the mortgage. They also pay an annual premium, which is added to their monthly payments. For most, that is 0.85 percent of the outstanding mortgage balance. Unlike mortgage insurance for conventional loans, FHA MIP lasts for the life of the loan.
- Loan Limits.
FHA loans were created to make home ownership accessible to people of modest means — not to help the rich buy mansions. For this reason, HUD imposes limits on the size of the loans it insures. FHA mortgage limits for specific counties can be found on this FHA Loan Limits page.
- More Paperwork.
In comparison to conventional loans, FHA borrowers must sign a few extra forms, many of which serve to protect the borrower. Doing so adds several minutes to the application process, but the protections associated with some disclosures are probably worth it. For example, the FHA Amendatory Clause changes the purchase contract to allow the buyer to cancel a home purchase if the property does not appraise for at least the sales price.
- FHA Appraisal.
The FHA's appraisal includes typical items a home inspector might look for. FHA-financed homes must meet minimum safety and livability standards to be eligible for financing. This means that not all home appraisers are qualified to perform FHA appraisals, and FHA appraisals usually cost a little more. The FHA is careful to disclose that its appraisal does not replace a home inspection.
- Harder for Condos.
Not all condominiums can be financed with FHA home loans. In fact, most condominium projects are not FHA-approved. To secure approval, the homeowners' association (HOA) or board must submit an extensive application package to HUD. However, the FHA will approve a single, qualifying unit in a non-approved development if no more than 10 percent of the project is financed with FHA home loans.
The Credit Alert Interactive Voice Response System, or CAIVRS, is a federal database all lenders must check before approving government-backed loans. It tracks people who owe the government money — who have incurred federal liens or judgments or have defaulted on government-backed loans. CAIVRS is not an issue for most borrowers. If you turn up on CAIVRS, however, you’re ineligible for FHA financing.You must enter into a repayment plan or have the reporting agency delete the listing before you can borrow with a government-backed loan.
FHA Loan Qualification: How to Get Approved for an FHA Mortgage
Many would-be borrowers are tripped up by the difference between FHA’s “official” guidelines and the “real world” requirements of mortgage lenders. Here are the most liberal:
- Minimum FICO score is 500.
- Maximum debt-to-income ratio is 56.9 percent.
- Minimum down payment is 3.5 percent.
But can you actually get FHA loan approval with these qualifications? Not really. You can’t obtain an FHA home loan with a low FICO score and a small down payment and a high DTI. In fact, when the Urban Institute tracked mortgage approval rates for so-called Low Credit Profile applications, it found that nearly 40 percent of these applicants with FICO scores under 580 were denied loans even with 32 percent down. And 22 percent of those applicants with FICO scores from 580 to 619 were denied despite a 32 percent down payment.
And for applicants with 5 to 10 percent down? The denial rates soared to nearly 70 percent for those with the lowest credit scores and just under 45 percent for applicants with scores between 580 and 619.
Understand also that while low credit scores may be approved under FHA guidelines, actual bad credit won’t be tolerated. The FHA requires borrowers to have an acceptable payment history for at least 12 months and direct underwriters as follows:
The Mortgagee must analyze the Borrower’s delinquent accounts to determine whether late payments were based on a disregard for financial obligations; an inability to manage debt; or extenuating circumstances.
If it appears that you are not managing your debt correctly and making your payments as agreed, you won’t be approved for an FHA loan - it won’t matter if your credit score is higher than the official minimum.
More FHA Information: Helpful Links
FHA mortgages include more than just one product - you can find loans to buy and rehabilitate fixer-upper properties, loans to increase the energy efficiency of your home and loans to refinance - with or without an appraisal. Follow the links below for more information:
- FHA Loan Requirements.
FHA purchase loan requirements include satisfactory credit (minimum credit score of 580 for 96.5 percent loans), stable, sufficient income and a down payment of at least 3.5 percent of the home's purchase price. These are the FHA's requirements. Some lenders also add their own guidelines to the FHA loans they issue and may have higher minimum credit score requirements.
- FHA Approved Lenders.
Not all mortgage lenders are approved to underwrite or fund FHA home loans. Borrowers who want an FHA mortgage need to work with an FHA-approved lender. These lenders may display an FHA seal on their premises and advertising. This seal indicates the FHA will approve their compliant loans.
- FHA Mortgage Insurance.
FHA mortgage insurance comes in two parts: an upfront premium, which can be paid out of pocket or financed, and an annual premium divided by 12 and added to each mortgage payment.
- FHA Refinance.
Homeowners with conventional, VA, USDA or FHA home loans can refinance with FHA mortgages. The FHA-to-FHA refinance is called an FHA Streamline refinance. Homeowners who also qualify to refinance with conventional financing should compare the costs before choosing an FHA loan.
- FHA 203(k) Rehab Loans.
FHA renovation loans (also called 203(k) rehabilitation loans) can be used to build or rehabilitate homes. These loans can be used for purchasing or refinancing a home or property. Property owners with little or no home equity may be able to secure approval based on what the property is expected to be worth after renovation or construction.
CAIVRS is a federal database that tracks consumers who have defaulted on government debt. FHA loan applicants who are listed on CAIVRS are not eligible for FHA (or any other government-backed) home loans.
- How to Apply for an FHA Loan.
FHA loan applicants need their bank, retirement and investment account statements, two pay stubs and W-2s for the last two years (if wage earners) or tax returns (if self-employed or commissioned employees). Their lender will help them complete a loan application and will pull their credit reports.
- FHA Loan Limits.
FHA loan limits range in 2019 from $314,827 to $726,525 for single-family homes (they are higher for two to four unit properties), and depend on the property location. Areas with higher housing costs have higher FHA limits, while those with lower costs have lower limits.
- FHA-Approved Condos.
Only units in condominium projects approved by FHA can be financed with FHA home loans.
- FHA Mortgage Rates.
FHA mortgage rates are not set by the government. The loans are approved and funded by private lenders which set their own interest rates and terms. It's up to FHA borrowers to compare offers from competing FHA lenders to find the best deal.
- Energy Efficient Mortgage (EEM).
The EEM allows homebuyers and homeowners to improve the energy efficiency of their homes. The EEM can also be added to other FHA loans including the 203(b) renovation loan. To qualify for financing, the proposed improvements must be cost effective — the savings must eventually offset the costs.
Alternatives to FHA Mortgages
The FHA program is not the only option for people with small down payments who want to buy homes. Here are other options you can explore.
Conventional Loans With 3 Percent Down
Both Fannie Mae and Freddie Mac offer 97 percent mortgages to eligible first-time homebuyers. Like FHA mortgages, these loans offer flexible underwriting guidelines. However, they have a few advantages over FHA loans:
The down payment is just 3 percent. There is no upfront mortgage insurance, and the annual premiums are lower. Borrowers can request mortgage insurance cancellation when the loan balance drops to 80 percent of the original home value.
Some home sellers are willing to finance their own properties. The buyer may be able to avoid FHA loan fees and other home buying costs like title insurance. Sellers may be more willing than mortgage lenders to overlook credit or income issues. However, buyers of owner-financed homes should have an appraisal done to avoid overpaying for the property. Inspections and title insurance are still a good idea for the buyer's protection, and it's wise to hire a real estate lawyer to review the loan terms. Individual sellers don't have to play by the same rules as licensed mortgage lenders, which means that borrowers have fewer protections.
USDA and VA Home Loans
FHA is not the only government mortgage program. VA and U.S. Dept. of Agriculture (USDA) home loans offer a number of advantages over FHA loans for those who are eligible. The U.S. Department of Veterans Affairs insures mortgages for eligible service members, veterans, and in some cases family members. These loans don't have down payment requirements, and borrowers don't have to pay monthly mortgage insurance. Often provided in rural areas, USDA loans allow qualified borrowers to get a mortgage without a down payment when they buy a home in an eligible area. About half of all U.S. citizens live in neighborhoods eligible for USDA loans. USDA mortgages have funding fees (2 percent), which can be financed, and require annual mortgage insurance, but the premiums are lower than FHA insurance.
FHA Loans Questions and Answers
Is an FHA loan really the best option for a first-time homebuyer?
The FHA mortgage was designed to meet the needs of homebuyers who have smaller down payments — it doesn't matter how many homes they have owned. A buyer with decent credit and a down payment of at least 10 percent is probably better off with a conventional (non-government) mortgage. A buyer with a smaller down payment might still be better off with a conventional loan — it really depends on the total package. Homebuyers should compare the total costs of conventional and FHA offers from competing lenders to make sure they are choosing the lowest-cost option that best meets their unique needs.
Are FHA loans cheaper?
It depends. Both FHA and conventional mortgage rates are set by private lenders, not the government. Costs and rates vary among mortgage lenders by an average of 0.25 to 0.50 percent. Rates and terms can change frequently. Mortgage insurance costs also change over time. Homebuyers with less than 20 percent down should compare both conventional and FHA loans when they shop for mortgages.
How do I know if an FHA loan is for me?
The very basic rule of thumb for FHA loans is that they are more appropriate for those with smaller down payments, lower credit scores, or higher debt-to-income ratios. There is no hard-and-fast rule because FHA home loans are made by private mortgage lenders, and they set their own rates and FHA loan fees. FHA lenders may also impose higher standards than the FHA requires — these standards are called overlays.
How hard is it to qualify for an FHA loan?
FHA mortgage underwriting is some of the most forgiving in the business. You need an acceptable credit history, which means no serious derogatory events in the most recent 12 months, a credit score above 579 (for a 96.5 percent loan), verifiable income that is ongoing, sufficient and stable, funds to cover the down payment and closing costs, and a debt-to-income ratio that doesn't exceed 43 percent.
Those are the basics. Applicants who exceed these minimum qualifications have a much better chance at loan approval, and those who barely meet guidelines may have to work harder to get a loan.
How long does it take to close on an FHA home loan?
Well-prepared applicants can usually close quickly if the applicant supplies the lender with a complete and accurate application, proof of income and asset documentation, and there are no credit or employment issues.
Most home loans (including FHA) are underwritten with automated underwriting systems (AUS), which deliver decisions in seconds. Those with less common circumstances including no reported credit history, cash (mattress money) down payments or identity theft must be underwritten manually, which can take longer. On average, home loans close in about 40 days. Experts recommend buyers get pre-approved before shopping for homes to make closing easier.
Is it harder to buy a house if I'm using an FHA loan?
Only if the seller's agent has an inaccurate view of FHA loans. Some think that FHA requires higher property standards and requires sellers to pay buyer's costs — not true. Others don't like the FHA Amendatory Clause, which allows buyers to cancel a purchase if the home does not appraise for at least the sales price. This is not an issue unless the property is overpriced. Some perceive FHA borrowers as borderline and harder to approve — an impression that can be overcome by getting loan approval before shopping for a home.
Is an FHA loan more expensive long-term?
One disadvantage of FHA home loans is that borrowers cannot drop FHA mortgage insurance coverage, even when the loan-to-value ratio drops below 80 percent. If a homebuyer keeps an FHA loan for an entire 30-year term, it could be expensive. However, typical homebuyers under 50 keep their houses between five and eight years, and many refinance sooner than that. Very few homeowners keep a mortgage for 30 years.
Why is my lender pushing me into an FHA loan?
The loan officer or mortgage broker doesn't earn more for selling an FHA loan (federal law prohibits basing compensation on loan terms). Chances are, he or she feels that it's the best loan for your situation, or the one most likely to result in approval. However, a good lender should be able to explain the reasoning behind a recommendation, and no one should feel pushed into a product. Ask your loan professional why he or she is positive about the FHA loan (instead of a conventional 97 percent loan, for instance) and see if that explanation makes sense to you. You should probably speak to more than one lender about your options and compare mortgage quotes from several before committing.
Where do I get started if I want to get an FHA loan?
First, you should obtain a few FHA mortgage quotes from competing lenders — by checking online, contacting companies by phone or visiting them in person. Next, get back to a couple of the lenders with the most competitive quotes and speak to the loan officers. This lets you judge the lender's service and make sure you qualify for its FHA program (individual lenders can add stricter requirements to FHA's basic underwriting restrictions, so it's good to ask about this upfront).
Finally, your loan pro should walk you through the application process — most lenders interview applicants, complete the forms online, submit the application electronically and have a decision in a few minutes. You'll then get a list of items needed to finalize the approval.
Do I have to be a U.S. citizen to get an FHA loan?
FHA loans are available to foreign nationals who are lawful permanent resident aliens or qualified non-resident aliens working in the U.S. Unlike many conventional programs, which require noncitizens to make down payments of 30 percent or more, FHA allows qualified buyers to put just 3.5 percent down.
Can I qualify for an FHA loan with bad credit?
That depends on how bad your credit is. The FHA insures loans for people with a bad credit history if it was not their fault, or if they have overcome their financial difficulties and re-established a positive credit history and an acceptable credit score. The FHA says:
The lender must document the analysis of delinquent accounts, including whether late payments were based on:
- A disregard for financial obligations.
- An inability to manage debt.
- Factors beyond the borrower's control.
*If a borrower's credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments and delinquent accounts, significant compensating factors, such as a higher down payment, will be necessary to approve the loan. *
Who should consider getting an FHA loan?
Those with smaller down payments, credit issues or higher debt-to-income ratios should probably include FHA when comparing mortgage programs. People who want to purchase a fixer-upper should look into the FHA 203(k) program, especially if they don't have a lot of money for repairs. Foreign nationals who don't want to make high down payments should also consider FHA loans. Finally, homebuyers who want an assumable loan should put FHA at the top of their lists.
Gina Pogol writes about mortgages and personal finance for several national publications. A licensed Nevada mortgage lender (#963502) with more than 20 years of experience, Gina loves teaching and empowering consumers.
About the Author
- Real Denial Rates. "A Better Way to Look at Who Is Receiving Mortgage Credit." Accessed July 23, 2020.